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{
"speaker": "Operator",
"content": "Good morning. My name is Daniel, and I will be your conference facilitator today. Welcome to T. Rowe Price's Second Quarter 2024 Earnings Conference Call. All participants will be in listen-only mode until the question-and-answer period. I will give you instructions on how to ask questions at that time. As a reminder, this call is being recorded and will be available for replay on T. Rowe Price's website shortly after the call concludes. I will now turn the call over to Linsley Carruth, T. Rowe Price's Director of Investor Relations."
},
{
"speaker": "Linsley Carruth",
"content": "Hello, and thank you for joining us today for our second quarter earnings call. The press release and a supplemental materials document can be found on our IR website at investors.troweprice.com. Today's call will last approximately 45 minutes. Our CEO and President, Rob Sharps, and CFO, Jen Dardis, will discuss the company's results for about 10 minutes. Then we'll open it up to your questions, at which time we'll be joined by Head of Global Investments, Eric Veiel. We ask that you limit it to one question per participant. I'd like to remind you that during the course of this call, we may make a number of forward-looking statements and reference certain non-GAAP financial measures. Please refer to the forward-looking statement language and the reconciliations to GAAP in the supplemental materials as well as in our press release and 10-Q. All investment performance references to peer groups on today's call are using Morningstar peer groups and are for the quarter that ended June 30, 2024. Now, I'll turn it over to Rob."
},
{
"speaker": "Rob Sharps",
"content": "Linsley, thank you and thank you all for joining us today. As we shared in our earnings release, we ended the quarter with just under $1.57 trillion in assets under management and $3.7 billion in net outflows. While market gains continued to support our financial results, I'm pleased to say that we are making steady progress in flows and investment performance. Our sales pipeline is healthy, redemption pressure is stabilizing, and our associates are driving our strategic initiatives forward. We continue to be on track to substantially reduce net outflows this year. Overall, our investment performance remained solid in the second quarter with two-thirds of our funds beating their peer group one-year medians and over 40% of our funds in the top quartile. In our equity franchise, US equity research, US mid-cap value, international value, financial services, integrated US small mid-cap core equity and integrated global equity are all top-quartile performers for the one-year, three-year and five-year time periods. The transparent equity ETFs we launched last year are demonstrating strong performance with the growth, value and small mid-cap ETFs, all top-quartile performers versus peers for the one-year time period. In our fixed income franchise, several of our muni funds as well as our institutional floating rate and credit opportunities funds have one-year, three-year and five-year top quartile performance. Both our flagship retirement funds and the newer retirement blend version of the strategy continued to deliver strong performance across multiple time periods. Returns across alternative strategies continued to be strong with alpha generated across the portfolios, primarily due to effective individual credit selection. Jen will discuss our flows and financials in more detail shortly, but I wanted to take a moment to highlight our ETF business. As of June 30, we reached $5.3 billion in assets under management, up from $1.2 billion in June 2023. In the first half of this year, we've had $2.4 billion of inflows to our ETFs. We are excited by this growth in our ETFs and that we are attracting diverse investors across wealth management, institutional, direct retail and investors outside the United States. We expect that the appetite for our ETFs will continue to grow throughout the year as five of our 16 ETFs, including US equity research and blue chip growth have each grown to over $300 million in assets, which is the size eligible for many platforms. Our transparent equity ETFs now have a one-year track record, a requirement for most platforms. We are broadening the product lineup, including the recently launched T. Rowe Price Intermediate Municipal Income ETF, which is our sixth fixed income ETF and our first federal tax-free fixed income ETF. And we are planning to make additional investment strategies available as ETFs over time. Our associates are driving this progress and it extends beyond our ETF business. I'll highlight a few recent milestones. We filed the launch of the T. Rowe Price OHA Flexible Credit Income Fund or OFLEX, our first interval fund. We were named a strategic partner to one of the largest independent broker-dealers in the United States, allowing us to bring our products and insights to their more than 10,000 financial advisors and their 2 million end clients. Our SMA franchise grew to more than $8 billion in assets as of June 30 with $1 billion in net flows year-to-date. After seeing strong demand for the ETF version of capital appreciation equity, we launched this strategy as an SMA. We unveiled our retirement income solutions 5D framework. This new patent-pending framework will help define the contribution plan sponsors evaluate retirement income offerings and quantify which solutions may best fit the needs and preferences of their planned participants. I'd like to finish by noting that I spent time in Europe, Asia and the Middle East in the second quarter. The constant across our offices is our associates' deep commitment to delivering results for our clients and to advancing our strategic initiatives. We are seeing their efforts reflected in our results, and I want to thank associates across all of our locations for their hard work to deliver value for our clients and our firm. I'll now turn to Jen for our financial results."
},
{
"speaker": "Jen Dardis",
"content": "Thank you, Rob, and hello, everyone. I'll review our second quarter results before opening the line for questions. Our adjusted earnings per share of $2.26 was up nearly 12% from Q2 2023, driven by higher operating income and a lower effective tax rate. As Rob mentioned, we reported $3.7 billion in Q2 net outflows. Results this quarter included a large fixed income win from an insurance client that funded in May. While these types of flows can be lumpy, we are pleased it's in a space where we've been building client relationships to help grow and diversify our business. We had net inflows in fixed income, multi-asset and alternatives this quarter. Within alternatives, net inflows were primarily driven by deployments across several private credit funds and from CLOs. Outflows remain concentrated in our equity products. However, we had several equity products with strong inflows, including our US equity research, US all cap opportunities and global focused growth strategies. Our target date franchise had another strong quarter with net inflows of $3.7 billion. In the first half of the year, we've recorded $10.5 billion in net inflows to target date strategies. During the quarter, we also saw positive net flows from clients outside the US. Looking at our income statement. Q2 adjusted net revenues were $1.8 billion, an 8.5% increase from Q2 2023, driven by higher average AUM. Compared with Q1 2024, adjusted net revenues were essentially flat as higher investment advisory fees were offset by a decline in accrued carried interest. Our annualized effective fee rate for Q2 2024 was 41.6 basis points, which is down from the prior quarter as client flows and transfers led to a mix shift in assets under management to lower fee products and asset classes. Investment advisory revenue of $1.6 billion included $16.8 million of performance-based fees, predominantly from certain alternatives products. Our Q2 adjusted operating expenses of $1.1 billion is up 7.8% from Q2 2023, due primarily to an increase in market-driven expenses, including a higher interim bonus accrual and distribution and servicing fees. This quarter also included an increase in advertising and promotional spend as we continue executing on the investment in our brand to support future growth and higher professional fees and travel and entertainment. Our adjusted operating income increased 9.8% from Q2 2023 to $655 million. We now expect 2024 adjusted operating expenses, excluding carried interest expense to be up 6% to 8% over the comparable full-year 2023 amount of $4.19 billion. The increase in the range is entirely due to the sustained rise in equity markets and the impact on our market-driven expenses. Additionally, we are tightening our prior tax rate guidance for the full year 2024. We now anticipate our non-GAAP effective tax rate will be in the range of 23.5% to 25.5%. Our long-term capital management philosophy remains unchanged. Returning capital to stockholders through the recurring dividend remains our top priority and our strong balance sheet provides ample liquidity to also fund our seed capital program, buybacks and select future M&A, should the opportunity arise. We remain opportunistic in our approach to buybacks and repurchased $112 million worth of shares during the second quarter, reducing shares outstanding to less than 223 million. Combined with our quarterly dividend of $1.24 per share, we have returned nearly $761 million to stockholders during the first half of the year. We continue to thoughtfully manage expenses while sustaining our core investment in our associates and delivering new capabilities to best serve our clients and expand in growth areas of the market. While we have more work to do, we are encouraged by the year-over-year improvement in overall flow trends, driven by the combination of a more positive market environment, improved investment performance and certain strategies leading to lower redemptions and increasing sales pipeline and our strategic initiatives yielding results. And now, I'll ask the operator to open the line for questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Our first question comes from Glenn Schorr with Evercore ISI. Your line is now open."
},
{
"speaker": "Glenn Schorr",
"content": "Hi, there. How are you? So a question on cash in retirement accounts and target date funds. I'm sure you've seen there's been heightened focus in the wealth management community in terms of what options and what people are getting paid on their cash. So I'm curious your thought process on how you handle it? Are there multiple options for clients or is this all client-driven? I'm just curious, you have obviously different business here and just want to see your approach. Thank you."
},
{
"speaker": "Rob Sharps",
"content": "Yeah, Glenn, this is Rob. I'll start. It's predominantly client-driven. In our individual investor business, clients have multiple options for money market funds. We don't have a big sweep business in the retirement plan services business, where we're the record keeper and also on other platforms, if the plan sponsor elects, we offer stable value as a short-duration option and a highly liquid option. And we also offer money market funds. So I think the issue that you're referring to is one that really doesn't touch us as much as it does many of the wealth platforms that have sweep approaches."
},
{
"speaker": "Operator",
"content": "Thank you. And our next question comes from Dan Fannon with Jefferies. Your line is now open."
},
{
"speaker": "Dan Fannon",
"content": "Thanks. Good morning. Rob, I was hoping you could just expand upon the sales pipeline that you've talked about. Clearly, flow is getting better. You had a large institutional fixed income win. But was hoping you could talk about the breadth, maybe, of the sales pipeline, some of the geographical differences. You had inflows outside the US. So just a little more granularity around, not so much the quarter, but the conversations in the prospective outlook around the sales and how that compares to previous periods."
},
{
"speaker": "Rob Sharps",
"content": "Yeah, maybe I'll zoom out a little bit and talk about flows broadly and then also talk about the pipeline. In terms of flows, I'm really pleased with the magnitude of improvement that we've had in the first half of the year. Our net outflows were $24 billion less in the first half of '24 than they were in '23. And I think we demonstrated in the second quarter, a lot of progress in really important areas. The target date flows were strong in the first half at $10.5 billion, which was better than last year's very strong $9.9 billion. That's also an area where, from a pipeline perspective, we continue to see strength. There's an element of seasonality to target date flows, but nonetheless, I really like what we're seeing, both in the flagship retirement date funds as well as with our blend offerings in retirement date. I think within alternatives, our fee basis AUM was up 11% year-over-year. But I think there's also a lot of interesting momentum in terms of new capital commitments and opportunities with OHA, whether it's in the wealth channel, as we steadily build momentum with OCREDIT, where we had $172 million [of flows] (ph) in the quarter, and continue to bring some new platforms on and are well placed to continue to build momentum there. To OLEND, which is a dedicated senior private lending facility, where there's been very strong interest. We had a first close this month and I think it also will continue to help us to show improved or accelerated growth in the alternatives area. As I noted in the prepared remarks, we had $2.4 billion of inflows year-to-date in our ETFs, with two-thirds of that in the second quarter. And I would expect the momentum there to continue to build given platform placements for several of our ETFs that either happen late in Q2 or are expected to happen in Q3. I see improvement broadly. Gross sales were up in most channels and most asset classes. We had net inflows in our Americas institutional business, in our EMEA business, and in our APAC business. I think if you look at the net sales pipeline, it does continue to improve broadly, across channels and most geographies. One element of that, though, is not just new business opportunity, I'd say it's a sharp decrease in at-risk assets corresponding largely to stronger investment performance in a lot of our well-distributed strategies. As you said, Q2 did benefit from a sizable insurance mandate. I think we have very strong positioning with scale buyers, whether it be in insurance, in retirement, in wealth, or OCIO, and I think that's likely to lead to additional large mandates down the road. In fact, we had six new wins of greater than $1 billion in the quarter, but these will be lumpy, and the one that came in in May was particularly outsized. So I'd say that combined with some seasonality would suggest to me that outflows are likely to be somewhat higher than the Q2 run rate in the third quarter and the fourth quarter, but still well below the levels that we saw last year. We're making meaningful progress, but I think we have more work to do to get to our goal of returning to positive flows at some point in calendar 2025. Hopefully, that answers the question, Dan."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Ken Worthington with JPMorgan. Your line is now open."
},
{
"speaker": "Ken Worthington",
"content": "Great. Good morning. Thanks for taking the question. I believe you said you're partnering with a new distribution broker. I think you said 10,000 representatives. A couple of questions here. Like first, can you talk about what this means? What do you expect to get from the relationship? What are the costs of partnering on this platform? And are there other larger distribution relationships that you aspire to work with that may actually be your partners in the not-so-distant future?"
},
{
"speaker": "Rob Sharps",
"content": "Yeah, Ken, we have partnership arrangements with most of the large wealth platforms in the US. Each of them is bespoke, and I'm not going to get into the particular terms. But needless to say, I think given our breadth of offering, our scale, our investment performance in brand, we've got a big opportunity as we've continued to build out our field coverage to further penetrate those accounts. We assess each of these individual opportunities standalone and kind of ultimately engage where we think there's a win-win and where it's mutually beneficial. This particular opportunity is a platform that we've worked with in the past, but this will give us additional shelf space and placement and additional opportunity to engage with their advisors, which should allow us to grow our share. It's a relationship where I think historically our share isn't what it could be. And I think this gives us the opportunity to meaningfully gain share over time. I'm optimistic about the impact of it, but again, this is one of many of these sorts of relationships. I think we simply called it out because it's a new one."
},
{
"speaker": "Ken Worthington",
"content": "Great. Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. And our next question comes from Patrick Davitt with Autonomous Research. Your line is now open."
},
{
"speaker": "Patrick Davitt",
"content": "Hey, good morning, everyone. Thank you. On the bond mandate, could you give us the actual size so we have a better idea of what the flows looks like without it? And you mentioned six new wins of $1 billion-plus. Should we take that to mean that those are still to fund or were those funded in the first half? Thank you."
},
{
"speaker": "Rob Sharps",
"content": "Specifically to the latter part of the question, they funded in the second quarter. Yeah. Again, I call that out partly just to say that I think we're really well positioned with buyers of scale and our pipeline would suggest that there are additional opportunities. But again, they'll be uneven. I'm not going to talk about the size of a particular mandate, but it was quite substantial. And I don't know, Jen, if we've said more about it."
},
{
"speaker": "Jen Dardis",
"content": "No, we haven't. I mean, I think you can get a sense by looking at our fixed income assets quarter over quarter and you can get a sense for general size."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Brian Bedell with Deutsche Bank. Your line is now open."
},
{
"speaker": "Brian Bedell",
"content": "Great, thanks. Good morning, folks. Thanks for taking my question. Maybe, Rob, if you can talk about the distribution channels that you think are most sensitive to the improved performance, where you may be able to more quickly leverage the performance improvement and in conjunction with that, the platforming of the equity ETFs and maybe just talk about the pipeline of adding new products there. And to what extent do you think these will be -- can be more bought products rather than sold products phase on online channels and whether that might be more sensitive to improve performance?"
},
{
"speaker": "Rob Sharps",
"content": "Sure. I think in general, look, all underlying investors are sensitive to performance, right? That's our value proposition as an active manager. But the cadence tends to happen differently in different channels. What I've observed is that in the -- our direct individual and in the wealth business, the reaction tends to happen a little bit more quickly. And in the institutional or large intermediary mandate channel, it tends to happen with more of a lag. I think we've observed in some of the areas where we had a performance challenge improvement in those areas that tend to leverage funds or commingled vehicles first and then subsequently, have started to see some improvement on the institutional or large mandate size. So if you think about institutional separate account, whether it's defined benefit mandate or defined contribution investment only, where it's on somebody else's recordkeeping platform or a big sub-advise mandate, those tend to react a little bit more slowly. So we first began to see improvement in the funds portion that tends to be leveraged in the wealth channel, and now we're beginning to see some improvement as well in the institutional channel."
},
{
"speaker": "Jen Dardis",
"content": "We've talked before about the fact that you'll see redemptions pick up when you have a performance cycle. You'll see redemptions pick up or sales slow first, then redemptions pick up, then you'll see redemption start to slow, and then you'll finally see sales start to pick up. I'd say on the redemption cycle, we're very far through seeing the improvement in redemptions, getting much closer to what are more traditional levels of redemptions in those products. I'd say on the sales cycle, we're much earlier in seeing the improvement in sales."
},
{
"speaker": "Rob Sharps",
"content": "Yeah. And then, with regard to ETFs and the pipeline, we launched, I think just recently our 16th ETF, which is intermediate muni bond ETF offering. We've got a handful of others that we're working on launching, and we'll continue to evaluate where there is a sizable opportunity and where we believe we can deliver a differentiated or compelling offering. It would be my intention to broaden the number of strategies that we offer as ETFs over time, but I think we'll do it in a thoughtful way. We want to do it kind of in areas that our clients value and where we can deliver something that's differentiated and durable."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Michael Cyprys with Morgan Stanley. Your line is now open."
},
{
"speaker": "Michael Cyprys",
"content": "Great, thank you. Maybe just continuing with the ETF topic here. You seem to be having some good traction and success there. Just want to drill down a little more. Hoping you could elaborate on your sales and distribution approach with ETFs. How that differs from your approach to sale of more traditional mutual funds for you? And then more broadly, if you could just comment on your strategy and approach, including the way that you are going to market with, in some cases, replications of what you already offer in mutual funds, versus opportunities with other strategies that are different from what you already have. How you think about that approach and navigate certain challenges in the marketplace that may or may not create. Thank you."
},
{
"speaker": "Eric Veiel",
"content": "Sure. This is Eric. I'll take a first cut at that one. In terms of how we go to market with our ETFs, it is, as Rob mentioned, we have 16 different strategies across asset classes. We have a specialist ETF capability where we have dedicated expertise from a sales perspective to support our field team as they're out talking to different parts of the USI or the US intermediary channel, across the wealth advisors specifically, but also to target parts of the market where historically we haven't done as much because prior to the last several years, we didn't have much of an ETF offering. So there are dedicated advisors out there who solely use ETFs and we've been working to discover those advisors and reach out to them with our capabilities. That's coincided with increased interest in active ETFs from a market perspective, and we've benefited from our capabilities as an active manager and the brand that we have in building out our presence there. I think there's plenty more to do, and we're still in, what I would say, the early stages of identifying and penetrating that unique market opportunity. In terms of the second part of your question, where we offer clones or similar clones to our existing strategies, as well as new capabilities, we want to be able to bring, as Rob said before, our full set of investment capabilities to our clients. We started with the semitransparent active equity ETF suite because that is what we were well known for, strategies that we believed that the market would embrace. And they did, up to a point. We then wanted to make sure that we were able to bring new capabilities, using our research platform to offer strategies that brought even more capabilities across the ETF suite, meaning, full transparency, maximized tax efficiency into that market. And we were able to do that also then to get into categories that we weren't able to do before with semitransparent, specifically the international area where the semitransparent doesn't allow you to do some of the holdings. So that allowed us to broaden our suite out."
},
{
"speaker": "Rob Sharps",
"content": "Yeah, I'd just add that we find that there are certain clients that really value the clone, semitransparent approach because they're able to access known strategy with long tenure track record in the ETF vehicle. I think there are other clients that are much more familiar and comfortable with the fully transparent approach. And I think we are now in a place where we are comfortable delivering a range of investment strategies across both approaches and feel both approaches have merit."
},
{
"speaker": "Jen Dardis",
"content": "And I think back to the earlier point of those relationships with larger platforms and clients, we use those relationships to help inform where people have gaps. I mean, we want to understand where things can get placement as early as possible. Because I think you've seen with a number of offerings in market. It's really important to try to get those scaled strategies -- those strategies scaled as quickly as you possibly can to make sure that they can cut through the noise. And so our focus has really been on both getting those products launched, but also getting them above those important sort of $100 million to $200 million asset ranges."
},
{
"speaker": "Rob Sharps",
"content": "I'd say I've been pleased and maybe a little surprised at the range of investors that the ETFs have appealed to. As Eric said, we're targeting a number of RIAs that are ETF power users, as well as more traditional wealth platforms and broker-dealers. And we've got some interesting placements that I think kind of really present a big opportunity. But we've also had some institutional investors, some investors based outside the US that have been attracted to the ETF vehicle. So I think it's encouraging. It's still relatively small in the context of our overall AUM base, but I think it's a huge and compelling opportunity for us, and it's one we're really leaning into."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Brennan Hawken with UBS. Your line is now open."
},
{
"speaker": "Brennan Hawken",
"content": "Good morning. Thanks for taking my question. I actually have a request and then a question. So one thing just to consider, many of your peers provide an adjusted income statement, which really would reduce the potential for misunderstandings and errors around interpreting your results. And I'd like to just please ask you to request putting that together because of the way the disclosure now is a little -- I'm worried it could lead to some confusion. My question is on OCREDIT. So we hear it's a bit of a me too product and given that it came after some firmly established products in the marketplace. I'd love to hear you lay out for me the case for how it's differentiated from established offerings such as BCRED and maybe how you're explaining that differentiation to your distribution partners. Thanks."
},
{
"speaker": "Rob Sharps",
"content": "Yeah. I think it's differentiated in a handful of ways. Look, it is a competitive marketplace and there are a number of established offerings. I think our approach is compelling, one, because we bring OHA's 30-year track record to delivering private credit strategies. Two, we bring T. Rowe Price's relationships with the wealth platforms and our relationships in the field. If you think about our regional investment consultants, they work with a lot of brokers and advisors that may not have used alternatives or a BDC in the past. And when I engage with the big wealth platforms, one of their key objectives is to broaden the penetration of alternatives within their advisor and client base. So I think what's differentiated about our approach is we can use the depth of our relationships in the field to help them further penetrate their base with a product that is being managed by a team that has a very compelling standout track record in running private credit strategies. So I do think that it is difficult to stand out, particularly in an environment where credit defaults have been extraordinarily low from an investment performance perspective. And I think it's fair to say that you really have to work hard to differentiate and get attention. I think there's a tremendous amount of power in the combination of T. Rowe Price's presence and relationships in the wealth channel, particularly with advisors that might this -- where this might be a first experience or a first opportunity to engage in alternatives. So that's the approach and the part of the market that we're really starting to attack. I think this is a first offering. We're also working on OFLEX, which is an interval fund. We're taking feedback from the wealth platforms on where there is interest and where something might be more differentiated or more attractive and I think are hopeful that as we roll those out and build those relationships that we'll be able to leverage them and establish more momentum going forward."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Our next question comes from Alexander Blostein with Goldman Sachs. Your line is now open."
},
{
"speaker": "Alexander Blostein",
"content": "Hey, Rob. Hey, good morning everybody. Question for you guys on the fee rates. It looks like the pace of fee rate compression picked up a little bit sequentially and I know you talked about both kind of the mix of flows and just some of the transfer. So can you help kind of go through that a little more? And as you think about the difference in the fee rates among some of the larger kind of transfer buckets, what does that stand today and how do you expect that to evolve over the next couple of quarters?"
},
{
"speaker": "Jen Dardis",
"content": "Yeah, thanks Alex. I'll start. We've said that over time we see fee compression of about 1% to 1.5%. That's what we've seen over the past several years. Quarter-to-quarter you can see some noise. And so in any given quarter, we can see the impact of clients choosing lower fee products, which could be vehicles or asset classes or individual strategies. You can also see periodically we'll do some realignments of clients into vehicles, so that'll be existing clients moving from one vehicle to another, and that can create kind of more noise in a specific quarter. We saw both of that during this quarter. And again, so I think over a longer period of time we've seen that continued trend, but this particular quarter you saw both of those things."
},
{
"speaker": "Rob Sharps",
"content": "Yeah, Alex, as Jen said, a lot of factors impact the fee rate, asset class mix, vehicle mix, performance fees, each of those can move around a lot in any one quarter. So I wouldn't read too much into a quarter’s results favorable or unfavorable. We want to continue to share some of the benefits of scale with our clients and invest in our value proposition and hope to win sizable new mandates, growing fixed income, growing some other lower fee areas including integrated equity and with our blend RDF strategy. So -- and the arithmetic is that success in those areas will pressure the fee rate, but it's still very good business. I would say that as we grow in alternatives, there should be some offset. And I think the net result is that we're likely to see kind of fee compression very consistent if you look over multiple quarters with what we've navigated in the past."
},
{
"speaker": "Operator",
"content": "Thank you. And our final question comes from Bill Katz with TD Cowen. Your line is now open."
},
{
"speaker": "Bill Katz",
"content": "Okay, thank you very much for taking the question and also thank you for the abbreviated opening remarks. I hope that's a trend for your peers. In terms of just a clarifying question, you mentioned that you expect seasonally a second half pick up in redemptions. Just wondering if you could sort of highlight the reason for that. But the broader question I have is, as you think about some of the changes that are happening in the competitive landscape, whether it be on the traditional side or more opportunity on the alternative side, where I think the greater focus is, how are you thinking about the sort of attacking that on a de novo basis and to alignments like KKR and Capital Group maybe shift your thinking about how to accelerate that opportunity? Thank you."
},
{
"speaker": "Jen Dardis",
"content": "Well, I think, starting with the redemptions question, I think seasonally we look at our flows and so it's both sales and redemptions and I think Rob had specifically referenced earlier the target date franchise. There it's less about redemptions, and it's more about the pace of sales and the pipeline that we see in the second half of the year. We've talked in the past about it's not fully seasonal, it's not that everything happens in the first quarter of the year, but you do see more activity in the first quarter of the year. You can see plan size changes in just smaller amounts through the balance of the year. I think -- yes?"
},
{
"speaker": "Rob Sharps",
"content": "Bill, I think what I was trying to get across isn't that I expect redemptions to pick up in the back half of the year. It's that, if you think about net flows, it’s gross sales and redemptions. And gross sales in the second quarter were inflated by a lumpy sizable mandate. So I wouldn't take the Q2 net flow rate and annualize it in the back half of the year. That's all I was really trying to say. We actually see a trend of redemption pressure easing in some of the places where we had some performance struggles at this point over a year and a half ago. So, again, I'm encouraged both on the gross sales side and the redemption side with regard to the outlook, but there is a little bit of seasonality in the gross sales side of the target date fund business. And we did have the benefit of that sizeable insurance mandate that funded in May. So that’s really only point that I was making there. I think we're well positioned whether it's across multi-asset with retirement date fund, we've got a big opportunity to grow outside of the United States, we've got a big opportunity to grow in fixed income, we've got a big opportunity to grow in ETFs, and we've got a big opportunity with OHA. I think there are more things that we can do in alternatives. And I think there are instances where we might be open to partnering, but only where I believe it would make sense. There are things that we can do de novo that we can develop organically and we'll continue to evaluate doing additional acquisitions like OHA. There might be instances where there's an offering that we choose not to be the manager for and to marry as part of a multi-asset offering or otherwise. But I think my preferred approach would be to kind of ultimately have our distribution focus on selling T. Rowe Price or T. Rowe Price controlled strategies. I think it makes things cleaner and simpler than having two investment teams coordinate, delivering a strategy. And obviously it gives us a little bit more control over the caliber of outcome that we deliver on behalf of our clients."
},
{
"speaker": "Operator",
"content": "Thank you. This concludes the question-and-answer session and today's conference call. Thank you for participating. You may now disconnect."
}
] |
trow | 2,024 | 1 | [
{
"speaker": "Operator",
"content": "Good morning. My name is Norma, and I will be your conference facilitator today. Welcome to T. Rowe Price's First Quarter 2024 Earnings Conference Call. [Operator Instructions] As a reminder, this call is being recorded and will be available for replay on T. Rowe Price's website shortly after the call concludes."
},
{
"speaker": "",
"content": "I will now turn the call over to Linsley Carruth, T. Rowe Price's Director of Investor Relations. Please go ahead."
},
{
"speaker": "Linsley Carruth",
"content": "Hello, and thank you for joining us today for our first quarter earnings call. The press release and the supplemental materials document can be found on our IR website at investors.troweprice.com."
},
{
"speaker": "",
"content": "Today's call will last approximately 45 minutes. Our CEO and President, Rob Sharps; CFO, Jen Dardis, and Head of Global Distribution, Dee Sawyer, will discuss the company's results for about 20 minutes. Then we'll open it up to your questions, at which time we'll be joined by Head of Global Investments, Eric Veiel. We ask that you limit it to 1 question per participant."
},
{
"speaker": "",
"content": "I'd like to remind you that during the course of this call, we may make a number of forward-looking statements and reference certain non-GAAP financial measures. Please refer to the forward-looking statement language and the reconciliations to GAAP in the supplemental materials as well as in our press release and 10-Q. All investment performance references to peer groups on today's call are using Morningstar peer groups."
},
{
"speaker": "",
"content": "Now I'll turn it over to Rob."
},
{
"speaker": "Robert Sharps",
"content": "Linsley, thank you. And thank you all for joining us this morning for our first quarter update. Before I get started, I'm pleased to say that Dee Sawyer, our Head of Global Distribution and a member of our firm's Management Committee, will be joining us today. Dee will provide an overview of our Retirement business, which is critical to our clients and integral to our firm's long-term success. We'll hear from Dee after Jen's update on our financial results."
},
{
"speaker": "",
"content": "With that, I'll turn to first quarter performance. Tailwinds from stronger-than-anticipated markets drove assets under management up in the first quarter, bringing our total assets under management to $1.54 trillion as of March 31, a 15% increase over the first quarter of 2023."
},
{
"speaker": "",
"content": "Our first quarter net outflows of $8 billion were about half the level we had in the first quarter of last year. This improvement came from increased client demand driving higher sales and stronger investment performance reducing redemptions, particularly in U.S. equity."
},
{
"speaker": "",
"content": "As I said on last quarter's call, we expect to see net outflows in 2024, but anticipate substantial improvement compared to last year. However, this improvement will not be linear. It's important to understand that monthly flows can be heavily impacted by client activity, including rebalancing, new mandates and terminations."
},
{
"speaker": "",
"content": "So far in the second quarter, net flows are shaping up to be weaker in April, in part due to rebalancing in a handful of large clients. However, at this point, our pipeline suggests the balance of the quarter will be stronger."
},
{
"speaker": "",
"content": "Investment performance was solid in the first quarter, with 65% of our funds beating their peer group 1-year medians."
},
{
"speaker": "",
"content": "I'd like to mention a few other performance highlights. Our capital appreciation, U.S. equity research, mid-cap value and financial services funds all had top quartile performance versus peers for the 1-, 3- and 5-year time periods. Our integrated U.S. Small Cap Core and integrated global equity funds, which combine our fundamental and systematic processes were also top quartile performers for these time periods."
},
{
"speaker": "",
"content": "And in our multi-asset range, our nearer dated retirement funds, the 2005 to 2035 vintages as well as our managed payout fund, retirement income 2020 are all top quartile performers for the 1-, 3- and 5-year periods. All vintages of our more recently launched retirement blend funds are top quartile performers for the 1-year period."
},
{
"speaker": "",
"content": "Over 50% of our fixed income funds beat their peer group medians for the 1-, 3- and 5-year time periods, and several of our fixed income Muni Funds as well as our global multi-sector bond, credit opportunities and U.S. dollar-hedged international bond funds are in the top third of their peer groups for these same periods."
},
{
"speaker": "",
"content": "Investment performance across the alternatives platform in the first quarter was generally strong. Private credit, Structured products and liquid portfolios generated attractive returns driven by strong credit selection and favorable market dynamics."
},
{
"speaker": "",
"content": "Before I turn it over to Jen, I want to acknowledge our associates. We reached important milestones in the first quarter, thanks to their hard work and commitment to our clients, including our capital appreciation equity ETF surpassed $1 billion in assets under management, less than a year after its launch last June."
},
{
"speaker": "",
"content": "Across a number of channels, we are seeing sales momentum with significant year-over-year gross sales improvement with our wealth and individual investor clients."
},
{
"speaker": "",
"content": "Earlier this month, OCREDIT launched on its first major wire house, demonstrating the close partnership of T. Rowe Price and OHA in successfully launching our first BDC with a key strategic partner in the wealth management channel."
},
{
"speaker": "",
"content": "We retained our #2 position among the over 330 asset managers nominated in Institutional Investors 2024 ranking of America's top asset management firms. This distinction reflects the value of our corporate access model and the importance of our differentiated research capabilities."
},
{
"speaker": "",
"content": "And for the 14th consecutive year, the firm was named one of Fortune Magazine's World's Most Admired Companies. I'm proud of these accomplishments, and I'm grateful to our associates around the globe, who continue to put our clients first in everything they do."
},
{
"speaker": "",
"content": "With that, Jen will now provide an overview of our first quarter results."
},
{
"speaker": "Jen Dardis",
"content": "Thank you, Rob, and hello, everyone. I'll review our first quarter results before turning to Dee for a look at our Retirement business."
},
{
"speaker": "",
"content": "Our adjusted earnings per share of $2.38 for Q1 2024 was up 40% from Q1 2023, driven by higher average AUM and investment advisory revenue and offset marginally by higher expenses."
},
{
"speaker": "",
"content": "As Rob mentioned, we had $8 billion in net outflows for the quarter. Across asset classes, outflows were concentrated in U.S. equity, particularly large and mid-cap growth strategies. However, it's important to note that this quarter's U.S. equity outflows were less than half the level in the first quarter of last year, a meaningful improvement driven by higher sales and lower redemption rates, and consistent with improved investment performance."
},
{
"speaker": "",
"content": "There were a few notable areas of strength within the equity franchise, including U.S. structured research and U.S. smaller companies, both of which had strong flows to the CCAP product from EMEA-based clients."
},
{
"speaker": "",
"content": "In fixed income, strong investment-grade flows in the institutional channel were offset by continued outflows from stable value in the DC channel."
},
{
"speaker": "",
"content": "Our target date franchise was positive for the quarter, with inflows of $6.8 billion, offset in part by outflows from other multi-asset products. And finally, we had just under $1 billion of outflows in alternatives from manager-driven distribution. However, we are encouraged by recent trends in fundraising and expect capital raising to increase through the year."
},
{
"speaker": "",
"content": "Turning to our income statement. Q1 adjusted net revenues were $1.8 billion, a nearly 14% increase from Q1 of last year, driven by higher average AUM. Our investment advisory revenue of $1.6 billion included $17.6 million in performance-based fees, predominantly from 2 of our U.S. equity strategies. These performance-based fees had a 0.5 basis point impact on our effective fee rate of 42.1 basis points."
},
{
"speaker": "",
"content": "Our Q1 adjusted operating expenses were $1.1 billion, which is up almost 5% over last year from market-driven expenses, including the interim bonus accrual and distribution and servicing costs. Expense growth was tempered by the cost savings efforts we announced last summer. Our adjusted operating expenses were down nearly 7% from Q4 2023, due to the Q4 seasonality in stock-based compensation, professional fees and advertising and promotion expenses."
},
{
"speaker": "",
"content": "Adjusted operating income increased 31% from Q1 2023 to $692 million. This brings our rolling 12-month adjusted operating margin to 36%, up from 35% a year ago."
},
{
"speaker": "",
"content": "Given the rise in equity markets over the last few months and related impact on our market-driven expenses, which, as a reminder, is about 1/3 of our expense base, we now expect 2024 adjusted operating expenses, excluding carried interest expense, to be up 5% to 7% over 2023's $4.19 billion."
},
{
"speaker": "",
"content": "Maintaining a strong cash position and distributing capital back to our stockholders remains a priority. We bought back $80 million worth of shares during the first quarter, reducing the shares outstanding to 223.5 million as of March 31, and have continued to buy back in April. Combined with our quarterly dividend of $1.24 per share, we returned $365 million in the first quarter."
},
{
"speaker": "",
"content": "With $2.9 billion of cash and discretionary investments on our balance sheet, we have ample liquidity to support the recurring dividend, continue opportunistic buybacks and if they were to arise, to pursue select M&A opportunities to add capabilities to our business."
},
{
"speaker": "",
"content": "We continue to manage the business with a long-term lens, balancing the investment in our strategic initiatives to drive growth over time with the need for ongoing expense discipline. From this position, we can continue delivering exceptional value for our clients by decking resources against new opportunities and added capabilities, while also identifying process improvements and driving efficiency."
},
{
"speaker": "",
"content": "And now I'll turn it over to Dee."
},
{
"speaker": "Dorothy Sawyer",
"content": "Thank you, Jen. I am pleased to join today's call to talk about our Retirement business. As Rob noted, our clients have entrusted us with $1.54 trillion in assets. Of that, over $1 trillion, more than 2/3, are identifiable as retirement assets, demonstrating that retirement is a critical component of our business. Slides 15 and 16 in the supplemental deck provide a detailed view of our retirement assets."
},
{
"speaker": "",
"content": "I want to take a moment to share a few highlights. First, the majority of our retirement assets, $676 billion or 65% are in U.S. defined contribution plans, with the balance in defined benefit and individual IRA accounts."
},
{
"speaker": "",
"content": "Taking a closer look at our U.S. defined contribution assets, 395 billion or almost 60% are in our Target Date franchise. In fact, we are the top manager of active Target Date assets, a position we have held for 7 years, and we have the third largest market share overall."
},
{
"speaker": "",
"content": "But our DC business is more than Target Date. Plan sponsors select T. Rowe Price for equity and fixed income investment options as well, with U.S. large cap growth equity and stable value being the largest proportion of the balance of our DC business."
},
{
"speaker": "",
"content": "We serve the DC channel in 2 ways. The majority of our DC assets are DC investment-only or DCIO, where the consultant adviser or plan sponsor selects T. Rowe Price to provide one or more of the investment options in their plan that is a record kept on an external platform. We are the fifth largest DCIO provider in the U.S."
},
{
"speaker": "",
"content": "About 1/4 of our DC assets are in our full-service record-keeping business, which we refer to as retirement plan services or RPS. Plan sponsors hire us to provide record-keeping services as well as key investment options for their plan lineup. As of the end of 2023, we provided these services for over 8,100 retirement plans."
},
{
"speaker": "",
"content": "About 60% of all of our RPS assets under administration are invested in T. Rowe Price products, which has been consistent over the past several years and is a significantly higher portion of proprietary assets than the industry average of 27%."
},
{
"speaker": "",
"content": "We provide solutions for a wide variety of clients, including our broad array of equity and fixed income strategies and our market-leading Target Date franchise. These are offered through a range of funds, common trust and custom solutions."
},
{
"speaker": "",
"content": "Within our Target Date franchise, we offer higher and lower equity glide path and approaches that include both active and passive building blocks. And our solutions extend to not only investment products, but also to tools and services to help clients, plan sponsors and participants manage their retirement accounts, track progress along their retirement journey and help improve their overall financial wellness."
},
{
"speaker": "",
"content": "Through our record-keeping business as well as our individual investors channel, we have direct retirement account relationships with over 3.2 million end investors. The insights we derive from these relationships, coupled with the emerging trends we identify from our work with plan sponsors and intermediaries, enhance our ability to design innovative solutions and research to pursue better retirement outcomes."
},
{
"speaker": "",
"content": "As a generation of retirement savers have aged and shifted from the accumulation phase to the decumulation phase, developing solutions to help people convert their retirement assets into income has become increasingly important."
},
{
"speaker": "",
"content": "Our proprietary research suggests that participants will need a variety of retirement income products and services to meet their individual needs in the decumulation phase. So we take a broad approach to retirement income. That means stand-alone retirement income products such as our managed payout products, single strategy investment products such as fixed income funds, along with the various services we offer, including guidance, retirement thought leadership and calculators are all included within our definition of retirement income."
},
{
"speaker": "",
"content": "Our broad distribution organization allows us to access all retirement client segments, whether direct to the consumer or through intermediaries, institutions, consultants or advisers."
},
{
"speaker": "",
"content": "We also have been adapting the expertise we have honed in the U.S. retirement market to pursue opportunities in the large retirement savings market in other countries. This access, along with directly managing end investor relationships, uniquely positions us to anticipate and deliver what our clients need. And as a result, we are continuously innovating and adding new capability."
},
{
"speaker": "",
"content": "A few examples include our managed payout products, an all-in-one solution for retirees, which offers the familiarity of our Target Date product, with the benefit of providing stable monthly income throughout retirement. We added a 2025 version of these funds in January."
},
{
"speaker": "",
"content": "The recently launched social security optimizer tool, which is designed to help individual investors and participants maximize social security benefits, which are a critical part of the retirement income equation for many favors. This is an early example of the impact of last year's Retiree Inc. acquisition."
},
{
"speaker": "",
"content": "And the retirement advisory service, which offers ongoing access to advisers and personalized financial planning. The financial plans include tax aware retirement income planning and actively managed portfolios led by the expertise of our multi-asset investment professionals."
},
{
"speaker": "",
"content": "We are excited we will be launching our new personalized retirement manager in the third quarter. This is an evolution of our robust Target Date offerings, driven by a highly customized approach. We plan to deliver a dynamic personal glide path for each participant by using plan level data, additional factors provided by participants and analyzing their portfolio through a monthly multifactor assessment."
},
{
"speaker": "",
"content": "And in the fourth quarter, we plan to launch a managed lifetime income solution that will allow participants to combine a managed payout strategy with a qualified longevity annuity contract or QLAC. The product is designed to enable a consistent income stream in retirement, while guaranteeing a minimal level of income for life after a defined age."
},
{
"speaker": "",
"content": "It is also important to mention that the breadth of our retirement platform enables us to develop industry-leading thought leadership and research on key retirement topics. We leverage both to build client relationships, advance our position as a retirement leader and enable clients and participants to pursue better retirement outcomes."
},
{
"speaker": "",
"content": "I will close by saying that the leadership team and our associates are deeply committed to helping our clients confidently prepare for, pay for and live in retirement. We are grateful for their trust in us, and we will continue to use our expertise to drive capabilities and solutions that meet their evolving needs."
},
{
"speaker": "",
"content": "With that, I'll ask the operator to open the line for questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Our first question comes from the line of Craig Siegenthaler with Bank of America."
},
{
"speaker": "Craig Siegenthaler",
"content": "Given that Dee is joining us, I do have a retirement question for her. If alternative investments enter the retirement channel, is it more likely through single investment elections or inside of a Target Date fund? And given that T. Rowe's ownership now includes OHA, is there potential for alts inside of a T. Rowe Target Date fund anytime soon, because we understand price may be one headwind with DC plan sponsors."
},
{
"speaker": "Dorothy Sawyer",
"content": "With regard to alternatives, this is an area we have been actively researching. Given preferences and regulatory guidance, there are some complexity around adding alternatives within a 401(k) plan such as the daily NAV. However, if we were to introduce alternatives for our Target Date strategy, we could act quickly with Target Date solutions, including T. Rowe price solutions or OHA solutions or others because we have a long list of partners that would be able to work with us in order to do that."
},
{
"speaker": "",
"content": "In regards to the specifics, we would likely offer that in a custom solution with a plan sponsor, and we have the benefit to be able to work with many plan sponsors, who are asking us around how can we continue to advance solutions."
},
{
"speaker": "",
"content": "Certainly, we could offer this also in a stand-alone parallel solution, and that would be another way that we could bring this to market when and if it makes sense."
},
{
"speaker": "Robert Sharps",
"content": "Yes, Craig, this is Rob. I'll just add a few things. One, it's a priority for us to continue to evolve and improve our Target Date offering. And this is an area that we've given a lot of thought to."
},
{
"speaker": "",
"content": "My first observation is that we've seen very limited interest from plan sponsors in incorporating alternatives into defined contribution lineup, either as a stand-alone investment offering or as part of target date funds. And as Dee mentioned, there are some limitations around accommodation of the record-keeping system daily liquidity, daily pricing, those sorts of things. There's also a tremendous amount of fee sensitivity in the defined contribution marketplace and alternatives naturally have higher fees."
},
{
"speaker": "",
"content": "Where we have seen interest and where we've engaged are primarily in custom target dates that are designed by corporate clients, usually where they have a defined benefit plan, and they have an investment staff and an existing roster of alternative investment managers. So it's something that we're paying a lot of attention to. We're engaging with our plan sponsor clients and listening to what they want. But so far, there's been really very little adoption or interest in alternatives in defined contribution."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Michael Cyprys with Morgan Stanley."
},
{
"speaker": "Michael Cyprys",
"content": "Maybe just sticking with the retirement theme. I was hoping to double click on decumulation. Just hoping you could talk a little bit more about the opportunity set that you see for decumulation products. What product structures, in particular, do you think have the biggest opportunity as you look out over the next 10 years?"
},
{
"speaker": "",
"content": "And with the products you have so far, just curious what traction you're seeing and with the new managed lifetime income solution that you're slated to launch later this year, just curious what ultimately you think will be the most successful way to approach that from a distribution standpoint to win as you think about the channels and go-to-market strategy?"
},
{
"speaker": "Dorothy Sawyer",
"content": "Great. Thank you so much for the question. I'll start us off. So first, I think I would highlight the breadth of our retirement platform, which gives us access to plan sponsors, intermediaries and participants. And this is really important because it allows us to really understand what types of retirement income solutions are critical for the varying types of participant needs in the decumulation phase."
},
{
"speaker": "",
"content": "What our research indicates is that these needs and preferences are diverse, and our perspective is that there will not be a one-size-fits-all solution for retirement income."
},
{
"speaker": "",
"content": "As you noted, we currently offer managed payout solutions, and we do have nearly 60 retirement plans that are using those solutions, which represents approximately 20% of our AUA in terms of overall coverage."
},
{
"speaker": "",
"content": "Our payout solutions, our retirement income 2020 solution has been launched 7 years ago, and then we extended that to offer it through our retirement plan services solution."
},
{
"speaker": "",
"content": "As you noted, we are working on a retirement insured solution, which we're calling Managed Lifetime Income product. This will be a collective investment trust vehicle, and we're planning to launch that in the fourth quarter of this year."
},
{
"speaker": "",
"content": "We also are planning to launch, as I mentioned earlier, personalized retirement manager, which is also a way to extend, as time goes by, into retirement income as well. This is a managed account program that we're excited about launching, and it will be introduced in the third quarter of this year."
},
{
"speaker": "",
"content": "So long-winded way, perhaps of saying that we do believe that it's really important to offer a variety of types of solutions in order to meet the different types of needs, and that's what we found by working with participants, individual investors, plan sponsors as well as advisers."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Dan Fannon with Jefferies."
},
{
"speaker": "Daniel Fannon",
"content": "Rob, I was hoping you could provide additional context around the trends you discussed of better gross sales as well as lower redemptions. It seems like April here is a bit more mixed. But can you talk to maybe the difference in the channels and/or geographies where you're seeing the biggest improvements versus what we saw last year?"
},
{
"speaker": "Robert Sharps",
"content": "Yes. Dan, thanks for the question. At a high level, I would say that our outlook for flows for the year really hasn't changed from what we discussed in January on the fourth quarter call. Although I would say that we have higher conviction now that our outflows this year will be substantially lower than they were last year."
},
{
"speaker": "",
"content": "As I've talked about in the past, I think investment performance is a good leading indicator and continue to be pleased with what we're seeing, particularly in U.S. equity. Performance in U.S. large cap growth is clearly having an impact. We've seen redemption rates there normalize. And we've begun to see the beginnings of a recovery in gross sales in that suite."
},
{
"speaker": "",
"content": "Obviously, outflows in Q1 being half of last year's level is an encouraging data point. I'm encouraged that the retirement date fund flows remain strong, just shy of $7 billion in Q1. I'd say our ETF momentum, Dan, is building, it's small, but growing to a point where it is having an impact."
},
{
"speaker": "",
"content": "And I would just say our pipeline is healthier in general. With improved performance, we have less AUM marked as at risk. We have more in the way of notified unfunded wins, fewer notified terminations, and there's just more activity around new opportunities."
},
{
"speaker": "",
"content": "At OHA, I think the capital raising pipeline there is going well, and ultimately that will convert to growth in fee basis, AUM and flows."
},
{
"speaker": "",
"content": "With regard to channels, we actually had modest positive inflows in 3 of our channels in Q1. And even in the areas where we remain with outflows, we did see less in redemptions and improving gross sales."
},
{
"speaker": "",
"content": "Look, flows are extraordinarily hard to predict. As I noted in the prepared remarks, we did have some rebalancing impact in April that was very short notification and went against us. That easily could have gone the other way. I mean ultimately, there are instances where you have really compelling performance or you manage an asset class that has outsized performance, and the underlying clients need to target back -- or rebalance back to their target allocation."
},
{
"speaker": "",
"content": "So those sorts of flows are part of the business. I think that is -- it makes me much less concerned than when we're losing mandates or being terminated."
},
{
"speaker": "",
"content": "The last thing I would say with regard to flows is that the industry backdrop really seemed to be firming in the first part of the year really through Q1, and it has been softer in April from the high-frequency data that we get. So I think we'll just have to watch with regard to whether that's a blip or kind of whether it's the beginning of a period of softer underlying flows broadly."
},
{
"speaker": "",
"content": "But ultimately, there are a lot of things that I see that are encouraging that will allow us to, as I said, kind of have substantially less in the way of outflows throughout the course of the year, even if it isn't linear improvement."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Patrick Davitt with Autonomous Research."
},
{
"speaker": "Patrick Davitt",
"content": "My question is on the expense guide. Are you factoring in the full 1Q AUM mark to that? Or did you discount it a bit given the Q-to-date beta quite negative?"
},
{
"speaker": "Jen Dardis",
"content": "Yes. Thanks, Patrick. We -- similar to last quarter, we used first quarter average as an estimate for our expense growth guide, and we try to give a range around reasonable assumptions for market movement from that average in our percentage guide. And as you noted, we've had some decrease in markets in the first start of the -- in the start of April in the quarter, but that puts us back around the place we started from an average perspective."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Brian Bedell with Deutsche Bank."
},
{
"speaker": "Brian Bedell",
"content": "Maybe just to go back to the retirement business. Can you talk a little bit about how you viewed the DCIO segment versus the full-service record-keeping segment in terms of economics to T. Rowe Price? I know full service is more costly, can be lower margin, but you, I think, have a better ability to capture IRA rollovers there. So if you can talk about that dynamic."
},
{
"speaker": "",
"content": "And then as you evolve your solutions, do you have more flexibility to do that with the record-keeping plans, hence that makes that segment more attractive than DCIO from that standpoint?"
},
{
"speaker": "Dorothy Sawyer",
"content": "Sure. So thanks for the question. Let me offer a couple of points. So the first point that I would offer is when you look at our U.S. defined contribution assets under management, roughly 75% of those defined contribution assets are our DCIO channel. And so we feel really strongly about the fact that we continue to offer solutions across many different types of record-keepers and through many different types of accounts in that DCIO channel, and that's through hard work with partners on the intermediary side of our business."
},
{
"speaker": "",
"content": "With specifically about our retirement services business, we feel really good about that business in the fact of 2 things. So number one, as I mentioned in my earlier remarks, in the fact that 60% of that business overall is in proprietary products, and that's unique for T. Rowe Price."
},
{
"speaker": "",
"content": "The second thing about that retirement business is we do also have an individual investor channel where a participant, if they should choose, can roll over. And we do see that, that is an advantage for us in terms of overall economics, but overall meeting participant needs where they are. So hopefully, that's helpful perspective."
},
{
"speaker": "Robert Sharps",
"content": "Yes. The one thing that I would add quickly is within our individual investor is one area that we've been investing in is our advisory capability, specifically around rollovers and retirement."
},
{
"speaker": "",
"content": "So in addition to the Retiree acquisition last year, which is another tool to help optimize decumulation, we've been investing in retirement advisory services, and it's part of the individual investor business that's growing."
},
{
"speaker": "Jen Dardis",
"content": "Maybe picking up on one more point that you mentioned, Brian, because we do have the recordkeeping business in-house, we are able to more quickly roll out solutions that we want to add on from a plan sponsor perspective."
},
{
"speaker": "",
"content": "So all the services that Dee talked about earlier, because we have the interworkings of the planned record keeping, we're able to launch those more quickly than if we had to do that on another platform. But it does allow us to kind of test those and then roll them out more broadly as clients prefer."
},
{
"speaker": "Robert Sharps",
"content": "It also gives us some pretty meaningful perspective to engage with clients outside of the U.S. as defined contribution schemes evolved. So we have an existing opportunity in Asia. We're working on another one. And there are a handful of opportunities to partner with folks to leverage the expertise that we have as a retirement date fund provider. But also as a plan sponsor to kind of partner with people outside of the U.S. as they really develop their approach to defined contribution."
},
{
"speaker": "Operator",
"content": "And our next question will come from the line of Alexander Blostein with Goldman Sachs."
},
{
"speaker": "Alexander Blostein",
"content": "I was hoping we could dig into OHA a little more, just kind of thinking about the underlying growth drivers from here. The revenue base has been a little bit more range bound over the last couple of quarters, and it's nice to see you guys launch a nontraded BDC out, so that's up and running."
},
{
"speaker": "",
"content": "But as you think forward, what do you see as kind of the key building blocks to accelerating revenue growth in this business? And are there any other known redemptions that you might call out kind of related similar to what you've seen regionally?"
},
{
"speaker": "Robert Sharps",
"content": "Yes, Alex, thanks for the question. On the latter, I would say nothing that kind of would be material enough to call out in terms of known redemptions there."
},
{
"speaker": "",
"content": "If you take a step back, I'd say there are many elements of the OHA deal that I'm very happy with. I think it's been an excellent cultural fit. They are very good investors. They have associates that are deeply committed to their clients. Their investment performance across their range of strategies from distressed to structure to multisector has been very strong."
},
{
"speaker": "",
"content": "We have some emerging distribution synergy. You mentioned launching the BDC in the wealth channel, so that's the first of many potential opportunities there. And I'll spend a few seconds more specifically on that. But we've also seen multiple T. Rowe Price referrals from institutional relationships around the globe that are now translating into new business for OHA."
},
{
"speaker": "",
"content": "But as you noted, the growth in fee-based AUM has been slower, particularly over the course of the last couple of quarters. There have been some redemptions primarily in their liquid book. There's been some challenges around deployment. Some of what they do in distressed is trigger based. And it -- I suppose it's a good thing that there hasn't been a lot of distressed or spreads haven't been wide enough to actually trigger calling and deploying some of that capital."
},
{
"speaker": "",
"content": "There's been less new issuance in private credit in general, and OHA has been less active in some of the parts of the market that have grown most rapidly. So insurance or senior direct lending."
},
{
"speaker": "",
"content": "That said, I think the direction of travel here is encouraging. I noted earlier, when I was talking about flows, that our capital raising pipeline is strengthening. I would expect call it, mid-teens growth in capital under management, and in particular, their dedicated senior private lending product is gathering a lot of momentum."
},
{
"speaker": "",
"content": "I do think, ultimately, they'll have, call it, kind of mid -- high single-digit growth in fee-based AUM this year, and that will start to build momentum going forward."
},
{
"speaker": "",
"content": "Specifically as it relates to OCREDIT, we had almost $1.4 billion in invested assets in OCREDIT at March 31. And I think we're doing all of the things we need to do to deliver a great experience for our wealth partners and their underlying clients."
},
{
"speaker": "",
"content": "The most important order of business right now is scaling and successfully launching on multiple platforms. We had an important launch our first wire house earlier this month, and we've had several smaller launches and have several lined up for the May to July time frame, and are working on filling things in beyond that. And I would say I'm encouraged by those discussions and the visibility, with regard to how that will unfold over the course of the next year."
},
{
"speaker": "",
"content": "We've had really good conversations with a range of clients from large broker-dealers and private banks to regional RIAs. We are investing in our sales capacity and field support, including education and additional alternative specialists. Again, this is the first of several offerings that we hope to bring to the wealth channel."
},
{
"speaker": "",
"content": "I think what I found is that this is a long sales cycle. It's the first time we've done this. So it has taken longer than I would have anticipated or I think the OHA folks would have anticipated at the outset. But I still think that it's a very, very large opportunity and I'm really enthusiastic about kind of what it will bring in time."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Ken Worthington with JPMorgan."
},
{
"speaker": "Kenneth Worthington",
"content": "Dee, a couple more questions for you, please. BlackRock announced its Paycheck product. Does the BlackRock announcement change the equation at all for de-accumulation or the competitive environment in retirement?"
},
{
"speaker": "",
"content": "Maybe second, do you feel that T. Rowe is ahead of peers in decumulation or retirement customization? And if so, are you ahead enough to win new business? Or is this more about keeping existing business?"
},
{
"speaker": "Dorothy Sawyer",
"content": "In terms of -- let me answer your second question first. I think we are in a really good position where we are with our overall approach to retirement income and how we are making sure that we are continuing to meet the evolving needs and addressing the complexity of decumulation. And so we certainly already have products in the marketplace. And then I mentioned a couple that are already in development that we're excited about launching later in the year. And so I would tell you, I feel really well -- really good about our position overall to be able to meet the needs of plan sponsors and end investors."
},
{
"speaker": "",
"content": "I think it's also important to note that we do plan to continue to extend those relationships through our other channels, including our intermediary channel, making sure that we're partnering with advisers and their end clients. And so we feel good about our lineup that we have today as well as the lineup coming. So that would answer the first question -- or the second part of your question."
},
{
"speaker": "",
"content": "Regarding the first part of your question, what I would tell you, though, is as we think about retirement income, it's just important to note that there is a fair number of solutions in the marketplace. And where I would say we are differentiated is in the fact of the breadth of our platform."
},
{
"speaker": "",
"content": "If you think about the fact that T. Rowe Price is uniquely positioned in the fact that we work with plan sponsors. We work with end investors. We work with intermediary clients. We work with institutions. We work with clients across the globe. We are uniquely positioned to be able to support that all the way across."
},
{
"speaker": "",
"content": "More specifically around retirement income, we also have solutions comparable to the solutions that you've mentioned. And so I do feel that we are well positioned, and there isn't anything that I would say is notable to say that we're behind to mention on this call."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Brennan Hawken with UBS."
},
{
"speaker": "Brennan Hawken",
"content": "I was curious about a couple of things on the expense front. You mentioned that there's a capitalization of labor in the U.K. So curious about what that impact was in the quarter and how you expect that would impact the expense growth going forward. You also referenced a change in practice around explicit payment for research. So curious about what sort of impact that has on 2024 growth in expenses?"
},
{
"speaker": "Jen Dardis",
"content": "I think for the first part of the question, just maybe to clarify, it wasn't about a capitalization of labor. This was related to our U.K. entity where we moved into a new building at the end of last year, and we had a nonrecurring benefit in the first quarter of this year related to that. It's not material in terms of operations and really wouldn't be expected going forward. We just called it out as a onetime benefit."
},
{
"speaker": "",
"content": "With regard to research fees, yes, we did call that out as a benefit in 2024. I think what I would say is that we remain fully committed to external research and its value, but the mix of hard and soft dollar will flex over time as we work with different regulations and work with how our clients want to receive those."
},
{
"speaker": "Robert Sharps",
"content": "Yes, that mix is really driven by the regulatory environment and client preference."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Aidan Hall with KBW."
},
{
"speaker": "Aidan Hall",
"content": "Just wondering if you could provide us with some color on the trajectory of fee rates by asset class, just given some of the mix shift that's taking place in the asset base. And then it was nice to see the contribution of performance fees this quarter. I know it's tough to predict, but should we be thinking about that as a more normal contributor on a go-forward basis? Have you seen some stronger performance from your products?"
},
{
"speaker": "Jen Dardis",
"content": "Sure. So I mean, we've spoken in the past, on average, if we take a step back, I mean, a number of our products, whether it's by different vehicles or by larger institutional clients, we tend to see about 1% to 1.5% fee compression annually. Again, that can be higher or lower depending on specific choices we make about fees."
},
{
"speaker": "",
"content": "But certainly, the direction of travel has been that when clients can take advantage of scale, they will get discounts for the pricing and when they come in and we have a number of large relationships that we manage as part of our strategic relationships."
},
{
"speaker": "",
"content": "With regard to performance fees, this was one-off. I mean, there are a handful of equity products that we have, not a significant number that have fee arrangements. Of course, within the OHA product range, there are more. This one in particular, this quarter related to a handful of equity products on the T. Rowe side."
},
{
"speaker": "Robert Sharps",
"content": "Yes. We use our scale to invest in our value proposition. And I would say that within asset classes, the trend of fee compression has -- is something that we've navigated for a very long time and is comparatively stable right now."
},
{
"speaker": "",
"content": "A few years ago, we made a substantial investment in fee competitiveness of the target date funds and called that out specifically at the time. But I would say, overall, I feel very good about our value proposition and our fee competitiveness right now. So where you see fee compression, I think it would be natural where you have a migration from funds to trust where you have more rapid growth in some lower fee vehicles or kind of ultimately, there are puts and takes."
},
{
"speaker": "",
"content": "I'd say market movement also drives a fair bit of this from quarter-to-quarter. But I don't think that there's anything unusual or that I would call out with regard to the fee environment right now."
},
{
"speaker": "Eric Veiel",
"content": "Yes, this is Eric. The one other thing I would add to that is that even within asset class, again, client preference is an important part of that. And when you have really strong performance in something like structured research in the U.S. equity business, which competes directly with passive but at a better fee versus passive, but lower than our overall average fee, you'll see some mix within asset class, but that's really a good business for us and is a really strong endorsement of our underlying research capabilities."
},
{
"speaker": "Operator",
"content": "And this completes our Q&A portion. I'll now turn the call back over to Mr. Rob Sharps for closing remarks."
},
{
"speaker": "Robert Sharps",
"content": "All right. Great. Well, we appreciate your questions and your interest in T. Rowe Price. Thank you for joining us this morning. Hopefully, you found Dee's retirement update informative. We will continue to evaluate special topics to integrate into future calls, so we can give you a deeper understanding of our business."
},
{
"speaker": "",
"content": "So again, thanks for joining us, and have a good day."
},
{
"speaker": "Operator",
"content": "This concludes today's conference call. Thank you for your participation. You may now disconnect. Everyone, have a wonderful day."
}
] |
trv | 2,024 | 4 | [
{
"speaker": "Operator",
"content": "Good morning, ladies and gentlemen. Welcome to the Fourth Quarter Results Teleconference for Travelers. We ask that you hold all questions until the completion of formal remarks, at which time you will be given instructions for the question-and-answer session. As a reminder, this conference is being recorded on January 22, 2025. At this time, I would like to turn the conference over to Ms. Abbe Goldstein, Senior Vice President of Investor Relations. Ms. Goldstein, you may begin."
},
{
"speaker": "Abbe Goldstein",
"content": "Thank you. Good morning, and welcome to Travelers' discussion of our fourth quarter 2024 results. We released our press release, financial supplement and webcast presentation earlier this morning. All of these materials can be found on our website at travelers.com under the Investors section. Speaking today will be Alan Schnitzer, Chairman and CEO; Dan Frey, Chief Financial Officer; and our three segment Presidents, Greg Toczydlowski, Business Insurance; Jeff Klenk of Bond & Specialty Insurance; and Michael Klein of Personal Insurance. They will discuss the financial results of our business and the current market environment. They will refer to the webcast presentation as they go through prepared remarks, and then, we will take your questions. Before I turn the call over to Alan, I'd like to draw your attention to the explanatory note included at the end of the webcast presentation. Our presentation today includes forward-looking statements. The company cautions investors that any forward-looking statement involves risks and uncertainties and is not a guarantee of future performance. Actual results may differ materially from those expressed or implied in the forward-looking statements due to a variety of factors. These factors are described in forward-looking statements in our earnings press release and in our most recent 10-Q and 10-K filed with the SEC. We do not undertake any obligation to update forward-looking statements. Also in our prepared remarks or responses to questions, we may mention some non-GAAP financial measures. Reconciliations are included in our recent earnings press release, financial supplement and other materials available in the Investors section on our website. And now, I'd like to turn the call over to Alan Schnitzer."
},
{
"speaker": "Alan Schnitzer",
"content": "Thank you, Abbe. Good morning, everyone, and thank you for joining us today. Before we begin, I want to take a moment to acknowledge the tragic wildfires that have devastated communities across Los Angeles. Our hearts go out to everyone affected, those who have lost their homes, their businesses, and most tragically, their loved ones. At times like these, words alone are, of course, not enough. As a company rooted in the communities we serve, we will be there for our customers and neighbors to support them as they recover and rebuild. We've assessed impacted areas through aerial imagery and made live contact with a substantial majority of our customers with claims, enabling us to expedite claim payments. In addition, our expert claim team is on the ground. We're grateful for their efforts. We also have mobile claim offices positioned in the area where customers can file a claim in person or receive an advanced claim payment. And we look forward to working with policymakers in California to make sure the state has a resilient insurance market going forward. Now let me turn to our fourth quarter and full-year 2024 results. We're very pleased to report that for the full-year core income is up 64% to more than $5 billion or $21.58 per diluted share, generating core return on equity of 17.2%. These results were driven by strong fundamentals, growth and earned premiums, excellent underwriting profitability, and a higher level of net investment income. That combination makes for a powerful earnings engine, and that momentum is at our backs as we enter 2025. Turning to our fourth quarter results, we are very pleased to have generated exceptional top and bottom line results. Core income for the quarter of $2.1 billion was a record. Net earned premiums increased 9% to $10.9 billion and the combined ratio improved 2.6 points to 83.2%. The improvement in the combined ratio was driven by very strong underlying profitability and higher net favorable prior year reserve development. The underwriting margins were strong in all three segments. The combined ratio in business insurance improved by more than a point to an excellent 85.2%. The combined ratio in our Bond & Specialty business was a very strong 82.7%. And the combined ratio in personal insurance improved more than 6 points to an exceptional 80.7%. These terrific segment results led to a reported consolidated combined ratio that improved 2.6 points to 83.2%. Turning to investments after tax net investment income for the full-year was up 21% to $3 billion, driven by strong and reliable returns from our growing fixed income portfolio and higher returns from our non-fixed income portfolio. These results, together with our strong balance sheet, enabled us to grow adjusted book value per share by 13% during the year to $139.04, after making important investments in our business and returning more than $2 billion of excess capital to shareholders. Turning to the top line, through continued terrific marketplace execution across all three segments, we grew net written premiums during the year by 8% to more than $43 billion and in the quarter by 7% to $10.7 billion. The strong value proposition that we offer to our customers and distribution partners along with outstanding execution by our colleagues in the field, contributed to our top-line success. In business insurance, we grew net-written premiums in the quarter by 8% to $5.4 billion. Renewal premium change in the segment remained very strong at 9.6%, including renewal rate change of 6.9%. Retention also remained strong at 85%. The combination of strong pricing and excellent retention reflects our deliberate and granular execution in a generally disciplined marketplace. In Bond & Specialty insurance, we grew net-written premiums by 7% to $1.1 billion, with excellent retention of 88% in our high quality management liability business. In our market leading surety business, we grew net-written premiums by 19%. We are very pleased to have generated terrific production results across our commercial segments where margins continue to be attractive. That includes our ENS offerings, where we grew net-written premiums by 13% in 2024. In Personal Insurance, we grew net written premiums in the quarter by 7%, $4.3 billion, driven by continued strong renewal premium change, particularly in our homeowners business. As we wrap up the year, I'd like to take a few minutes to reflect on our 2024 results and put them into an overtime context. As we've shared, we are and have been focusing our investments on three strategic innovation priorities. First, extending our advantage and risk expertise; second, providing great experiences for our customers, distribution partners, and employees; and third, optimizing productivity and efficiency. These investments are designed in large part to position us to grow over time at leading returns. The successful execution of that strategy has been an important contributor to our strong results, providing us with the financial resources that enable us to continue investing at scale, which we believe will increasingly be a differentiator in this industry. It's a virtuous cycle. The data on slide 19 of the webcast presentation illustrate the significant acceleration of our performance, since we launched this strategy. We've grown our net written premiums over the past eight years by more than 70% to over $43 billion. At the same time, we've improved our underlying combined ratio by nearly 7 points. High quality growth with strong underwriting profitability is a noteworthy achievement in this industry. In lines of business with returns that meet our objectives, growth over time has generally come from a combination of price increases and growth in customers. In lines where the emphasis has been on improving returns, premium growth has been driven by higher pricing. In addition, our growth has largely been organic, from products in which we have deep expertise to distribution partners with whom we have longstanding relationships, and in geographies where we have a thorough understanding of the regulatory environment and other market dynamics. In other words, a relatively low-risk growth strategy. Through our focus on productivity and efficiency, we've also meaningfully improved our operating leverage over this time. We've allocated some of that benefit to investments and strategic priorities. As you can see on slide 21, since 2017, we've more than doubled our investments in strategic technology initiatives. Over that same period, we've carefully managed growth in routine, but necessary technology expenditures. In other words, over an eight-year period, we simultaneously and meaningfully increased our technology spend and improved the strategic mix of that spend. In 2017, our strategic investments represented about a third of our tech spend. In 2024, our strategic tech investment approached nearly half of our overall tech spend of more than $1.5 billion. At the same time, our efforts to improve operating leverage also enable us to lower our expense ratio by more than 3 points, or about 10%. The flexibility that operating leverage gives us to allocate the benefit between investment opportunities in the bottom line is a valuable competitive advantage. Turning to underwriting, the tremendous strength and relative predictability of our underlying underwriting income has increasingly contributed to our bottom line. Our underlying underwriting income has more than tripled over the last eight years, reaching $4.5 billion after tax in 2024. This level of underlying underwriting income positions us to deliver strong income and returns, even with the level of outsized natural catastrophes we in the industry experienced in 2024. Our growth in underwriting income also contributes to the increase in our cash flow from operations, which was $9.1 billion in 2024, our highest level ever, and nearly $4 billion more than it was just five years ago. Our strong operating cash flow is important. It gives us the ability to make strategic investments in our business, return excess capital to shareholders, and grow our investment portfolio. Our investment portfolio, which we grew to almost $100 billion at year end, positions us to continue generating a higher level of predictable and reliable net investment income. In summary, we're capitalizing on the successful execution and effective strategy. Our strong results in financial position enable us to be there when our customers need us most, as our friends and neighbors in Los Angeles do right now. The significant momentum we have built gives us great confidence in our ability to continue serving our customers and distribution partners, while delivering for our shareholders. In other words, we remain very confident in the outlook for Travelers. And with that, I'm pleased to turn the call over to Dan."
},
{
"speaker": "Dan Frey",
"content": "Thank you, Alan. Core income for the fourth quarter was $2.1 billion and core return on equity was 27.7%, bringing the full-year core income to $5 billion and full-year core ROE to 17.2%. We once again generated record levels of earned premium this quarter, and we're very pleased with both the total combined ratio of 83.2% and the underlying combined ratio of 84%. The value of premium growth at strong underlying margins is evidenced by the quarter's underlying underwriting income of $1.4 billion after tax, bringing the year-to-date figure to $4.5 billion. That's our first time ever above $4 billion and an increase of nearly 40% from last year's then record level. The reported and underlying combined ratios for both the quarter and the full-year were very strong in all three segments. The expense ratio for the fourth quarter came in at 28.2%, once again reflecting the benefits of our focus on productivity and efficiency coupled with strong top line growth. The full-year expense ratio of 28.5% was in line with our expectations and our guidance throughout the year, even as the excellent loss ratio resulted in higher supplemental commission expense. Looking ahead to 2025, we're comfortable with the annual expense ratio at this level for now as the strength of the underlying loss ratio provides continued opportunity to make meaningful investments in both people and technology that we believe will broaden and deepen our competitive advantages well into the future. Catastrophe losses in the fourth quarter were a modest $175 million pre-tax, including a net increase of a little more than $100 million related to re-estimation of prior quarter cats. Turning to prior year reserve development. We had total net favorable development of $262 million pre-tax with all three segments contributing. In Business Insurance, net favorable PYD of $147 million was driven by favorability in workers' comp that was partially offset by adverse development in abuse and molestation exposure in our runoff book. In Bond & Specialty, net favorable PYD of $45 million was driven by better-than-expected results in fidelity and surety. Personal Insurance had $70 million of net favorable PYD with favorability in both auto and home. After-tax net investment income of $785 million was, up 22% from the prior year quarter. Fixed maturity NII was again higher than the prior year quarter, reflecting both the benefit of higher yields and the significant growth in our portfolio of invested assets, which as Alan mentioned, is approaching the $100 billion mark. Returns in the non-fixed income portfolio were also higher than in the prior year quarter. In terms of our outlook for fixed income NII for 2025, including earnings from short-term securities, we expect approximately $3 billion after-tax, beginning with $710 million in the first quarter and growing to $790 million in the fourth quarter. Page 22 of the webcast presentation provides information about our January 1 catastrophe reinsurance renewal. Our long-standing cat XOL treaty continues to provide coverage for both single cat events and the aggregation of losses from multiple cat events, and we have increased the amount of total coverage for 2025. The per occurrence loss deductible was unchanged at $100 million and we've placed coverage for $3.7 billion of the $4 billion layer above the $4 billion attachment point. We're pleased to have added $150 million of coverage, while reducing the total amount of ceded premium for this treaty. Also as part of our January 1st renewals, we enhanced our casualty reinsurance program for 2025. Thanks to the reinsurance market's receptivity to our casualty book, we were able to purchase more coverage at a lower attachment point on a roughly margin-neutral basis. I point this out to make you aware that the incremental ceded premium related to the additional coverage will impact the growth rate of consolidated net written premium for full-year 2025 by a little less than half a point. Because the written ceded premium impact all hits business insurance in the first quarter, the impact on net written premium growth in Q1 for the BI segment will be about 4 points or about 2 points on a consolidated basis. And while we're talking about the 2025 year, on a financial modeling note, as you can see on Slide 23 of the webcast presentation, our pre-tax catastrophe plan for 2025 is 6.9 combined ratio points. Slide 23 also provides a summary of the seasonality of our cat losses over the prior decade. As shown in the data, second quarter has regularly and noticeably been our largest cat quarter. We've provided this view of historical data in our year-end packages for a few years now, but we thought it might also be helpful to share our planned view for the coming year by quarter, so you'll find that here as well. Obviously, the 2025 plan figures were put together without knowledge of the January wildfires in California. As you know, the California wildfires that began earlier this month are going to be a material event for the industry and will have a material impact on our first quarter earnings. Because the event is so recent and to some degree still ongoing, we'd like to take more time to refine our analysis before providing an estimate. Also of interest for 2025, we continue to value our relationship with Fidelis and are pleased to have renewed the 20% quota share with them. The renewal includes the same loss ratio cap we had in place for both 2023 and 2024. Turning to capital management. Operating cash flows for the quarter of $2.1 billion were again very strong and we ended the quarter with holding company liquidity of approximately $1.8 billion. For the full-year, we generated our best-ever level of operating cash flow at $9.1 billion. Interest rates increased during the quarter, and as a result, our net unrealized investment loss increased from $2.1 billion after-tax at September 30, $3.6 billion after-tax at year-end. Adjusted book value per share, which excludes net unrealized investment gains and losses, was $139.04 at year-end, up 13% from a year ago. We returned $494 million of capital to our shareholders this quarter, comprising share repurchases of $252 million and dividends of $242 million. We have approximately $5 billion of capacity remaining under the share repurchase authorization from our Board of Directors. Recapping our results for 2024, core income was just over $5 billion and core ROE was 17.2%. We delivered our highest-ever levels of written premium, underwriting income, net investment income, core income and cash flow from operations. In addition, we ended the year with our all-time high in adjusted book value per share and with our largest investment portfolio ever. In short, we're extremely well-positioned for 2025 and beyond. And with that, I'll turn the call over to Greg for a discussion of Business Insurance."
},
{
"speaker": "Greg Toczydlowski",
"content": "Thanks, Dan. Business Insurance had another strong quarter, rounding out a terrific year in terms of financial results, execution in the marketplace and progress on our strategic initiatives. Segment income for the quarter was nearly $1.2 billion, our highest quarter ever and up about 25% from the prior year quarter, which was our previous quarterly high. The improvement from the prior year was broad-based, driven by higher net investment income, higher underlying underwriting income and higher favorable prior year reserve development. The all-in combined ratio of 85.2% was a great result and we're once again particularly pleased with our exceptional underlying combined ratio of 86.2%, an all-time quarterly best. The underlying loss ratio improved by more than half a point from the prior year driven by the benefit of earned pricing. The expense ratio remained excellent at 28.8%. Turning to the top line. We grew net written premiums by 8% to an all-time fourth quarter high of more than $5.4 billion. Pricing remained strong with renewal premium change of 9.6%, driven by renewal rate change of 6.9%. Retention remained excellent at 85% and new business of $641 million was the second highest fourth quarter result ever, second only to last year's record fourth quarter. We're pleased with these production results and our ability to sustain strong levels of pricing, reflecting the relative return profiles and environmental trends for each line. Renewal rate increases in umbrella and auto were both well into double-digits and both up sequentially from the third quarter. Rate increases in CMP and GL remained strong and generally in line with third quarter levels, while the rate increases in property were less than Q3. More specifically on property rate, the moderation continues to be driven by our national property book, where returns are very strong after several years of compounding rate and improvements in terms and conditions. Across the book, even with these sustained strong pricing levels, retention remained excellent, as I mentioned earlier, reflecting our strong value proposition and the marketplace's acknowledgment of environmental trends and uncertainty. As for the Individual businesses, in Select, renewal premium change remained strong at 12%, up about a point from the fourth quarter of last year. Renewal rate change of 5.6% ticked up from the third quarter and was up more than 1.5 points from the prior year quarter. As we expected, retention moderated as we continued to intentionally optimize our CMP risk/return profile in a couple of targeted geographies. New business was healthy and near historical highs. Overall, we remain pleased with the granular pricing and underwriting execution driving profitable growth in Select. The mix we are achieving through these actions positions us for long-term success. In middle market, renewal premium change was close to 10% with renewal rate change of 7.8% about flat with the third quarter and up about a point from the prior year quarter. The rate increases remain broad-based as we achieved positive rate change on almost 80% of our middle market accounts. And the execution was once again excellent with meaningful spread from our best-performing accounts to our lower-performing accounts. Lastly, new business of $357 million was our highest-ever fourth quarter and we're pleased with the risk selection and strength of pricing on the accounts we added to the portfolio. As we close out 2024, let me provide a little color on full year results before turning the call over to Jeff. Segment income of more than $3.3 billion, the underlying combined ratio of 88.1% and top-line of more than $22 billion were all record results. As for production, renewal premium change and retention, both remained historically high, while new business premiums reached an all-time best. These results are a direct reflection of our strong value proposition as well as the successful execution of our thoughtful and deliberate strategies. And while delivering these exceptional financial and production results, I'm also extremely pleased with our field's execution and our broader team's dedication to delivering new tools, insights and product enhancements. We've strengthened our competitive advantages in several key areas. Among other achievements, we have developed more granular and predictive price-to-risk models, enhanced submission insights based on quality and appetite, leveraged more segmented and responsive loss analytics methodologies and integrated a customer relationship platform with our cutting-edge underwriting workstation. Our financial and operational performance this year was terrific and our continued focus and investment in strategic capabilities positions us extremely well for long-term profitable growth. We're proud of these results and the best-in-class team that produce them. With that, I'll turn the call over to Jeff."
},
{
"speaker": "Jeff Klenk",
"content": "Thanks, Greg. Bond & Specialty ended the year with another strong quarter on both the top and bottom lines. We generated segment income of $228 million, an excellent combined ratio of 82.7% and a strong 86.8% underlying combined ratio in the quarter. Turning to the top line, we're pleased that we grew net written premiums by 7% in the quarter. In our high-quality domestic management liability business, we delivered very strong retention of 88%. We're pleased that Corvus transition from an MGA to writing on our high-quality paper drove higher retention relative to Corvus' historical experience. Management liability renewal premium change was positive and improved a point from the third quarter and new business was consistent with the very strong fourth quarter of 2023. Turning to our market-leading surety business. We grew net written premiums by an outstanding 19% from prior year quarter. This growth reflects a robust construction environment, continued strong demand for our surety products and services and outstanding execution by our team and growing our high credit quality portfolio. So we're pleased to have once again delivered strong top and bottom line results this quarter in Bond & Specialty Insurance, capping off a year during which we delivered record levels of net written premiums in both our surety and management liability businesses. We're also pleased to have delivered excellent returns while making significant strategic investments in our business, including enhancing our cyber capabilities, upgrading our management liability technology platform and optimizing segmentation and productivity through advanced analytics and AI. And now I'll turn the call over to Michael."
},
{
"speaker": "Michael Klein",
"content": "Thanks, Jeff, and good morning, everyone. I'm very pleased to share that Personal Insurance delivered segment income of $798 million and a combined ratio of 80.7% for the fourth quarter of 2024. Both results outpaced last year's strong fourth quarter results. For the full-year, PI delivered record segment income of $1.25 billion and a combined ratio of 94.4%, reflecting substantial improvement in the fundamentals of our business. Net written premiums grew 7% in the quarter and 8% for the year, bringing full-year net written premium to a record of nearly $17.2 billion. In Automobile, the fourth quarter combined ratio was 94.2%. The underlying combined ratio of 96.3% improved 6.4 points, compared to the prior year. This improvement was primarily driven by the benefit of higher earned pricing, lower losses resulting from favorable frequency across a number of coverages and sustained moderation in physical damage severity trends. This quarter's underlying results included a 1.5 point benefit from the favorable re-estimation of prior quarters in the current year. For the full-year 2024, the auto combined ratio of 95% was a considerable improvement, compared to the prior year, reflecting the success of our disciplined approach to execution. With another quarter of sustained profitability, we remain focused on growing the auto book. In Homeowners and Other, the fourth quarter combined ratio of 67.8% improved 3 points, compared to the prior year as an improved underlying combined ratio was partially offset by the impact from higher catastrophes. The underlying combined ratio improved 4.3 points, primarily driven by favorable non-weather losses relative to the prior year and the continued benefit of earned pricing. This quarter's underlying results included a 2 point benefit from the favorable re-estimation of prior quarters in the current year. Stepping back, the 2024 full-year property combined ratio of 93.9% was a strong calendar year result. That said, we have more work to do to improve accident year profitability and consistently deliver target returns over time. Our production results reflect our continued focus on generating growth in auto, while improving profitability in property through the execution of a granular state-by-state strategy. In domestic automobile, retention remained consistent, while renewal premium change of 10.2% continued to moderate as intended, reflective of auto profitability. We're pleased to note that auto new business premium increased relative to the prior year quarter, driven by growth in new policies and new business premiums in states that are not constrained by our property actions. In Domestic Homeowners and Other, retention rose slightly to 86% and renewal premium change of 14.1% remained strong and consistent with recent quarters. In 2025, we expect renewal premium change to increase to the high-teens, as we continue to seek rate increases and further increase insured values to ensure they remain aligned with replacement costs. The slight decline in homeowners policies in force continues to reflect our deliberate efforts to improve profitability and thoughtfully deploy our property capacity. To recap, in 2024, we delivered record net written premiums and segment income. The substantial year-over-year improvement reflects the success of the significant actions we've taken to improve the fundamentals of the business, as well as the moderation of underlying loss trends. At the same time, we continue to invest in and deliver capabilities that will support the profitable growth of our business. Examples include the re-platforming of our specialty products, continued advancement of our IntelliDrive telematics offering, further evolution of our AI-enabled aerial imagery capabilities and modernization of our infrastructure. I couldn't be more proud of our team or more grateful to our distribution partners for their hard work and dedication in the face of an environment that continues to test and challenge us and our industry. In particular, I'd like to recognize our claim team, who as we speak are on the ground in California, supporting our customers in their time of need. With that, I'll turn the call back over to Abbe."
},
{
"speaker": "Abbe Goldstein",
"content": "Thanks, Michael. We are ready to open up for questions now."
},
{
"speaker": "Operator",
"content": "Thank you. We will now begin the question-and-answer session. [Operator Instructions] We'll go first to Robert Cox at Goldman Sachs."
},
{
"speaker": "Robert Cox",
"content": "Hi, thanks for taking my question. Maybe just first on pricing. I was hoping you could kind of unpack the renewal rate change a little bit and what you saw over the quarter, that might have been indicative of a trend into 2025, whether it's by account size or product. Just curious what changed in the context of an overall stable figure for business insurance?"
},
{
"speaker": "Greg Toczydlowski",
"content": "Hey, Robert, this is Greg. Given the headline numbers, you can see there isn't meaningful change between the pricing. And so, you know, again, our very granular local execution, we continue to look at them account-by-account basis, and we haven't seen any meaningful shift, other than the color that I gave you in the prepared comments. So very stable."
},
{
"speaker": "Robert Cox",
"content": "Okay, got it. Thank you. And then maybe just as a follow-up on cats, you know, obviously a number of large events here. I was hoping you could just walk us through what you booked for Milton, if that $100 million increase in current year cats was all related to Helene and then, you know, not necessarily a quantitative question, but ultimately like the impacts that you expect might come out of the California fires?"
},
{
"speaker": "Dan Frey",
"content": "Hey, Rob, it's Dan. So I'll start with the PYD. So, you know, no big events in the quarter, as you can see, by no new events. You'll be able to see when the cake comes out in the table. Milton was around $60 million for us, a little less than the preliminary range we had provided on the third quarter earnings call. A number of prior quarter cats had adjustments to them, that's typical. That change that you referenced from my prepared remarks was driven by Helene. Not surprising, not concerning. That was a big event in the last five days of the quarter and with sort of an unusual pattern as it, you know, had sort of did more damage in Georgia and the Carolinas than it did in Florida. So when you get a big event at the end of the quarter, you're trying to say, I have other similar historical events that I can model out how claims are going to come in and then what the severity of different types of claims is going to be. We just didn't have a lot of comparables in terms of Helene, so it's not really surprising to see a move there. In terms of California, look as we said in our remarks, it's going to be a big event for the industry. We think it will have an impact on our first quarter earnings for sure, but to the degree that it's still very early and it's still really ongoing, in some cases it's just too soon for us to provide a number at this point."
},
{
"speaker": "Operator",
"content": "We'll move next to Gregory Peters at Raymond James."
},
{
"speaker": "Gregory Peters",
"content": "Good morning, everyone. I guess for the first question, kind of, building on the last answer, in your prepared remarks, Greg, you talked about the select retention dropping down a little bit, doing part to some changes in your CMP profile. If you could give us a little color on that? And maybe as we look at business insurance, give us some perspective on the retention ratios as it relates to lost business that you're losing on price versus intentional re-underwriting?"
},
{
"speaker": "Dan Frey",
"content": "Oh yes, Greg, let me take those two pieces first. The Select one, start there. You get into a little bit of competitive, sensitive information if I give you the exact specifics of what geographies and industry classes that were non-renewing. But let me give you a little color over the top. We would only do non-renewals when we can't get the right price to risk through the regulatory process. So you can think about severe convective storm. That's a recent peril that continues to be more severe. We've isolated a couple spots where we've needed to non-renewal components of the small commercial book, but that gives you a little bit of the flavor of what's driving that. We think we bottomed out on those non-renewals of Select. So at that 80% retention, that's kind of the expectation that we have given that we are through the thrust of those renewals. In the back half of 2025, we would see some improvement there. So that's really the driver of what's driving the slight deterioration in retention across business insurance."
},
{
"speaker": "Gregory Peters",
"content": "Great. And then I guess as a follow-up, and I've asked this question of you before, Alan, but looking at slide 21, which is your technology investments, not really, can you provide us this chart, don't really put some numbers in there, and we hear you in various comments dribble out commentary about where you're making investments in technology, but I thought maybe we could spend a minute and give us some more granular details on what's going on there, because it seems like it's a pretty important initiative for the company."
},
{
"speaker": "Alan Schnitzer",
"content": "Yes, thanks Greg, and good morning. In terms of numbers, we don't put numbers on that scale, but we have shared that the overall tech spend is over $1.5 billion last year, and I think we shared that in the prior year. And if I had to give you a broad brush response to where is it, I would say broadly speaking, but not exclusively, but broadly speaking, we're digitizing the value chain. And so that's digitizing the customer journey. It's modernizing the foundation. It's advanced analytics. It's automation. It's faster speed to market, getting the right price on the risk, those sorts of things. But at the enterprise level, we're also investing in talent and AI and third-party data, product development. The business units and segments are busy at work investing in new products, partner integration, better funding for customers, things like that."
},
{
"speaker": "Operator",
"content": "We'll go next to Mike Zaremski at BMO Capital Markets."
},
{
"speaker": "Mike Zaremski",
"content": "Hi, thanks. First question on the reserve releases in commercial. Most releases we've seen in a couple of years, good to see. Any -- I heard the prepared remarks, the high level prepared remarks, but anything you'd want to call out as kind of a notable true up, or I guess this level of releases would kind of imply that the IBNR you guys have added in recent years more so than your peers, you know, kind of is helping?"
},
{
"speaker": "Dan Frey",
"content": "Sure Mike, it's Dan. So, you know, just to come back to the remarks specific to business insurance, you know, the main driver of the favorability was workers comp. Workers comp has been, as you all well know, a very favorable story for a long time now. It's sort of just a question of how much is it from quarter-to-quarter, depending on the way data developments and changes in frequency and severity. We've said it before and I'll just say it again. You know, we don't really think of PYD as a run rate of any sort, so I expect that number to be different from quarter-to-quarter. That was the big piece of good news in the quarter. The only noteworthy piece of unfavorable development in the quarter, as I mentioned on the call, was strengthening in the runoff book for abuse and molestation. There are always other puts and takes in the quarter, but nothing of any significance or worth calling out."
},
{
"speaker": "Mike Zaremski",
"content": "Okay, great. And I guess my follow-up will stick to workers' comp. You may have answered this in Rob's question, but in the prepared marks, I don't think you mentioned kind of any pricing changes quarter-over-quarter or trends on workers' comp? So is it just fair to assume, given the workers' comp pricing is still a bit negative on real pricing?"
},
{
"speaker": "Alan Schnitzer",
"content": "I would say, Mike, I would describe it as largely stable. The pure renewal rate change is a little bit negative, and with exposure, you get to something a little bit positive. And there's always some fluctuations quarter-to-quarter, but I think stable is the way I'd describe it."
},
{
"speaker": "Operator",
"content": "We'll go next to David Motemaden at Evercore ISI."
},
{
"speaker": "David Motemaden",
"content": "Hey, thanks. Good morning. I had a question just on the business insurance underlying loss ratio. Greg, I heard you call out just earned rate coming in. I guess I'm wondering, is there anything else in that 57.3% that's not sustainable or favorable mix or anything like that that's flattering the result?"
},
{
"speaker": "Dan Frey",
"content": "Hey, David, it's Dan. I'll take that, so I guess the answer is not really. You know, when we have something that we think you need to sort of call out as non-recurring, we try to do it in prepared remarks. You heard Michael referenced, you know, current year prior quarter adjustments benefiting the fourth quarter in auto and home. We didn't call anything out in BI, because we didn't really think there was anything unusual to call out. So the benefit in the quarter is earned price, you know, really terrific underlying at 57.4%. And even within that, we did choose to add a little bit of IBNR to the casualty line, again, reflecting uncertainty in that line. Not a big move. So a pretty clean jump-off point and really driven by benefit of earned pricing."
},
{
"speaker": "David Motemaden",
"content": "Got it. Thank you. And then maybe just on that point, just adding more IBNR to some of those casualty lines and then maybe just looping in the decision to increase the reinsurance protection on the casualty book? Could you just walk through sort of the thought process of getting the reinsurance and is it just sort of, I mean, you guys are, it seems like you guys are reacting sooner than many in the industry? And is that just sort of added protection as you lean into growth? Or I'd be interested in sort of the thought process there?"
},
{
"speaker": "Alan Schnitzer",
"content": "David, let me start and then I'll turn it over to Dan, if I leave anything out. I would say the changes we made, we made because we could. And every renewal of every reinsurance treaty, we take a look at our business, we take a look at the reinsurance marketplace and make the best, you know, risk-reward decisions we could make. And so what we were able to achieve for the price we were able to achieve it, we thought made a lot of sense. But I would describe, you know, ordinary course process and a terrific result."
},
{
"speaker": "Operator",
"content": "We'll go next to Brian Meredith at UBS Financial."
},
{
"speaker": "Brian Meredith",
"content": "Yes, thank you. I'm just curious, looking at the BI results, you know, the underlying combined ratios is as good as it's been in 20-years. I'm just curious, in your thoughts, are we kind of sitting here at peak margins? Is there more room for improvement? How should we kind of think about the margin to return to joining in the business, which are record?"
},
{
"speaker": "Alan Schnitzer",
"content": "Well, thanks for that, Brian. They are terrific margins, and we're very pleased with these margins. I'm not going to forecast the margins for you, but what I'll tell you is we love the business that we're putting on the books, and we love the pricing. We love the stability in the marketplace. We love the retention that we're seeing. And these -- you take a look at this RPC, which is near double-digits, that's it's about the highest it's ever been over a long period of time. So market feels stable for us, and we feel good about the outlook, but I'm going to stop short of telling you what the direction is going to be."
},
{
"speaker": "Brian Meredith",
"content": "I appreciate that. And then maybe a little bit as a follow-up that I'm curious your comments and thoughts on the tort environment right now. I always appreciate your comments on it. Anything that you're seeing are happening that maybe point to some improvement potentially going forward or vice versa?"
},
{
"speaker": "Alan Schnitzer",
"content": "Yes. The tort environment is -- it’s definitely continues to be front and center in front of mind for us. It's an environmental issue that we're all facing. Yes, from a public policy perspective, the insurance industry might be the tip of the spear, but this is really an industry for businesses and consumers. And I think there's a growing recognition of that. It also has contributed to some very difficult insurance markets in a few states, and we've seen a couple of states take action to respond to that. And in a couple of other states, we've had some favorable development in terms of some legislation around third-party litigation financing disclosure, which we think is positive and hope is a trend. So continues to be front and center for us, and we continue to try to get at it."
},
{
"speaker": "Operator",
"content": "We'll move next to -- excuse me Wes Carmichael with Autonomous Research."
},
{
"speaker": "Wes Carmichael",
"content": "Hey, good morning and thanks for taking my question. My first was on catastrophes in the 2025 plan. I think you mentioned there's nothing in there related to California wildfires, but your full year assumption at 6.9 points, I think that's a little bit maybe below the last couple of years. So could you maybe just help us with what's going into that planning assumption?"
},
{
"speaker": "Alan Schnitzer",
"content": "Sure. Well, there's a lot of methodology and thought and frankly, judgment that goes into that number. And I think it would be premature to assume that what we've seen in the last couple of years that, that high watermark is a new normal going forward. But certainly, we take a look at that and incorporate into our thinking and we've waived the more recent years more heavily as we've come up with the cat plan. So I think that 6.9 points on a point basis would cover the cat losses in seven out of the last 10 years or something like that. So we've got a bias toward the high end of recent experience. But again, we think it would be a little premature to assume that this high watermark is any normal."
},
{
"speaker": "Wes Carmichael",
"content": "Got it. And my follow-up on reserve development in BI, I know you talked about favorability in workers' comp. Are you able to size the gross amount of favorable development for us in the fourth quarter?"
},
{
"speaker": "Dan Frey",
"content": "Yes, Wes, it's Dan. So we were -- you could think about that as comp in the fourth quarter being in the ballpark of around $250 million of good news."
},
{
"speaker": "Wes Carmichael",
"content": "Yes. Thank you."
},
{
"speaker": "Operator",
"content": "We'll take our next question from Alex Scott at Barclays."
},
{
"speaker": "Alex Scott",
"content": "Hey, good morning. Thanks. First one I have is on the Personal lines business. I appreciate there's a big event going on in Homeowners right now, but just the underlying results this quarter kind of coming along faster than I would have guessed. I'm wondering if it changes your approach to the market and just how competitive you want to be on place and desire to grow, et cetera?"
},
{
"speaker": "Michael Klein",
"content": "Sure, Alex. It's Michael. I would say, not really. As I mentioned in my prepared remarks, if you look at the full-year result at about a 94 and you take out PYD, you get to a 98 that is not delivering target returns in the property line of business. We also, throughout the year, have commented on favorable frequency in property, offset by a bit of percent severity. Hard to know how much of that favorable frequency is going to persist. And so that's really why I said we still have work to do in property and our focus on property really remains on improving profitability and generating consistent target returns."
},
{
"speaker": "Alex Scott",
"content": "Got it. As a follow-up, I wanted to see if I could ask one on the ongoing wildfires in California. Any additional color you can help us with regarding your exposure maybe to Pacific Palisades in particular, the way you approach the more wildfire prone areas of that market, anything on additional living expenses that might just help us well, I know you're not willing to quantify at this point, that totally makes sense. Like anything that could kind of help us understand."
},
{
"speaker": "Alan Schnitzer",
"content": "Alex, I just don't think there's a lot we can share there. We have, and I think Michael shared this recently we've taken steps to thoughtfully manage our exposure in wildfire prone areas, others have too. So we don't know what that's done to our relative market share in some of these places. So I don't know if there's any real color that we can give beyond what we've already shared."
},
{
"speaker": "Operator",
"content": "We'll go next to Elyse Greenspan at Wells Fargo."
},
{
"speaker": "Elyse Greenspan",
"content": "Hi, thanks. Good morning. My first question, I just want to go back to the Business Insurance underlying loss ratio. So you guys saw in the third quarter, right? There was 180 basis points of year-over-year improvement? And you said, right, that there was no real noise to call out. So that was kind of a good run rate? Now it seems like 60 basis points this quarter is a run rate. I know you guys said that you -- there was some conservatism put into the casualty picks, but I believe that was the case in every quarter this year. So what was the change from the 180 to the 60 that now seems like run rate in BI from Q3 to Q4 on the underlying loss ratio?"
},
{
"speaker": "Dan Frey",
"content": "Elyse, it's Dan. So when we're talking about adjustments to jump off point of run rate, again, we really think it's important to look at the business comparing the fourth quarter to the fourth quarter, the third quarter to the third quarter, not either the sequential quarter or the sequential margin improvement. So we're trying to give you a jump-off points of was there anything particularly unusual in a quarter that you think about that as your model beginning point for the next year's quarter that you'd call out. It's not to say that there's zero besides pricing. There are -- as we've said in each of the quarters this year, there's a number of puts and takes each year, but none of them were individually that significant and so we're down to a point of we're inside of a point of change, and we're trying to say, is there anything in there that really seems like it's abnormal and should be adjusted or are we thinking about it as not a “clean jump-off point”, and that's the color we're trying to give you there, not to the basis point of how much is the improvement going to be in one quarter versus the next."
},
{
"speaker": "Elyse Greenspan",
"content": "Thanks. And then my follow-up, I just wanted to go back to the California fires for a second. We obviously can look at statewide share -- market share. Is there any commentary, I guess, you would give relative to statewide share for travelers relative to potential share in the impacted areas? And my second question, Dan, on the reinsurance coverage, right, that's an aggregate cover, right? So I know there's like a $4 billion retention and then there's deductibles. But if the fire is a large event, this does earmark your cats to a certain degree, right, for the full-year. I just want to make sure I'm thinking about that correctly."
},
{
"speaker": "Alan Schnitzer",
"content": "Let me start on your market share question, and then I'll turn it over to Dan for the reinsurance question. So you could take some estimate of market share and apply it to an estimate of industry loss, and that would give you what I would describe as a point of reference. So pretty blunt instrument, though, for reasons. First, it's obviously pretty sensitive to whatever estimate you have of insured losses for the industry, and that's going to develop over time. And second, when it comes to market share, the publicly available market share is dated information. It doesn't reflect actions we or others have taken to manage exposure and it doesn't reflect any differences that might exist between local market share and statewide market share. So those are the cautions I'd give you in applying that. But it's a reference point, I get it."
},
{
"speaker": "Dan Frey",
"content": "And then, Elyse, with regard to the 2025 cat treaty, you're right, one of the, we think, great features of our treaty is that it is an aggregate cover. So while I wouldn't expect recoveries under the treaty from the California wildfires to the degree that they impact first quarter earnings, and it's a big number. There's $100 million per event deductible as I said in my prepared remarks and as you can see on the chart. But yes, this will accumulate towards the $4 billion retention, which if there's a very active second quarter for cats, or a very active third quarter for cats, it's possible that we'd be talking about recoveries under the treaty."
},
{
"speaker": "Operator",
"content": "We'll move next to Yaron Kinar at Jefferies."
},
{
"speaker": "Yaron Kinar",
"content": "Thank you. Good morning. Just going to the topic of the data of the California wildfires. Can you maybe talk about how, if at all, they would impact the company's appetite for Home and Property business in the state. Would you look to further prune exposure to wildfires? Or do you believe that the actions that you've taken to-date positioning well from that perspective?"
},
{
"speaker": "Alan Schnitzer",
"content": "I'll start and then Michael, I'll turn it over to you. I think it's going to depend on how the market reacts to it. The insurance market was challenged going into this. There were some recently adopted reforms, and I think that was a good start. It's possible that this is going to be a catalyst for further and meaningful reforms. So I think we're just going to wait and need to see how that shakes out before we make any decisions."
},
{
"speaker": "Michael Klein",
"content": "Yes. And the only thing I would add to that, Yaron, is we've been shrinking in California coming into the event. We have a rate increase for property on file with the department as we speak, which clearly doesn't include the losses from the California wildfires. So all of that will certainly feed into our assessment of actions we need to take going forward."
},
{
"speaker": "Yaron Kinar",
"content": "Makes sense. And then, Michael, maybe another question for you. It sounds like your appetite for Auto is -- Personal Auto is growing, you're open for business in a growing number of states. At the same time, I'm sure you're seeing the same headlines we are on tariffs and the like. Are you -- is your appetite for Auto taking into account the potential for tariffs? Or is that something that you'll react to if and when we actually see those put in place?"
},
{
"speaker": "Michael Klein",
"content": "Sure. It's a great question, and I would lean more towards the latter in terms of your question. I think certainly, it's hypothetical, it's hard to predict. We don't know which countries we don't know what amounts and where auto parts and autos come from. It depends a lot on which countries you're talking about. And what level those tariffs are at. And so as opposed to trying to predict it, we're looking at our prospective viewer rate adequacy. We feel great about the margins in the business. Today, we're actively pursuing Auto growth and will continue to do so. And then we'll reflect any changes in our pricing when and if we know what they are and then factor that into the calculus at that point in time."
},
{
"speaker": "Operator",
"content": "We'll take our next question from Josh Shanker at Bank of America."
},
{
"speaker": "Josh Shanker",
"content": "Thank you. I hate asking more wildfire questions. I understand you don't know, but education very valuable to us. Can you tell us the degree to which some Travelers' policies might exclude fire or is the Travelers' policy, one that has not been put anyone to the fair plan and has comprehensive coverage?"
},
{
"speaker": "Michael Klein",
"content": "Sure, Josh. It's Michael. So we write two types of property policies in California. We write a standard Quantum Home 2.0 property policy that does include coverage for a wildfire in areas where we do not have an appetite to write policies that cover fire. We do write what we call a DIC policy, which you can think of as a policy that excludes losses from fire and wildfires. Some customers pair that with a fair plan policy, because then they have the Travelers, claim service, they have the Travelers coverage for non-fire losses. And so we do have both types of policies in force in the state."
},
{
"speaker": "Josh Shanker",
"content": "And just one other question, and I'm not trying to hold number on you, just trying to be smart. What is Travelers appetite for $5 million on in the state of California or whatnot? I don't think Travelers is targeting high net worth individuals, but California is an expensive real estate market. Can you just talk about appetite and what are the normal Travelers target home in that state?"
},
{
"speaker": "Michael Klein",
"content": "Yes, sure, Josh. It's Michael again, I would say our appetite for and our exposure to $5 million homes in California is very limited. As you know and we've talked about in the past, our appetite really is middle market and mass affluent business. I would say when you get to $5 million homes, we would consider that really more high net worth business, and we're not a significant player in that market."
},
{
"speaker": "Josh Shanker",
"content": "Thank you very much for the answers."
},
{
"speaker": "Operator",
"content": "We have time for one more question and that question comes from the line of Michael Phillips at Oppenheimer."
},
{
"speaker": "Michael Phillips",
"content": "Thanks. Good morning, and thanks for fitting me in. Wonder if you could pull back the growth in Commercial Auto mid-teens right now. How much of that is rate? How much of that is PIF? And then maybe any comments on Commercial Auto that you're seeing on frequency and severity would be appreciated. Thank you."
},
{
"speaker": "Greg Toczydlowski",
"content": "Hey, Michael. I'm not going to get into the details on loss trend on that, but give you a little bit of color on the top line delta that you asked about. The thrust of that is renewal premium change, so really is rate and exposure that's driving that top line growth."
},
{
"speaker": "Michael Phillips",
"content": "Okay, perfect. And then you talked a bit about Personal Auto. I guess we're kind of hearing a bit of a mixed bag between different companies on where they are with rates and how much they want to grow. Can you just -- at a higher level, can you talk about what you're seeing this quarter versus maybe the last couple of quarters and certainly last quarter in the competitive environment in Personal Auto?"
},
{
"speaker": "Michael Klein",
"content": "Sure, Michael, it’s Michael here. I would say the competitive environment last quarter versus this quarter is fairly consistent. And I would say our observations on what's happening in the marketplace are fairly consistent. I think the good news is that we continue to make progress. As we pursue auto growth, new business was up 6% relative to the fourth quarter of last year. This quarter's fourth quarter new business is actually a record for fourth quarter new business for us in Auto. And as I mentioned, in states that aren't constrained by our property actions, we're growing both new policies and new business premium in aggregate. So we're encouraged by the progress and I would say the marketplace has remained relatively consistent over the last couple of quarters."
},
{
"speaker": "Operator",
"content": "And that concludes our Q&A session. I will now turn the conference back over to Abbe for closing remarks."
},
{
"speaker": "Abbe Goldstein",
"content": "Thanks, everyone, for joining us. We appreciate your time. And as always, if there's any follow-up, please reach out directly to Investor Relations. We hope you have a good day, and thanks again."
},
{
"speaker": "Operator",
"content": "And this concludes today's conference call. Thank you for your participation. You may now disconnect."
}
] |
trv | 2,024 | 3 | [
{
"speaker": "Operator",
"content": "Good morning, ladies and gentlemen. Welcome to the Third Quarter Results Teleconference for Travelers. We ask that you hold all questions until the completion of formal remarks, at which time you will be given instructions for the question-and-answer session. As a reminder, this conference is being recorded on October 17, 2024. At this time, I would like to turn the conference over to Ms. Abbe Goldstein, Senior Vice President of Investor Relations. Ms. Goldstein, you may begin."
},
{
"speaker": "Abbe Goldstein",
"content": "Thank you. Good morning, and welcome to Travelers' discussion of our third quarter 2024 results. We released our press release, financial supplement and webcast presentation earlier this morning. All of these materials can be found on our website at travelers.com under the Investors section. Speaking today will be Alan Schnitzer, Chairman and CEO; Dan Frey, Chief Financial Officer; and our three segment Presidents, Greg Toczydlowski, Business Insurance; Jeff Klenk of Bond & Specialty Insurance; and Michael Klein of Personal Insurance. They will discuss the financial results of our business and the current market environment. They will refer to the webcast presentation as they go through prepared remarks, and then, we will take your questions. Before I turn the call over to Alan, I'd like to draw your attention to the explanatory note included at the end of the webcast presentation. Our presentation today includes forward-looking statements. The company cautions investors that any forward-looking statement involves risks and uncertainties and is not a guarantee of future performance. Actual results may differ materially from those expressed or implied in the forward-looking statements due to a variety of factors. These factors are described under forward-looking statements in our earnings press release and in our most recent 10-Q and 10-K filed with the SEC. We do not undertake any obligation to update forward-looking statements. Also in our prepared remarks or responses to questions, we may mention some non-GAAP financial measures. Reconciliations are included in our recent earnings press release, financial supplement and other materials available in our Investors section on our website. And now, I'd like to turn the call over to Alan Schnitzer."
},
{
"speaker": "Alan Schnitzer",
"content": "Thank you, Abbe. Good morning, everyone, and thank you for joining us today. I'd like to start by acknowledging the devastation caused by recent hurricanes Helene and Milton. These were powerful storms and our hearts go out to all those who have been impacted. Of course, we send our thoughts and prayers, but we're also sending claim resources. From our national catastrophe center in Hartford, we're managing the deployment of hundreds of Travelers claim professionals, along with mobile claim offices and quick response vehicles. We've activated thousands more cross-trained colleagues across the country to support our local response. Our catastrophe response model enables us to adjust virtually every claim with the Travelers claim professional. And without resorting to independent adjusters, that results in a better outcome for our customers and distribution partners. Thanks to these efforts in the advanced analytics and geospatial tools that we leverage. We're on track this year to meet our objective of resolving 90% of our claims from natural catastrophes within 30 days. That can make the difference between whether a customer of ours is able to celebrate the holiday season in their living room instead of a hotel room. I'd also like to express my deep gratitude to our claim organization. The entire team tirelessly delivers exceptional technical expertise and support to our customers, demonstrating day-in and day-out, the value of the travelers promise. Turning to results. We are very pleased to have generated outstanding top and bottom line results this quarter. Excellent underlying underwriting income, higher net investment income and net favorable prior year reserve development, all contributed to core income, of more than $1.2 billion or $5.24 per diluted share, generating core return on equity of 16.6%. Underlying underwriting income of $1.5 billion pre-tax was up 73% over the prior year quarter, driven by record net earned premiums of $10.7 billion, up 10% and an underlying combined ratio that improved 5 points to an excellent 85.6%. Both underwriting income and underlying margins were strong in all three of our segments. The underlying combined ratio in our Business Insurance segment improved nearly 2 points to an excellent 87.9%. And our Bond & Specialty business delivered a very strong underlying combined ratio of 85.6%. The underline combined ratio in Personal Insurance improved 11.5 points to an exceptional 82.7%. These terrific segment results contributed to a reported consolidated combined ratio that improved nearly 8 points to 93.2%. Turning to investments. Our high quality investment portfolio continued to perform well, with after-tax net investment income up 16% to $742 million, driven by strong and reliable returns from our growing fixed income portfolio and higher returns from our non-fixed income portfolio. Our underwriting and investment results together with our strong balance sheet, enabled us to grow adjusted book value per share by 4% during the quarter, and that's after returning $496 million of excess capital to shareholders and continuing to make important investments in our business. As we notched another quarter of successful execution on a number of important strategic initiatives. Turning to the top line, we grew net written premiums by 8% to $11.3 billion. The strong value proposition that we offer to our customers and distribution partners, along with outstanding execution by our colleagues in the field contributed to our top line success. In Business Insurance, we grew net written premiums by 9% to more than $5.5 billion. Renewal premium change in the segment remained very strong, increasing to 10.5%, driven by strong contributions from the liability coverages. Renewal rate change accelerated to 7.3% in the quarter, and was steady or higher in every product line. Even with the firm pricing environment, retention in the segment ticked up to 86%. The combination of strong pricing and excellent retention reflects our deliberate execution and a marketplace that is reacting in a generally disciplined way to the headwinds of social and economic inflation. In Bond & Specialty Insurance, we grew net written premiums by 7% to a record $1.1 billion, driven by excellent retention of 90% in our high quality management liability business and strong production in our market-leading surety business. We grew surety net written premiums by 7% from a very strong result in the prior year quarter. We are very pleased to have generated terrific production results across our commercial segments, where margins continue to be attractive. That includes our E&S offerings, where we've grown net written premiums by 13% year-to-date. In Personal Insurance, we were pleased to grow net written premiums by 7%, driven by strong renewal price change in both auto and home. The strong production results across our three segments are a reflection of our view that in order to achieve our objective of industry-leading returns over time, we need an effective strategy to grow profitably over time. As we've shared before, we seek to achieve profitable growth by investing in franchise value, making sure that we offer the products, services and experiences that our customers want to buy and our distribution partners want to sell. Also central to our growth strategy is our very granular approach to risk selection, underwriting and pricing, which we've discussed many times. As a result of that approach and investments we've made over decades in leading data and analytics, our growth in insured exposures correlates to returns. In other words, generally speaking, the more attractive the returns in the business, the more we've been growing insured exposures in that business, all of which is to say, Travelers unique combination of franchise value and execution yields very effective capital deployment, a high-quality, profitable growth. The numbers speak for themselves. Over the last four years, we've grown our premium base by more than $13 billion, nearly a 50% increase while simultaneously improving our underwriting margins. The result is that we've more than doubled our underlying underwriting income and increased our total underwriting income by more than 80%. The combination of strong underwriting income and the reliable investment income from our substantial and growing investment portfolio makes for a powerful earnings engine. That's what's driving our strong results this quarter and year-to-date, and that's what's driving our core return on equity of 15.9% over the last 12 months. And that's what gives us great confidence in the outlook for our business into 2025 and beyond. With that, I’m pleased to turn the call over to Dan."
},
{
"speaker": "Dan Frey",
"content": "Thank you, Alan. I'm pleased to provide some additional color on an exceptionally strong quarter. Core income for the third quarter was $1.2 billion, and core return on equity was 16.6%. As we delivered another quarter of excellent underlying underwriting results, net favorable prior year reserve development and strong investment income. We're pleased to have once again generated record levels of earned premium this quarter and an excellent combined ratio of 93.2%, an improvement of nearly 8 points. Inside of that, our underlying combined ratio improved 5 full points from last year's strong results. This combination of premium growth and underlying margin improvement led to our best ever underlying underwriting gain of $1.2 billion after tax, up $503 million or 74% from the prior year quarter. The expense ratio for the third quarter was 28.4% and reflects the benefits of our continued focus on productivity and efficiency, coupled with strong top line growth. That brings the year-to-date expense ratio to 28.6%, in line with our expectations. Our third quarter results include $939 million of pre-tax catastrophe losses, more than half of which relates to Hurricane Helene, a devastating storm, which made landfall in the last few days of the quarter. For travelers, the financial impact of Helene was greater in Georgia and the Carolinas than in Florida. Turning to prior year reserve development. We had total net favorable development of $126 million pre-tax. In Business Insurance, the annual asbestos review resulted in a charge of $242 million. Ex-asbestos, Business Insurance had net favorable PYD of $151 million, driven by favorability in workers' comp. In Bond & Specialty, net favorable PYD of $36 million was driven by another quarter of better-than-expected results in fidelity and surety. Personal Insurance had $181 million of net favorable PYD with favorability in both home and auto. After-tax net investment income of $742 million was up 16% from the prior year quarter. Fixed maturity NII was again higher than the prior year quarter and in line with our previously shared outlook. Reflecting the benefit of both higher average yields and significant growth in the portfolio. Returns in the non-fixed income portfolio were also above the prior year quarter. In terms of our outlook for fixed income NII, including earnings from short-term securities, we now expect approximately $700 million after-tax for the fourth quarter. For 2025, we expect approximately $2.9 billion after-tax, our highest level ever, beginning with approximately $700 million in the first quarter of 2025 and growing to approximately $760 million for the fourth quarter. Turning to capital management. We generated our strongest ever level of quarterly operating cash flows at $3.9 billion. Bringing the year-to-date figure above $7 billion, also our strongest ever September year-to-date results. Interest rates decreased during the quarter, and as a result, our net unrealized investment loss decreased from $4 billion after-tax at June 30th, to $2.1 billion after-tax at September 30th. Adjusted book value per share, which excludes net unrealized investment gains and losses, was $131.30 at quarter end, up 7% from year-end and up 13% from a year ago. We returned $496 million of excess capital to our shareholders this quarter, comprising share repurchases of $253 million and dividends of $243 million. We have approximately $5.3 billion of capacity remaining under the share repurchase authorization from our Board of Directors. While it obviously did not impact our third quarter results, let me make a quick comment on Hurricane Milton. It's still early days in terms of assessing our ultimate losses, but at this point, we have a preliminary range of between $75 million and $175 million of pre-tax losses net of reinsurance. To sum things up, our third quarter and year-to-date results illustrate the fundamental earnings power that has resulted from our multi-year focus on growth at attractive margins and our rock-solid balance sheet. In addition to best ever levels of net written premium and net earned premium, our diversified portfolio of businesses delivered a terrific underwriting result, thanks to our best ever underlying combined ratio clearly demonstrating that we are positioned for success even during periods of weather volatility, like, we and the industry have experienced. In fact, despite having absorbed the highest ever level of catastrophe losses for the first-nine months of the year, our September year-to-date core earnings per share of $12.43 is a record high. And with that, I'll turn the call over to Greg for a discussion of Business Insurance."
},
{
"speaker": "Gregory Toczydlowski",
"content": "Thanks, Dan. Business Insurance had another strong quarter in terms of both top and bottom line results. Segment income for the third quarter was $698 million, up about 50% from the prior year quarter, driven by improved prior year development and higher underlying underwriting income. The combined ratio of 95.8% was strong and improved from the prior year quarter by more than 3 points. Similar to the past several quarters, we're extremely pleased with the quarter's exceptionally strong underlying combined ratio of 87.9%, which improved by about 2 points from the prior year quarter, primarily reflecting the benefit of earned pricing. This was our best third quarter underlying result ever. Turning to the top line. We grew net written premiums by 9% to an all-time third quarter high of more than $5.5 billion. Renewal premium change was once again historically high at 10.5%, with renewal retains that increased nearly 1 point sequentially and to 7.3%, driving the majority of the strong pricing. Retention remained excellent at 86%, and a new business of $680 million was the second highest third quarter result ever, just slightly trailing last year's record third quarter. In terms of pricing, we're pleased to sustain strong levels of renewal premium change, which increased sequentially from the second quarter. Strong pricing was broad-based with renewal premium change at or close to double-digits in every line other than workers' comp. With respect to pure renewal rate change, we're pleased with the exceptional granular execution by our field organization reflects and appropriately balances the current return profile and environmental trends for each line. Umbrella and Auto continue to lead the way with rate increases well into double-digits. In terms of sequential renewal rate change, every line was at or higher than the second quarter. Even with these strong pricing levels, retention remains strong, as I mentioned earlier, a reflection of marketplace discipline in the face of industry headwinds. As for the individual businesses, in Select, renewal premium change remained strong at 12.3%, up almost 2.5 points from the third quarter of last year. Renewal rate change of 5.5% was up sequentially from the second quarter and up more than 2.5 points from last year's third quarter. Retention tick down as we continue to intentionally optimize our CMP risk return profile in a couple of targeted geographies. New business was healthy and near historical highs. Overall, we remain pleased with the granular pricing and underwriting execution, driving profitable growth in Select. In middle market, renewal premium change was exceptionally strong at 10.6%, about 1 point higher than the second quarter, driven by renewal rate change, which reached 8%. The rate increases were broad-based with more than three quarters of our middle market accounts achieving positive rate change. And at the same time, the granular execution was excellent with meaningful spread from our best performing accounts to our lower performing accounts. We're pleased that retention also remained exceptionally even with these levels of price increases. Lastly, new business of $364 million was our highest ever third quarter result. And we're pleased with the risk selection and the strength of pricing on the accounts that we added to the portfolio. To sum up, Business Insurance had another terrific quarter. We're pleased with our execution in driving strong financial and production results, while continuing to invest in the business for long-term profitable growth. With that, I'll turn the call over to Jeff."
},
{
"speaker": "Jeffrey Klenk",
"content": "Thanks, Greg. Bond & Specialty posted another strong quarter on both the top and bottom lines. We generated segment income of $222 million and an excellent combined ratio of 82.5%. We also delivered a very strong 85.6% underlying combined ratio in the quarter. The increase of 4.9 points from last year's quarter reflects a modestly elevated expense ratio, primarily related to the Corvus acquisition and the impact of earned pricing. We expect the expense ratio to remain elevated for a few more quarters as we integrate Corvus' operation and as we ramp up and earn in premiums from its attractive book of business. Turning to the top line. We grew net written premiums by 7% in the quarter to a record high $1.1 billion. In our high-quality domestic management liability business, we again delivered excellent retention of 90%, with positive renewal premium change that reflects terrific execution by our field organization and our focus on retaining our profitable book of business. We're pleased that we grew new business by over 80% from the prior year quarter, to a record $113 million, driven by Corvus. Nine months following the closing of our Corvus acquisition, we continue to feel terrific about the talent, capabilities and business that we've added to our cyber portfolio. We're deploying Corvus' proprietary underwriting and risk control capabilities across our Cyber book, helping our customers remediate vulnerabilities and avoid cyber losses. Our distribution partners have endorsed our go-to-market strategy, which includes both admitted and excess and surplus lines cyber offerings. And realizing the benefit of our high-quality travelers paper and brand, we've considerably improved Corvus' legacy renewal retention. In short, we couldn't be more pleased with the addition of the Corvus team to the Travelers family. Turning to our market-leading surety business. We grew net written premiums by 7% from a very strong level in the prior year quarter. This growth reflects a robust construction environment, continued strong demand for our surety products and services and outstanding execution by our team, and growing our high credit quality portfolio. So we're pleased to have once again delivered strong top and bottom line results this quarter in Bond & Specialty Insurance. And now, I'll turn the call over to Michael."
},
{
"speaker": "Michael Klein",
"content": "Thanks, Jeff, and good morning, everyone. In Personal Insurance, we are very pleased with our third quarter results, which continue to reflect the positive impact of our rate and non-rate actions across the portfolio. In the quarter, we delivered significantly improved segment income of $384 million and a combined ratio of 92.5%, driven by excellent underlying -- by an excellent underlying underwriting results and strong net favorable prior year reserve development. The underlying combined ratio of 82.7% reflects an 11.5 point improvement compared to the prior year quarter, primarily driven by the benefit of earned pricing in both auto and home, as well as favorable non-catastrophe weather. Continued strong price increases drove 7% growth in net written premiums as we continue our focus on improving profitability in property, while seeking profitable growth in auto. In auto, we're pleased with another quarter of improved profitability. The third quarter combined ratio was very strong at 93.4% despite 4.9 points of catastrophe losses, primarily related to Hurricane Helene. The underlying combined ratio of 91.2% improved 9.4 points compared to the prior year quarter. The improvement continues to be driven by the benefit of higher earned pricing and lower losses from physical damage coverages. This quarter's underlying underwriting -- this quarter's underlying result also included a 2 point benefit related to the re-estimation of prior quarters in the current year. Taking a step back, the year-to-date underlying combined ratio of 93.7% reflects considerable progress and is compelling evidence of our return to profitability in auto. Looking ahead to the fourth quarter of 2024, it is important to remember that the fourth quarter auto underlying loss ratio has historically been about 6 points to 7 points above the average for the first-three quarters because of winter weather and holiday driving. In Homeowners and Other, the third quarter combined ratio of 91.5% improved by nearly 25 points compared to the prior year quarter, primarily as a result of a lower underlying combined ratio, as well as lower catastrophe losses and higher favorable prior year development. Hurricane Helene and a severe convective storm in July drove catastrophe losses in the quarter. The underlying combined ratio of 74.4% improved 13.6 points compared to the prior year quarter. Approximately three quarters of the year-over-year favorability was related to non-catastrophe weather and non-weather losses. The benefit of earned pricing also contributed to the improvement. Turning to production. Our results reflect our ongoing efforts to balance profitability and growth across the portfolio. We're pleased with our progress, as we execute a very granular state-by-state strategy. In domestic auto, retention of 83% remained strong. Renewal premium change of 12.8% continued to moderate as intended. Renewal premium change will continue to decline, reflective of improved auto profitability. Auto new business premiums continue to reflect our success in achieving positive auto growth in many states. While auto new business premium was down slightly in total, the decline reflects our focus on auto profitability in a few remaining challenging states and the cross-line impact of our actions to manage property exposure in high risk cat geographies. We're comfortable with this trade-off in the near term and remain confident in our ability to profitably grow our portfolio over time. In Homeowners and Other, retention of 85% and renewal premium change of 14.6% remained strong and consistent with recent quarters. We expect renewal premium change to generally remain at this level in the fourth quarter. As we intended, homeowners new business premium and policies in force continued to decline compared to the prior year quarter. Also, as we intended, the decline was most significant in high-risk catastrophe geographies, reflecting continued actions to reduce exposure and mitigate volatility through improved risk selection, restricted binding authority, tightened eligibility requirements and higher deductibles. To sum up for the Personal Insurance segment overall, this was a great quarter, reflecting disciplined execution by our team and further progress toward delivering a profitable growing portfolio of personalized business over time. Now I'll turn the call back over to Abbe."
},
{
"speaker": "Abbe Goldstein",
"content": "Thanks, Michael. We're happy to open up for your questions."
},
{
"speaker": "Operator",
"content": "Thank you. We will now being the question-and-answer session. [Operator Instructions] Your first question comes from the line of Gregory Peters from Raymond James. Your line is open."
},
{
"speaker": "Gregory Peters",
"content": "Okay. Good morning, everyone. So I guess for the first question, I'll focus on domestic business insurance and the renewal premium change, which continues to be quite strong even through the third quarter. I guess, where I'm going with this is, given the strong improvement in the underlying results, at what point will that renewal premium change begin to moderate?"
},
{
"speaker": "Alan Schnitzer",
"content": "Hey, Greg. Good morning. It's Alan. Thanks for the question. We're not going to try to forecast what that's going to be. But I would say, there are headwinds out there in terms of inflation. There is uncertainty out there in terms of the political and regulatory environment, the geopolitical environment, so on and so forth. So I'll share that with you as the kind of things we think some of the market is reacting to, but we're not going to project it."
},
{
"speaker": "Gregory Peters",
"content": "Okay. Fair enough. I thought, I’d give it a shot. I guess the other question, listening to the comments about the strong results, the best third quarter ever in business insurance, etc. and the free cash flow. I guess, I want to pivot back to capital management. I know you're not going to disclose M&A on the call, but it seems like a balanced approach, including capital return to shareholders and M&A, or investment in organic is a high likelihood that could happen. But considering the cash flow numbers, should we just plow that all on the share repurchase or what are you thinking?"
},
{
"speaker": "Alan Schnitzer",
"content": "Yeah, Greg, I'll just tell you philosophically for every single dollar of capital that we generate, our first priority is to invest it back in the business in whatever way we can do that to create shareholder value. Whether that's organic growth, investing in talent or capabilities, products, etc., or whether it’s inorganic. So that’s our first objective, and we try to do that. But it’s not our capital, it’s investor capital, and we try to be very, very good stewards of shareholders’ capital. And so we’ve got a pretty high bar for what we do with that capital, and we don’t think we can generate it back in the business and create a return, we’re going to return it to shareholders."
},
{
"speaker": "Gregory Peters",
"content": "Okay. Congrats on the results."
},
{
"speaker": "Alan Schnitzer",
"content": "Thanks, Greg."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of David Motemaden from Evercore ISI. Your line is open."
},
{
"speaker": "David Motemaden",
"content": "Thanks. Good morning. I sort of had a follow-up on the prior question on the BI renewal rate change. So it was good to see the acceleration quarter-over-quarter after its decelerated the past three quarters. I guess, I'm just wondering, Alan, if you could comment on how sustainable you feel like this rate environment is? And if you think the hurricanes over the last few weeks will change the trajectory on the property side, which I know is -- has kind of been a standout a drag on that RRC recently? And then just relatedly, how that impacts your appetite for growth within property, but also in liability lines where it's still an uncertain environment?"
},
{
"speaker": "Alan Schnitzer",
"content": "Yeah. So there's a lot there, David, let me start, and if I don't get to it, I’ll follow-up. But in terms of pricing, I would say that we expect renewal price change continue to be positive and strong for all the reasons I shared in response to Greg's question, now whether that means it goes up a little bit from here or down a little bit from here, I don't really know. But I think the message we would give you for all those reasons is positive and strong. You mentioned you’re -- the comment about property and that price weighing. I guess I would say, you got to take that property pricing together in connection with the return to the property line. So it's not like the returns are struggling and the price is falling. The price change in property is a reflection of the returns on that line. So it's totally rational and totally appropriate. We're not going to share our property pricing strategy, and we'll all just have to wait and see where the market goes on that. But clearly, these storms are a reminder of the potential volatility and the things that we've all got to be thoughtful about in committing capital to risk. Did I get that, David, anything I missed?"
},
{
"speaker": "David Motemaden",
"content": "And then just on the -- it sounds like the liability lines in auto and umbrella the rates. It sounded like they accelerated a bit sequentially in the quarter. I'm just wondering, I guess, you guys have made the reserve changes last quarter. It didn't sound like there was any noise this quarter from -- post that. But just your comfort level in terms of leaning into growth in some of those lines?"
},
{
"speaker": "Alan Schnitzer",
"content": "Yes. So I think we shared last quarter that even after the charge we took an umbrella, we were comfortable with the returns in umbrella even the last quarter and we remain comfortable with the returns. And again, we're going to execute on a very granular account by account basis. But given where the returns are, given – we’ve shared before and we talked a lot about this last quarter, there’s a real advantage to reacting quickly to loss cost trends and getting your view of pricing in order. And that gives us real confidence with the way we’re executing in the marketplace today. So we do think in terms of both growth and profitability, there is a huge advantage to reacting quickly to loss trend."
},
{
"speaker": "David Motemaden",
"content": "Great. Thank you."
},
{
"speaker": "Alan Schnitzer",
"content": "Thanks, David."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Mike Zaremski from BMO. Your line is open."
},
{
"speaker": "Michael Zaremski",
"content": "Hey, thanks. Good morning. This might be an easy answer, but I don't think I heard any call out of maybe one-time items are helping the underlying business insurance, the underlying loss ratio?"
},
{
"speaker": "Dan Frey",
"content": "Hey, Mike. It's Dan. That's right. It's pretty clean, pretty straightforward quarter, and really, we wouldn't call out anything that you need to adjust for."
},
{
"speaker": "Michael Zaremski",
"content": "Okay. Got it. Okay. For my follow-up, so I guess my follow-up be on personal lines. You have said in your prepared remarks that you are, I think, making some changes to deductibles, I believe. I guess, from a -- some of the super regionals are talking about kind of trying to overhaul their roughing with us -- basically the deductibles in a major way, increasing deductibles and maybe rough depreciation schedules or just a higher percentage deductible for rough replacement. Are you -- is Travelers taking more of a slower approach to that or are you making any kind of meaningful changes to your terms and conditions and personal lines in certain geographies?"
},
{
"speaker": "Michael Klein",
"content": "Sure, Mike. It's Michael. I would say, yes, we're very active in making meaningful changes to our terms and conditions for property, particularly, in cat exposed geographies. It's really what I was referring to. When I talked about one of the drivers of the shrink and property is. And specifically, to your question about deductibles, we have moved -- in some states, we have deductibles that are dollar denominated, in other states, we have deductibles that are percentage. But we've made significant moves, particularly in cat exposed states in the Midwest. Along those lines, again, among the other things I mentioned, which are restricting eligibility, doing quite a bit of re-underwriting of the portfolio to really try to manage that exposure."
},
{
"speaker": "Michael Zaremski",
"content": "Okay. I guess that would maybe change the way we need to think about modeling this maybe the loss ratio versus the cat ratio, but I guess, I think I'll follow up offline. Thank you."
},
{
"speaker": "Michael Klein",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Rob Cox from Goldman Sachs. Your line is open."
},
{
"speaker": "Robert Cox",
"content": "Hey. Thanks for taking my question. So obviously, on the renewal premium change, great numbers overall. I did just want to ask on Select. It looks like there was a little pressure on a little bit lower new business growth and retention, if I look back relative to a few quarters ago? I just wanted to ask on that?"
},
{
"speaker": "Gregory Toczydlowski",
"content": "Good morning, Rob. This is Greg. Yeah. As I shared with you in my comments, we're constantly optimizing our book of business in terms of getting the right equation between risk and reward. When you look at the webcast, first of all, 2023, we had some historical high retention number throughout that period. And we are -- similar to the question Mike just asked around deductibles, that's driven based on severe convective storm and a new peril that's been very dynamic and much more of a frequent weather event. And so, like, Michael and his team, our team in small commercial has also been fine-tuning that particular apparel and the coverage associated with that. And that's why we saw a little bit of the tick down in retention. I called that out in my prepared comments for you."
},
{
"speaker": "Robert Cox",
"content": "Got it. Thank you. And then, I just wanted to ask as a follow-up on just thinking about catastrophe losses, I don't think you guys provide an explicit guidance on this, but I was just curious, if you guys could give us any help in thinking about how we could size your annual expected catastrophe load? Any color or thoughts you could provide would be helpful?"
},
{
"speaker": "Alan Schnitzer",
"content": "Yeah. Rob, good morning. It's Allan. In our proxy statement, we do give it admittedly for the prior year, so it won't give you the -- our current year view, but you can see the prior year. And one thing we've shared is, we’ve had a couple of years now of pretty heavy cat losses is that we continue to factor those more recent years into our thought process, and we continue to weigh more recent years more heavily. And so that influences the way we think about cat loads going forward. We haven’t yet given an outlook for cats."
},
{
"speaker": "Robert Cox",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Elyse Greenspan from Wells Fargo. Your line is open."
},
{
"speaker": "Elyse Greenspan",
"content": "Hi, thanks. Good morning. My first question, I think it kind of was addressed in one of the earlier questions, but can you just confirm, I guess, that no reserving action was taken with NGL in the quarter. You didn't call it out, so it sounds like there was nothing, but I just want to confirm that?"
},
{
"speaker": "Dan Frey",
"content": "Yeah, Elyse. It's Dan. So I'll reiterate what I said, which was -- so ex-asbestos in BI, we were favorable about $151 million that was driven by workers' comp. It wasn't entirely workers' comp. So there were some other lines that moved, but they were small amounts, and the net of that was a good guy as well."
},
{
"speaker": "Elyse Greenspan",
"content": "Thank you. And then my follow-up, my second question is on personal auto. When you guys -- the 93.7% year-to-date and recognizing like there is some seasonality in the Q4, but this puts you guys right at a good spot relative to kind of mid-90s, which is kind of what folks typically target on the auto side. So, is this like the sustainable run rate margin as we think about the business with rates slowing and just your view of overall loss trend within personal auto?"
},
{
"speaker": "Michael Klein",
"content": "Sure, Elyse. It's Michael. I would say, certainly, the year-to-date result points you to a view that across the book, we're rate adequate. We're very pleased with the results and the returns. I shared that reminder again because it's pretty dramatic seasonality inside the book, and I just wanted to make sure that folks were aware of it. But broadly speaking, again, pleased with and really rate adequate across the book in auto at this point."
},
{
"speaker": "Elyse Greenspan",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Brian Meredith from UBS. Your line is open."
},
{
"speaker": "Brian Meredith",
"content": "Yes. Thanks. I could just follow up on that one. If you're rate adequate across your book, should we start to expect that policy count is going to grow here in the near future?"
},
{
"speaker": "Michael Klein",
"content": "Great question, Brian. It's Michael. We are hard at it, right? I tried to give you the pieces impacting auto growth as we sit here today. And again, in states where we don't have some of the other complications. We are seeing new business growth. And again, that's many states across the country. We're working hard at the states where we don't yet have adequate rates and we're making progress. But obviously, we're subject to those rates getting filed and approved before those flip into that category. But again, we're hard at work on that. And then the other element is the cross-line impact of our work to improve property risk reward, that will take some more time. But again, we're making strong progress there. And so again, as I've said the last couple of quarters, our focus in auto is to profitably grow it. Our focus in home is to improve profitability, given our focus on portfolio business, those two things kind of go hand in hand and that's what I mean when I say we're trying to balance growth and profitability across the book, but it's definitely a strong focus of ours."
},
{
"speaker": "Brian Meredith",
"content": "Appreciate it. And then one for Greg. I'm just curious, like, any kind of insight into what workers' comp pricing might look like going forward? I think we've -- you've heard that maybe a state or so, you might get some positive stuff out of ratings bureaus?"
},
{
"speaker": "Gregory Toczydlowski",
"content": "Yeah, Brian. This is Greg. Yeah. If I look at workers' comp as a portfolio, I think we're going to see a continuation of what we're seeing right now. And that really is driven based on the strong experience on the line, and we certainly, as leaders in that line have demonstrated that. And so when you look at the bureaus and CCI being the largest one, what we're looking at for a forecast in 2025 for loss cost recommendation. It's very similar to what we saw in 2024. Of course, that doesn't apply to every individual account will have [indiscernible] and etc., on the individual account. But I think it's going to, kind of, stay with the levels that it’s at right now."
},
{
"speaker": "Brian Meredith",
"content": "Thanks. Appreciate it."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Josh Shanker from Bank of America. Your line is open."
},
{
"speaker": "Joshua Shanker",
"content": "Yeah. More questions for Michael. Very popular today. I wanted to talk a little bit about, first, the favorable development in the Personal Lines segment. What years were it growing off the favorable development, and does that mean to some extent you may have overreacted on pricing in some states?"
},
{
"speaker": "Dan Frey",
"content": "Hey, Josh. It's Dan. So I'll start with the PYD story. Part of the PYD story, remember, the end of 2023 was really favorable in Personal Insurance and it was also brand new. The fourth quarter was terrifically strong from a profit perspective, it wasn't fully developed. We posted a really good number in the fourth quarter last year, but we were allowing for the uncertainty that where some of those claims are going to come later, were some of the ones that that did come, going to come with more severity. Nine months further on, we're just more confident. But if I look at the spread of accident years in Personal Insurance, favorable prior year reserve development. There is favorability in recent years. But if I look at the last 10 years, there is favorability in each and every one of the last 10 years. And I'll leave the pricing question for Michael."
},
{
"speaker": "Michael Klein",
"content": "Yeah. And Josh, I would say, in terms of did we overreact on pricing, again, I would reiterate the comment I made in response to a lease, which is, as we look across the book, we're rate adequate. And I'd also point you to the combined ratio for the year-to-date, if you add back prior year development to try to get to an accident year type number, that number is 97.4%. So I don't think that would be an indication that we've overshot."
},
{
"speaker": "Joshua Shanker",
"content": "That makes sense. And so we've had two quarters in a row now with about $170 million, $180 million of prior year favorable development in the Personal Lines segment. A lot of times, there's a certain trend and when that trend deviates throws off favorable development. But are these discrete things that you've noticed that make this degree of favorable development probably less likely to be sustainable if the trends continue or could we continue to see hundreds of million dollars of favorable development, if just the trends keep playing out? I hope, I'm asking the question appropriately."
},
{
"speaker": "Dan Frey",
"content": "Yeah. Josh, it's Dan. I think I get it, and I'm glad you asked it. I mean, I think if there's two words that I would not put in a sense together, it's prior year reserve development and trend or run rate. And I think we tell you this pretty consistently. We look at all the data as it comes in every quarter. We do thorough reviews of every line every quarter. We're just trying to get it right. What you've seen probably in the last couple of years when loss costs were elevated in '22 and '23. We said we want to get it right. But in getting it right, we want to acknowledge the fact that if there's an elevated level of uncertainty we're going to contemplate that in our reserves. And now, if you've seen some of the inflationary pressures come back down to a more normal level, some of those years have matured and aged out, that's sort of what you're seeing. So you may or may not believe it, I literally don't have a view of whether prior year reserve development is going to be higher, lower or sideways in prior -- in PI in the next several quarters, but that's the way we think about it."
},
{
"speaker": "Joshua Shanker",
"content": "Thank you for the answers. Appreciate it."
},
{
"speaker": "Dan Frey",
"content": "Thanks, Josh."
},
{
"speaker": "Operator",
"content": "And we have one more question, and that question comes from the line of Michael Phillips from Oppenheimer. Your line is open."
},
{
"speaker": "Michael Phillips",
"content": "Thanks. Good morning, everybody. I want to go back to the BI casualty renewal price changes for a second. From another side, when you have gotten more rate today than last quarter, and then I hear your answers, Alan, about uncertainty and geopolitical risk and social and economic, we talked about stuff for years. I guess, when you're getting more rate today than last quarter, with such strong current core margins, does it mean element your concerns on those things that you answered are more today than they were last year or the year before when you started talking about them?"
},
{
"speaker": "Alan Schnitzer",
"content": "Does it mean that we're more concerned about it. No, I -- the answers that you gave."
},
{
"speaker": "Michael Phillips",
"content": "Okay. That's the answer. That's the question. Are you more concerned today than maybe you were last year?"
},
{
"speaker": "Alan Schnitzer",
"content": "I wouldn't say that we're more concerned today, you can't really think about this sort of static at a point in time. We're thinking about this looking out the windshield of the future and loss trend is certainly positive, and we'd like pricing to keep up with that. But I would not say that we're more concerned today. And I do think one thing you get with Travelers is pretty early detection and reaction to changes in loss activity. And so, I don't know where it's going to go, but we feel pretty good about the actions that we've taken so far this year."
},
{
"speaker": "Michael Phillips",
"content": "Okay. Thanks. A quick one maybe for Jeff, perhaps. Any updates you can share with, I guess, loss trends in the management liability section? Thanks."
},
{
"speaker": "Jeffrey Klenk",
"content": "Not specific to loss trend, no. I called out in the script for you, and again, this is Jeff Klenk, we said that the earned pricing had an unfavorable impact on the underlying combined ratio. I'd point out though that the pricing strategy is a function of rate adequacy. The returns in the business have been excellent. Our renewal pricing reflects deliberate execution and I feel great about the renewal retention percentage at 90%. Thanks for the question."
},
{
"speaker": "Operator",
"content": "And that concludes our question-and-answer session. I will now turn the call back over to Abbe Goldstein for some final closing remarks."
},
{
"speaker": "Abbe Goldstein",
"content": "Thank you. Thank you all for joining us this morning. I appreciate the questions. And as always, if there's any follow-up, please get in touch with Investor Relations. Have a good day."
},
{
"speaker": "Operator",
"content": "This concludes today's conference call. Thank you for your participation. You may now disconnect."
}
] |
trv | 2,024 | 2 | [
{
"speaker": "Operator",
"content": "Good morning, ladies and gentlemen. Welcome to the Second Quarter Results Teleconference for Travelers. We ask that you hold all questions until the completion of formal remarks, at which time you will be given instructions for the question-and-answer session. As a reminder, this conference is being recorded on July 19, 2024. At this time, I would like to turn the conference over to Ms. Abbe Goldstein, Senior Vice President of Investor Relations. Ms. Goldstein, you may begin."
},
{
"speaker": "Abbe Goldstein",
"content": "Thank you. Good morning, and welcome to Travelers' discussion of our second quarter 2024 results. We released our press release, financial supplement, and webcast presentation earlier this morning. All of these materials can be found on our website at travelers.com under the Investors section. Speaking today will be Alan Schnitzer, Chairman and CEO; Dan Frey, Chief Financial Officer, and our three segment presidents, Greg Toczydlowski of Business Insurance; Jeff Klenk of Bond & Specialty Insurance; and Michael Klein of Personal Insurance. They will discuss the financial results of our business and the current market environment. They will refer to the webcast presentation as they go through prepared remarks and then we will take your questions. Before I turn the call over to Alan, I'd like to draw your attention to the explanatory note included at the end of the webcast presentation. Our presentation today includes forward-looking statements. The company cautions investors that any forward-looking statement involves risks and uncertainties and is not a guarantee of future performance. Actual results may differ materially from those expressed or implied in the forward-looking statements due to a variety of factors. These factors are described under forward-looking statements in our earnings press release and in our most recent 10-Q and 10-K filed with the SEC. We do not undertake any obligation to update forward-looking statements. Also in our remarks or responses to questions, we may mention some non-GAAP financial measures. Reconciliation are included in our recent earnings press release, financial supplement and other materials available in the investor section on our website. And now, I'd like to turn the call over to Alan."
},
{
"speaker": "Alan Schnitzer",
"content": "Thank you, Abbe. Good morning, everyone, and thank you for joining us today. We are pleased to have generated a strong bottom line result in the quarter that included a record number of severe convective storms across the United States. Excellent underlying results, favorable net prior year reserve development, and higher net investment income contributed to core income of $585 million or $2.51 per diluted share. Underlying underwriting income of $1.2 billion pre-tax was up 55% over the prior year quarter. This year's exceptional result was driven by record net earned premiums of $10.2 billion and a consolidated underlying combined ratio that improved 3.4 points to an excellent 87.7%. Net earned premiums were higher in all three of our business segments. The underlying combined ratio in our Business Insurance segment was an excellent 89.2%, and the underlying combined ratio in our Bond & Specialty business improved 1.7 points to a very strong 86.1%. Looking at our two commercial segments together, the aggregate BI, BSI underlying combined ratio was an outstanding 88.7% for the quarter. The underlying combined ratio in Personal Insurance improved by nearly 8 points to a terrific 86.3%. Turning to the top line, we grew net written premiums by 8% to $11.1 billion in the quarter. Outstanding execution by our colleagues in the field across all three segments contributed to our top-line success. We are very pleased to report terrific production results in our commercial segments, where, as you've heard, margins are attractive. In Business Insurance, we grew net written premiums by 7% to more than $5.5 billion. Renewal premium change remained very strong at 10.1%, while retention remained high at 85%. A combination of strong pricing and retention reflects deliberate execution on our part and a marketplace that continues to be generally disciplined. New business increased 9% to a record $732 million, a reflection of the fact that our customers and distribution partners value the products and services that we offer and the experiences that we provide. In Bond & Specialty insurance, we grew net written premiums by 8% to more than $1 billion, driven by very strong retention of 90% in our high-quality management liability business, and excellent production in our market-leading surety business, where we grew net written premiums by 11%. At year-end 2023, we shared that across our two commercial segments, our E&S writings had reached $2.5 billion for the year, doubled the level from 2021. Year-to-date, we've grown E&S net written premiums by 16%. The margins continue to be quite attractive. In Personal Insurance, continued strong pricing drove 9% growth in net written premiums with growth of 10% in auto and 8% in home. You'll hear more shortly from Greg, Jeff, and Michael about our segment results. Turning to investments, our high-quality investment portfolio continued to perform well, generating after-tax net investment income of $727 million, driven by strong and reliable terms from our growing fixed-income portfolio and higher returns from our non-fixed income portfolio. Our investment results benefit from the strong cash flow we've generated over a sustained period. This quarter marks the seventh consecutive quarter in which we've generated more than $1 billion in operating cash flow. This isn't a measure that we or the industry talk a lot about, but it's important. Cash flow is what enables us to make strategic investments in our business, return excess capital to shareholders, and grow our investment portfolio. Since 2016, we've invested $11 billion in important technology initiatives, returned more than $20 billion of excess capital to our shareholders, and grown our investment portfolio by more than $25 billion. It's a virtuous cycle as well-conceived and executed strategic initiatives, an effective capital management strategy, and a thoughtful investment strategy contribute to attractive returns and growth in adjusted book value per share. Strong underwriting is the flywheel that sets it all in motion. Thanks to exceptional franchise value and excellent marketplace execution, we've profitably grown our premium base from about $25 billion in 2016 to more than $40 billion today. Our growth over this period of time has been largely organic, selling products in which we have deep expertise through distribution partners with whom we have longstanding relationships, and in geographies where we have a thorough understanding of the regulatory environment and other market dynamics. In other words, our competitive advantages have enabled us to effectively execute a relatively low-risk growth strategy. The success of that strategy is evidenced by a return on equity that has averaged about 900 basis points over the 10-year treasury over that period at industry-low volatility. What all this boils down to is steady consistent growth and adjusted book value per share after making important investments in our business and returning substantial excess capital to shareholders. And as a leader in the US PNC market with broad product capability, demonstrated success with innovation and plenty of market share headroom, we're confident there's a lot more opportunity in front of us. To sum it up, we continue to be very confident in the outlook for our business. Our results for the first half of the year include strong premium growth, an excellent bottom line result, record operating cash flow, and steadily rising investment returns in our growing fixed income portfolio. With a strong and diversified business and balance sheet, we delivered 13.6% core return on equity over the last 12 months, despite substantial industry-wide catastrophe losses. With this momentum, we remain well-positioned for success this year and beyond. And with that, I'm pleased to turn the call over to Dan."
},
{
"speaker": "Dan Frey",
"content": "Thank you, Alan. We're pleased to have generated record levels of earned premium this quarter and an underlying combined ratio of 87.7%, a 340 basis point improvement from last year's strong result, and the third consecutive quarter below 88%. This led to one of our strongest ever underlying underwriting gains of $952 million after tax, up $337 million, or 55% from the prior year quarter. The expense ratio for the second quarter was 28.8%, in line with our expectations and once again benefiting from the combination of our focus on productivity and efficiency, coupled with strong top line growth. We continue to expect 2024's full year expense ratio to be 28% to 28.5%. As Alan mentioned, the industry experienced a very active cat quarter, and our second quarter results include $1.5 billion of pre-tax catastrophe losses, driven by a record number of severe convective storms. As disclosed in the significant events table in our 10-Q, we had five events surpass the $100 million mark in Q2, all in the month of May. Turning to prior year reserve development, we had total net favorable development of $230 million pre-tax. In Business Insurance, net favorable PYD of $34 million resulted from approximately $300 million of better than expected loss experience in workers' comp across a number of accident years, largely offset by about $250 million of strengthening in general liability driven by Umbrella for accident years 2021 through 2023. In terms of the Umbrella line, these are very young accident years made up almost entirely of IBNR. While we will obviously continue to evaluate loss activity as it comes in, we believe we have been proactive and decisive in addressing the latest observed loss activity and adjusting our view of loss development factors to allow for the prospect of rising settlement costs and lengthening settlement patterns. Importantly, our picks for accident years 2015 through 2020 did not require much adjustment in the first half of this year. It's also worth noting that our returns in the Umbrella line for the impacted accident years remain attractive. As we saw five years ago, when we were the first to call out a change in loss levels tied to an increase in attorney rep rates, sharpening our view of loss costs early in the development of immature accident years and long tail lines positions us to enhance our risk selection, pricing, and claim strategies, ultimately setting us up to outperform in terms of growth and profitability. And on a related note, with court backlogs from the COVID shutdown now largely resolved, that element of uncertainty is, to a large degree, behind us. In Bond & Specialty, net favorable PYD was $24 million pre-tax. Personal Insurance had significant net favorable PYD of $172 million pre-tax with good news from recent accident years in both home and auto. After tax net investment income of $727 million, increased by 22% from the prior year quarter. As expected, fixed maturity NII was again higher than the prior year quarter, reflecting both the benefit of higher average yields and higher invested assets. Returns in the non-fixed income portfolio were also up from the prior year quarter. Our outlook for fixed income NII, including earnings from short-term securities, has increased slightly. We now expect approximately $675 million after tax in the third quarter and $695 million after tax in the fourth quarter. New money rates as of June 30th are still above the yields embedded in the portfolio. So fixed income NII should continue to improve beyond 2024 as the portfolio gradually turns over and continues to grow. Turning to capital management. Operating cash flows for the quarter of $1.7 billion were, again, very strong and we ended the quarter with holding company liquidity of approximately $1.7 billion. Interest rates increased during the quarter and, as a result, our net unrealized investment loss increased modestly from $3.7 billion after tax at March 31st to $4 billion after tax at June 30th. Adjusted book value per share, which excludes net unrealized investment gains and losses, was $126.52 at quarter end, up 3% from year end, and up 10% from a year ago. We returned $498 million of capital to our shareholders this quarter, comprising share repurchases of $253 million and dividends of $245 million. We have approximately $5.5 billion of capacity remaining under the share repurchase authorization from our Board of Directors. Turning to reinsurance, Page 19 of the webcast presentation shows a summary of our July 1st reinsurance placements. We increased coverage when we renewed our Northeast property CAT XOL Treaty, which now provides $1 billion of coverage above the attachment point of $2.75 billion. A year ago, we purchased $850 million of coverage, and the attachment point was $2.5 billion. We also renewed the Personal Insurance hurricane cat excess of loss treaty for coastal exposure, which continues to provide 50% coverage for the $1 billion layer above an attachment point of $2 billion. Recapping our results, Q2 was another quarter of strong premium growth, excellent underlying underwriting profitability, and continued growth in net investment income, all of which bode well for our future returns. Our ability to absorb $1.5 billion of pre-tax cat losses and still deliver $585 million of core income for the quarter is a testament to the overall strength of our diversified franchise and the fundamentals of our business. To give a little more color on that, underlying underwriting income has become an increasingly reliable and important component of our earnings power. Going back to the combination of Travelers in St. Paul, from 2005 through 2019, annual underlying underwriting income averaged $1.2 billion after tax. Our focus on profitable premium growth, which began accelerating around 2016, resulted in underlying underwriting income surpassing $2 billion for the first time ever in 2020. And we stayed above $2 billion through 2022. We then surpassed $3 billion in 2023. And through the first half of 2024, underlying underwriting income of just over $1.9 billion is up by 32% compared to the first half of 2023. In short, underlying underwriting income has become a significant and growing contributor to our ability to continue generating industry-leading returns with industry-low volatility. And now, for more color on each segment's results, I'll turn the call over to Greg to begin with a discussion of Business Insurance."
},
{
"speaker": "Gregory Toczydlowski",
"content": "Thanks, Dan. Business Insurance had another strong quarter in terms of both top and bottom line results. Segment income was $656 million, up more than 60% from the prior year quarter, driven by prior year reserve development, higher net investment income, and higher underlying underwriting income. We're once again particularly pleased with the quarter's exceptionally strong underlying combined ratio of 89.2%, our best second quarter result ever. For modeling purposes, property losses for this quarter were about a point favorable to our expectations. Net written premiums increased 7% to an all-time second quarter high of more than $5.5 billion. Renewal premium change was once again historically high at 10.1% with renewal rate change of 6.5% driving the majority of the strong pricing. Retention remained excellent at 85% and new business was up 9% to a record quarterly high of $732 million. In terms of pricing, we're pleased to sustain strong levels of renewal premium change, which was double digits for the fifth quarter in a row. The strong pricing was broad-based with renewal premium change in every line other than workers' comp at or pretty close to double digits. In terms of pure renewal rate change, we're pleased that the exceptional granular execution by our field organization reflects and appropriately balances the current return profile and environmental trends for each line. In terms of sequential rate movement from the first quarter, CMP, auto, umbrella, and workers comp all increased. Umbrella and auto led the way with double-digit rate increases. Renewal rate change in our property line moderated, driven by the National Property business, reflecting strong returns after several years of substantial compounding rate and improvements in terms and conditions. Even with these strong pricing levels, retention was improved or flat in every line other than property, where some large accounts in our National Property business in particular traded away to the subscription market this quarter on terms we weren't willing to accept. As for the individual businesses, in select, renewal premium change was exceptionally high at 12.3% with the renewal rate change of 5.3%, up a point and a half from the first quarter and more than 2 points from the second quarter of last year. Retention remained healthy but ticked down a bit from recent periods to 83% as we begin to purposely optimize our risk return profile in a couple of targeted geographies and classes. New business remains strong and increased 8% from the prior year quarter. We're pleased with the impact that our production, product, and platform initiatives are having in the marketplace and building a high-quality mix of business and driving profitable growth in this market. In middle market, renewal premium change remains strong and consistent with recent levels at almost 10%. Renewal rate change of 7% was up more than a point from the second quarter of last year and has now been at or around the 7% mark for the fourth consecutive quarter. Retention also remained strong at 89%. A new business of $383 million was the highest ever second quarter result. Lastly, fresh off my most recent round of field visits, I couldn't be more pleased with our team's execution, ideation, energy, and enthusiastic adoption of the tools and capabilities that have come from the strategic investments we've been making. And our distribution partners were once again crystal clear about our team's value and shared many examples of how our local teams, the best in the business, distinguished themselves. These trips continue to highlight for me the value of our high-performing talent in training curriculums, as well as the dividends we are receiving from our investments to be the undeniable choice for the customer and an indispensable partner for our agents and brokers. With that, I'll turn the call over to Jeff."
},
{
"speaker": "Jeffrey Klenk",
"content": "Thanks, Greg. Bond & Specialty posted another strong quarter on both the top and bottom lines. We generated segment income of $170 million and a strong combined ratio of 87.7%. The underlying combined ratio improved 1.7 points to a very strong 86.1%. The underlying loss ratio improved 4.1 points to an excellent 46.4%, reflecting the comparison to an elevated level of losses in the prior year quarter from a small number of surety accounts. As we discussed last quarter, the expense ratio is modestly elevated primarily due to the Corvus acquisition. We expect that to continue to be the case for a few more quarters as we integrate the operation and as premiums from Corvus attractive book of business ramp up and earn in. Turning to the top line, we grew net written premiums by 8% in the quarter to a record high. In our high-quality domestic management liability business, we again delivered excellent retention of 90% with positive renewal premium change that is generally consistent with recent quarters. We're pleased that we grew new business by nearly 60% from the prior year quarter to a record $111 million driven by Corvus. As a reminder, all of Corvus production will continue to be reflected in new business through next quarter. We grew net written premiums in our market leading surety business by a terrific 11% in the quarter, reflecting a robust construction environment and continued strong demand for our surety products and services. So we're pleased to have once again delivered strong top and bottom line results this quarter. And now, I'll turn the call over to Michael."
},
{
"speaker": "Michael Klein",
"content": "Thanks, Jeff. Good morning, everyone. In Personal Insurance, an excellent underlying underwriting result and strong net favorable prior year reserve development drove a significantly improved bottom line result relative to the prior year quarter, despite another period of elevated industry-wide catastrophe losses. The underlying combined ratio of 86.3% reflects nearly an 8 point improvement compared to the prior year quarter, primarily driven by higher earned pricing in both automobile and homeowners and other. Continued strong price increases in both auto and home drove 9% growth in net written premiums. In auto, we're pleased with another quarter of improved profitability and with the underlying fundamentals of the business. The second quarter combined ratio of 97.9% improved more than 10 points compared to the prior year quarter due to a lower underlying combined ratio as well as favorable prior year development. The underlying combined ratio improved more than 8 points, driven by the benefit of higher earned pricing and to a lesser extent lower losses from physical damage coverages. For modeling purposes, we view roughly 2.5 points of the improvement in the quarter as non-recurring. In homeowners and other, the second quarter combined ratio improved over 16 points compared to the prior year quarter, reflecting a lower underlying combined ratio, as well as higher favorable prior year development. While catastrophe loss dollars were similar to the prior year quarter, they had a smaller combined ratio impact as price increases continue to benefit earned premiums. Catastrophe losses this quarter, primarily resulting from severe convective storms, again significantly exceeded long-term industry averages. The 28 PCS designated cat events were the most ever for a second quarter and 150% of the historical 10-year average. Our catastrophe losses in the quarter were consistent with our market share. And for context, our average annual cat losses over the last five and 10 years remain below our market chart. This most recent experience will of course be reflected in our models going forward and we will continue to weigh our recent experience more heavily in our ongoing process of optimizing our exposure, underwriting, and pricing. The underlying combined ratio of 77.6% improved 7.6 points, due in large part to lower than expected fire and non-weather water losses, as well as the benefit of earned pricing. For modeling purposes, we expect approximately 5 points of the improvement in the homeowners and other underlying combined ratio to be nonrecurring. Turning to production, our results reflect the ongoing execution of a granular state-by-state strategy as we balance profitability and growth across the portfolio. In domestic automobile, retention of 82% remains strong. Renewal premium change of 15.8% continued to moderate as anticipated. Auto renewal premium change will continue to gradually decline, reflecting the improved profitability on the line. While new business premiums were higher than the prior year quarter in many states, new business premium in aggregate was down slightly relative to the second quarter of last year. This is the result of our continued efforts to manage auto profitability in a few remaining challenge states, as well as the cross-line impact resulting from some of our property actions, particularly in high-risk cat areas. Production results in homeowners and other reflect our focus to manage growth, while improving profitability. Renewal premium change increased sequentially to 15.1%, reflecting higher rate change, while retention remains strong at 85%. We expect renewal premium change to remain at this level through year end. As we intended, new business and policies enforced declined, reflecting our efforts to thoughtfully deploy capacity. To sum up for the Personal Insurance segment overall, we're pleased with our progress as we continue to deliver improved profitability. We're confident that the actions we've taken and continue to take will result in a profitable growing portfolio of personalized business over time. Now, I'll turn the call back over to Abbe."
},
{
"speaker": "Abbe Goldstein",
"content": "Thank you. Operator, we're ready to open up for Q&A."
},
{
"speaker": "Operator",
"content": "Thank you. We will now begin the question-and-answer session. [Operator Instructions] Your first question comes from David Motemaden with Evercore ISI. Please go ahead."
},
{
"speaker": "David Motemaden",
"content": "Thanks. Good morning. I just had a question on the moving pieces around reserves in Business Insurance. So just the $250 million of recent accident year umbrella charges. That comes after $100 million last quarter. So I guess I'm wondering if you could just elaborate on some of the more puts and takes and maybe give some confidence that you've put this behind you after the changes you made this quarter."
},
{
"speaker": "Dan Frey",
"content": "Hey, David, it's Dan. So you're right. We've seen umbrella in the general liability lines require some strengthening in the last few quarters. As we said in prepared remarks, we think that we're being proactive in reacting early and being decisive in meaning that we're being reasonably comprehensive in a meaning -- by reacting in a meaningful way to what we're seeing. I think the confidence we have is two pieces. One is, we are reacting both to the changes in actual versus expected and allowing for longer development factors going forward on the very recent accident years. So for the most part, we haven't even seen these claims come in yet, but we are allowing for the fact that when claims come in, they're likely going to cost more and take longer to settle. And then I think importantly, the 2015 through 2020 period has held up pretty well, given the actions that we had taken through the end of 2023."
},
{
"speaker": "David Motemaden",
"content": "Got it. Okay. And maybe also within Business Insurance, the underlying loss ratio, if I sort of adjust out the light non-cat weather this quarter and then in 2Q 2023, there still was around 50 basis points of improvement year-over-year on a clean basis. Could you talk about, I guess, what was driving that improvement? And especially given all these changes, was there any change to loss trend baked in there?"
},
{
"speaker": "Dan Frey",
"content": "Yes, David, it's Dan again. So I'll take that. So I'll start with the second part first. So every time we have an impact on PYD, we reevaluate, is that going to have an impact on current loss year, jump off point, or loss trend. We had said last quarter that we had added beginning last quarter some IBNR to the current accident year. So we had already taken some action. The changes that we made in PYD have some carry forward impact on the umbrella line, but there's puts and takes across a variety of lines. And when you blend them all together inside of Business Insurance, it did not result in a big movement. In terms of the overall movement in BI's underlying loss ratio, you've got the big parts. There's still some benefit from earned pricing. Greg called out the fact that property losses, other than cat, were about a point favorable than our expectations. Other than that, in any quarter, you're going to have a half a dozen things that move favorably or unfavorably from mixed to base year to the impact of reinsurance, and you're seeing the net of those things. Nothing significant in there in terms of those individual movements."
},
{
"speaker": "David Motemaden",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from Elyse Greenspan with Wells Fargo. Please go ahead."
},
{
"speaker": "Elyse Greenspan",
"content": "Hi, thanks. Good morning. My first question, I'm looking at the BI pricing trends, which the [RSE] (ph) decelerated by 40 basis points. Is that just due to property, given that select and middle markets did improve in the quarter?"
},
{
"speaker": "Gregory Toczydlowski",
"content": "At least. This is Greg. Good morning. Yes, you can see in the webcast the individual pieces of select and middle market. And select is up, and middle market is flat. And I did call out that National Property is the primary driver of that slight deceleration."
},
{
"speaker": "Elyse Greenspan",
"content": "Okay, great. And then just going back to the umbrella increase as well, can you give us a sense maybe just some more color by accident year? And then, maybe just a little bit more following up on David's question, like, what emerged, I guess, in the Q2 more than what you saw in the Q1 to think that you put this issue to bed that we're not going to be dealing with additional charges as we go through the balance of this year?"
},
{
"speaker": "Dan Frey",
"content": "Yes, Elyse, it's Dan. So I think it's a pretty narrow range. We're giving you that it's three accident years, 2021, 2022, and 2023. I don't really feel the need to break it apart between the three. And it's a little bit more of the same, right? Things have continued to come in a little higher, whether it's attorney rep rate or severity, jury awards, all of those things, lengthening of the tail. What we're doing this quarter is, again, both reacting to what did we see that came in differently than what we would have expected and adjusting the development factors that we're going to use going forward? And that's what we mean when we say we think we're being proactive and decisive in this quarter's action."
},
{
"speaker": "Elyse Greenspan",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Rob Cox with Goldman Sachs. Please go ahead."
},
{
"speaker": "Robert Cox",
"content": "Hey, thanks for taking my question. Yes, I just wanted to ask on the data surrounding the court backlogs, I thought that was interesting. The court backlogs are now resolved from the COVID shutdown. Could you give us a little more color on that? Are you referencing data for Travelers or is that external industry data?"
},
{
"speaker": "Alan Schnitzer",
"content": "Yes, Rob, good morning. It's Alan. That is really an evaluation of our own data. We think we probably have the market relevance to understand what's going on more broadly, but that's based on our view of our data."
},
{
"speaker": "Robert Cox",
"content": "Okay, got it. And the changes to reinsurance do you expect any impacts to the combined ratio at all or the underlying combined ratio from any of the movements there?"
},
{
"speaker": "Dan Frey",
"content": "Rob, it’s Dan. So not really. Pricing was about in line with what we would have expected. I'll just remind you that although cost of reinsurance might have gone up a little bit, we're getting price increases on the direct side, so the margin impact is insignificant probably, if any."
},
{
"speaker": "Robert Cox",
"content": "Okay, great. Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from Gregory Peters with Raymond James. Please go ahead."
},
{
"speaker": "Gregory Peters",
"content": "Good morning, everyone. I'd like to, for my first question, focus on Slide 8 of your PowerPoint presentation. And what I'm focused on is your competitive positioning. If I look at the year-to-date top lines results, kind of seeing some movements that I'm surprised by. I guess seeing national accounts grow as much as they did on a year-to-date basis kind of seems like it's counterintuitive. You expect the larger account business to be more competitive. And then on the selective middle market, I kind of anticipate maybe that to be higher growth areas for you from a net premium written perspective. So maybe you can provide some colors on that topic."
},
{
"speaker": "Dan Frey",
"content": "So Greg, it's Dan. I'll start, and maybe Greg will chime in. So national accounts, on a relative basis, in terms of its contribution to Business Insurance in total, not the biggest piece, and its large accounts. So how many you retain -- you could lose one account in a quarter and that has a big impact on retention. You could write one new big new piece of business. That's going to change the premium base. So I'd say two things about national accounts. One, we're really happy with the profitability of that book. Two, I'm not surprised to see the variability given: one, that it's a relatively small base; and that two, the accounts themselves tend to be big. In terms of selecting middle, look, we love the performance of both of those businesses. Greg did make comments in his script about some refinement of the way we're thinking about underwriting in small commercial. Middle market, margins are really good, 8% growth. We're very happy on how we focused on the balance of retention and price where we need it. But I don't know, Greg, anything to add to that?"
},
{
"speaker": "Gregory Toczydlowski",
"content": "Yes, Greg, maybe just start with the bigger picture, the total business. 7% is a really good result given the attractive margins in this business right now. And you pointed out some of the individual business units. When you look at them from quarter-to-quarter, a number of items can have some level of variation, including booking lags, reinsurance processing, things that Dan just referenced. But in terms of the aggregate results, I'd point you as close as they are, the quarter to year to date, I'd point you to the year to date number, as that's a better indicator of how we're feeling about the top line of the business right now."
},
{
"speaker": "Gregory Peters",
"content": "Fair enough. I guess for my follow-up question, I'm going to pivot to the Personal Insurance segment. And Michael, I appreciate your comments about the challenge to the states and trying to get the right positioning and pricing for your auto product. One of the largest and most visible peers seems to be really gaining share at this moment in time in the personal auto space. And I guess, when I look at your policy for in-force count going down, both in the first and second quarter, I'm just curious if you think your competitive positioning in personal auto is consistent with what's going on in the marketplace."
},
{
"speaker": "Michael Klein",
"content": "Yes, Greg, I think it's a great question. I would say, to your point about is it consistent with what's going on in the marketplace, it's interesting. The one peer you're talking about is the one peer with those results, not everybody else inclusive of us. So I would take a step back first of all and say, certainly kudos to them and the results they're generating and the success that they're having, but it's really not us who's the outlier. And then underneath that, I think, again, I tried to detail it for you. We are having success in the geographies that I'll say are the ones that aren't noisy and generating new business growth in those places where we like the auto margins and we're not impacted by some of the property actions, number one. That growth is, if you just look at the auto line by itself, being hampered by those challenged geographies. And then I also think that it's important to think about the differences in our strategy and our book of business when you look at our auto growth numbers, right? We are predominantly a package writer of personal lines business. The competitor that's growing auto is not predominantly a package writer of personal lines business. And when you look at the challenge of geographies from a property standpoint and you look at the independent agent channel, what you find in the marketplace is that, in many of those geographies in order to write the property, the carrier is insisting on also writing the auto. And so, if you are a competitor that's less dependent on auto business that brings property with it, you're not as challenged by those marketplace dynamics in those high-risk property geographies. So those are -- I think those are some of the things that explain the differences. But again, I would come back and say we're very pleased with our ability to generate auto new business growth in the places where we're not challenged by those factors. The other thing is, if you were to look underneath the new business growth numbers, first of all, you can see in aggregate auto new business growth is much better than property new business growth. And particularly, in those challenged geographies from a property standpoint, our auto new business is down, but it's not down nearly as much as the property new business in those geographies."
},
{
"speaker": "Alan Schnitzer",
"content": "And Greg, I would just point out at a very high level. Michael points out some distinguishing characteristics of our Personal Insurance business, there are some significant benefits from that business model. I mean, obviously, it's having the impact it's having on growth, but there are some significant offsetting benefits to that business model, and we're well on the way to sorting this out."
},
{
"speaker": "Gregory Peters",
"content": "Got it. Thank you very much for the detailed answers."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of [Jimmy Bueller] with JP Morgan. Please go ahead."
},
{
"speaker": "Unidentified Analyst",
"content": "Hey, good morning. So first just had a question on just your cat losses. Given changes we've seen in the reinsurance market the last year and a half, should we assume that you're going to be absorbing higher levels of cats going forward, or is the high number that you posted this quarter, same quarter last year as well, more of a function of the type of events you have seen."
},
{
"speaker": "Dan Frey",
"content": "Yes, Jimmy, it's Dan. So, if you look at the reinsurance detail we gave at the January 1 renewals and now again at July 1 renewals, we're not really holding onto more. We tend to buy more tail coverage on big cat events. The attachment points have gone up, but the attachment points have gone up naturally as a result of the growth in the premium base and the growth of the insured values. So what's coming through our net result is not really any impact from less use of reinsurance."
},
{
"speaker": "Unidentified Analyst",
"content": "Okay. And then just for Michael, can you talk about just competitor behavior in the personal auto line, both in terms of pricing and then advertising spending by some of the larger peers?"
},
{
"speaker": "Michael Klein",
"content": "Sure, Jimmy. I would say, in terms of pricing, we continue to see renewal premium changes and price changes working their way into books of business across the industry similar to what we're seeing. I do think it's important when you look at our renewal premium change number though, to distinguish between what's coming through renewal premium change and the rate that's being filed for go-forward business, right? What you're looking at when you look at our renewal premium change number and many renewal premium change numbers across the industry is the lagged effect of the rate that's already been taken. When we look at filing activity for ourselves and for others, you see a much less significant amount of rate filing this time this year than you would have seen this time last year. And so again, what you're seeing in renewal premium change in auto is the lagged impact of that. In terms of your question about advertising, certainly we see increased advertising amongst some of our competitors who are big advertisers across the industry. In marketplaces where we bid for demand, where we bid for leads. We see the prices of those leads going up. That's reflective of that increased advertising spend and that increased appetite for leads. But I think that both of those things, I think, demonstrate that what you're seeing is improved profitability in auto across the industry and a pivot towards profitable growth very consistent with the conversation and the messaging that we're sharing."
},
{
"speaker": "Unidentified Analyst",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Joshua Shanker with Bank of America. Please go ahead."
},
{
"speaker": "Joshua Shanker",
"content": "Yes, thank you very much. I guess for Michael, you're right to point out that the property declines are greater than the auto declines. I'm wondering if you can talk about whether there's non-renewals of customers who you no longer want given their geographies or whether it's pricing actions that are driving those customers away? When we look at the policy count changes in homeowners, what's driving them?"
},
{
"speaker": "Michael Klein",
"content": "Sure, Josh. The biggest driver of the policy count decline in homeowners is the reduction in new business. You see where the retention holding relatively steady. And so for the most part, new business production being down is what's driving the [PIF] (ph) decline. I'll also say that, sort of consistent with my comments earlier, the new business reduction in the cat challenged states is down more significantly than the new business reduction you see in the production highlights as we work to manage the distribution of our property exposure. There is some limited non-renewal activity that I would say is really twofold. One is normal course, good hygiene, evaluating the worst performing risks in the portfolio and taking action on them. The other is, some targeted non-renewals, again, as we manage the geographic distribution of our exposures and manage growth in some higher concentration, higher cat geographies. But again, those actions are all intentional and the new business reductions, as I said in my prepared remarks, really are as intended as part of our efforts to improve profitability."
},
{
"speaker": "Joshua Shanker",
"content": "And then a quick question on catastrophe. It's been quite a decade in terms of catastrophe losses. While you've made changes over time, you were a cat [indiscernible] pretty consistent. You like the risk and you only have protection really at the top for very extreme events. A broken clock is right twice a day in hindsight 2020, but looking at the last 10 years, has the cat program at Travelers been the most efficient use of your capital? And when you revisit, say that this is exactly what we need to do for the next 10 years?"
},
{
"speaker": "Alan Schnitzer",
"content": "Josh, I think we're very comfortable with being a net underwriter. We think that we've got the data, the analytics, the culture to manage this the right way. And you can't expect a reinsurer to take on losses without conveying a margin to them. And so, when we look at the strength of our underwriting, we think that there's a real advantage for us in being largely a net underwriter."
},
{
"speaker": "Joshua Shanker",
"content": "Okay. Thank you very much."
},
{
"speaker": "Alan Schnitzer",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Ryan Tunis with Autonomous Research. Please go ahead."
},
{
"speaker": "Ryan Tunis",
"content": "Hi, thanks. Good morning. First question, a couple parts on casualty. First of all, I guess with what you're seeing in Umbrella, is it safe to assume that the underlying cause of a lot of those losses you're seeing is mostly auto-related? That's the first part. And then the second part, I remember like six years ago in 2019, you guys experienced some of this earlier than others. Is there something about your small middle market, your writing lower limits, that there's a little bit less of a tail. So just to make sure your business kind of experiences some of the inflationary impacts you've seen from 2021 to 2023 faster."
},
{
"speaker": "Alan Schnitzer",
"content": "Hey Ryan, let me start there. So in terms of what we're seeing, no, it's not -- actually not a predominantly auto issue. This is a combination of economic inflation and social inflation driving claim activity into the Umbrella line in short. And economic inflation sort of speaks for itself. Social inflation, it's an aggressive plaintiff's bar. It's third-party litigation funding. It's sympathetic jury. It's the exact same constellation of factors we've been talking about, just a little bit more pronounced. In terms of our ability to see it sooner, I honestly don't think it's a function of our book of business or our limits or anything else. I think it's a function of our data, our analytics, and really importantly, our culture. We've got a culture that looks for this, that sees it. We've got a very, very important and very valuable feedback loop among our claims professionals, our pricing actuaries, our reserving actuaries, and our underwriters that can put together a story very, very quickly. And it's actually a competitive advantage. As Dan highlighted in his prepared remarks, the ability to sharpen a view of lost costs very, very early in the life of immature long-tail lines is a huge advantage. It's a difference on whether you're subject to adverse selection or inflicting adverse selection. And we think this positions us very well. Again, it's very, very early. These years are predominantly IBNR. And the returns that we're looking at in those years actually continues to be very attractive. So I get the interest in it. Believe me, we're interested in it, too. But our ability to see this and react to it really is a competitive advantage for Travelers."
},
{
"speaker": "Joshua Shanker",
"content": "Got it. Then I guess just to follow up. I think Greg mentioned lower retention in select accounts. I heard the word geography. I mean, to the extent that you are seeing elevated cats in commercial lines, I'd be curious if you guys think you are. Is that more of a small commercial issue or if not, is it kind of more middle market or a national account?"
},
{
"speaker": "Gregory Toczydlowski",
"content": "Hey, Ryan, this is Greg. Yes, we're not seeing cats disproportionately across any of the business units in Business Insurance. And it's just our normal good housekeeping and selected that we're going through and looking at the book of business and understanding parts of it where we need to get a better risk return profile. And folks certainly aren't going to share the individual geographies as that's market sensitive, but that's what's going on underneath that statement."
},
{
"speaker": "Alan Schnitzer",
"content": "It's the kind of optimizing we do in every business every day."
},
{
"speaker": "Joshua Shanker",
"content": "Understood. Thank you."
},
{
"speaker": "Alan Schnitzer",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from Brian Meredith with UBS. Please go ahead."
},
{
"speaker": "Brian Meredith",
"content": "Hey, thanks. I only have a couple of quick questions here. First one, there was some legislation in Florida, I guess, that passed in June that talked about Medicare reimbursement rates to doctors that will affect workers' comp. I'm just curious if you could maybe talk a little bit about how that would affect comp, pricing and loss cost severity trends. And is that something you see continuing throughout the US?"
},
{
"speaker": "Alan Schnitzer",
"content": "Brian, what I would say about workers' comp loss trend is that, we continue to look at it based on long-term basis and frequency and severity both continue to emerge favorable to our expectations. So there's nothing we're seeing out there that's necessarily adversely impacting that perspective, but it's a long-tailed line and we're going to have a lot of respect for the duration of the liability."
},
{
"speaker": "Dan Frey",
"content": "And Brian, in terms of any specific state change that you mentioned, our product managers are looking at that at the state level. They're estimating what some of the bills and changes are. And we factor that in the pricing over time as we see those trends come in. So if there's a new reg out there and we think it's meaningful, we certainly are going to take an estimate at that and how it plays out in the marketplace."
},
{
"speaker": "Brian Meredith",
"content": "Terrific. Thanks. And Alan, second question is, you all have seen some great growth in your E&S capabilities and clearly seems like you're building those out. I'm just curious, you've typically been known as kind of the largest standard commercial and admitted market player in the US. Why kind of the sudden change, or not sudden change, but that kind of gradual change in strategy here toward more focus on the E&S markets? And do you think this continues here for the Travelers that E&S will become a larger and larger percentage of your overall, call it, commercial business mix?"
},
{
"speaker": "Alan Schnitzer",
"content": "So Brian, we are predominantly a standard lines writer and we will continue to be that for the foreseeable future. We're not changing any stripes here and we've had substantial E&S capability for a very long time. So, for a long time a lot of our National Property business has been written on E&S paper. We've got our Northfield E&S business. We've got our Lloyd's business, some of what we do, in our Bond & Specialty business is written on E&S paper. So it's been a capability that we've had for a long time. And there have been ebbs and flows of business in and out of E&S for a long time. And so, part of this is what's been flowing into it and our ability to capture it. In addition, as we've seen an attractive E&S opportunity, we've leaned into it a little bit. So think what we've done with Fidelis and our acquisition of Corvus, and those have been contributors too. So this isn't a changing of strides by any stretch of the imagination, but there's an opportunity out there and we're participating in it at very attractive margins."
},
{
"speaker": "Brian Meredith",
"content": "Great, helpful. Thank you."
},
{
"speaker": "Alan Schnitzer",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from Meyer Shields with KBW. Please go ahead."
},
{
"speaker": "Meyer Shields",
"content": "Great, thanks and good morning. I guess first question, I'm not sure who this is best sent to, but does the Supreme Court overturning the Chevron doctrine, how does that impact exposure for various casualty lines?"
},
{
"speaker": "Alan Schnitzer",
"content": "I don't really know how to answer that, to be honest, Meyer. And we'll see over time whether there's any significant impact at all from Chevron. I mean, I hesitate to speculate on that at all and maybe it depends on who the regulators are in place and how that changes from one administration to the next. But I'm trying to decide whether I want to answer this off the top of my head or not, because it's not something that we've really rung our hands over. But if you imagine that regulatory activity is a contributor to loss activity, the impact of that decision on the Chevron document, you'd expect might be a good guy, frankly. But I think it's too early for us to make that call."
},
{
"speaker": "Meyer Shields",
"content": "Okay, fair enough. The second question, I guess, this is for Michael. When you look at the sort of potential outcomes for non-catastrophe weather and catastrophe losses, do you think of those as being inversely related or unrelated?"
},
{
"speaker": "Michael Klein",
"content": "Meyer, I think it depends on the quarter. The non-cat weather in Personal Insurance sometimes will see a benefit because much of the weather gets classified as a cat. That actually was the case in the second quarter of last year. That was less so the case this year. When we talked about the underlying result this quarter, I talked about the fact that it was really fire and non-weather water losses, just to put a point on it and really didn't talk about non-cat weather, because in this quarter, it really -- we had both elevated catastrophes and we had about what we expected from a non-cat weather standpoint. So, in some cases, you'll see a little bit of an inverse relationship depending upon sort of the footprint of the weather and how significant the events are. But they're not always inversely related or directly related for that matter."
},
{
"speaker": "Gregory Toczydlowski",
"content": "I mean, it was a little bit of a factor of force this quarter in Business Insurance. Not huge, but it did have that impact this quarter. And so, when we do think about our weather, obviously, we're managing it as one, but there's a lot of what we would report favorably or unfavorably in small weather that you would see in the catastrophe line of some of our peers."
},
{
"speaker": "Meyer Shields",
"content": "Okay, that's perfect. Thank you so much."
},
{
"speaker": "Operator",
"content": "Your next question comes from Mike Zaremski with BMO. Please go ahead."
},
{
"speaker": "Mike Zaremski",
"content": "Hey, thanks. Good morning. Just stepping back and thinking about the competitive environment in commercial lines, maybe a little more focused on Business Insurance, but maybe not. Would you expect current pricing power trends and maybe for the industry to kind of be stable? Or would you expect kind of an upward sloping trend if indeed Travelers is kind of ahead of others in terms of being proactive on loss trends, especially on the casualty side."
},
{
"speaker": "Alan Schnitzer",
"content": "Mike, I think we're going to try very hard not to give outlook on pricing. But I will say that from here, we would expect renewal price change continue to be positive and strong and in particular, driven by casualty. Now, whether that means up a little bit or down a little bit in one line or another. I don't really know. But I would say we expect it to remain relatively strong. There's a lot of uncertainty out there and you've heard from others about their experience in the casualty lines. As we look at the schedule P's, honestly, we expect there to be more of that coming from the industry. When we look at our position relative to the industry position, we would expect there to be more coming from the industry. So I would say positive and strong, particularly driven by casualty."
},
{
"speaker": "Mike Zaremski",
"content": "Got it. Quick follow-up, and I wish there was a live transcript if there's not because of this global IT issue, but I feel Dan, you made some prepared remarks that were a bit longer and you talked about kind of underlying profitability and consistency. Is there can you unpack what was the -- what was the message you were trying to convey to us and investors? Are you trying to tell us to focus kind of more on the underlying loss ratio and less on kind of PYD levels or am I misunderstanding what you meant by that?"
},
{
"speaker": "Alan Schnitzer",
"content": "Mike, so thanks for listening. I think the main gist was sort of there was a period of time where underlying underwriting income was a pretty steady level. And it was a long period of time. And that was a period of time when written premium growth was sort of ticking around low single digits for a fair amount of time. And then when we started to accelerate the rate of top line growth again around 2016, and did it at consistent margins. The point was, that just translated into a much bigger base of pretty reliable underlying underwriting income. You can't quite go so far as to say it's just going to come in like the tide, but you look at the last five years where we -- before 2020, we had never reached $2 billion in after-tax underlying underwriting income. We crossed $2 billion in 2020 and stayed there. Then we crossed $3 billion in 2023. And in the first half of the year, we're up 30-something percent compared to that. So it was -- I sometimes think that people don't think of us as having grown, but really the underlying earnings power of the franchise is just in a completely different ballpark than it was five or six years ago."
},
{
"speaker": "Dan Frey",
"content": "And that's the important point, Mike. When you look at the various things that impact the bottom line, underlying underwriting income has been a much bigger, much more reliable contributor to that. And when you think about the earnings power of the Travelers, that's an important contributor. And, well, I'll leave it at that."
},
{
"speaker": "Meyer Shields",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "We have time for one more question, and that question comes from [Bob Hwang] with Morgan Stanley. Please go ahead."
},
{
"speaker": "Unidentified Analyst",
"content": "Great, thank you. Just maybe on workers comp a little bit. Obviously, California's benchmark rate decreased by 2%. As we think about more and more people go back to work, cost of medical inflation going up, can you maybe talk about the dynamics between your pricing, your severity as well as your frequency and how we should think about the $300 million relief this quarter and then also just the overall reserving position for the book on workers comp."
},
{
"speaker": "Alan Schnitzer",
"content": "So a lot there Bob and I'm not -- honestly, I'm not sure what the question is. The workers comp book continues to be extraordinarily attractive. We are the market leader and very good at it. We like the business. We like the returns. We feel great about the balance sheet position. I mean, if there's a specific question there, let me know so we can be responsive."
},
{
"speaker": "Unidentified Analyst",
"content": "Yes, sorry. Maybe it got cut off. I'm just trying to get a better understanding of, given where the rates are, given where medical cost inflations are going, which is increased, right? And given that frequency, or at least from the fact that more and more people are going back to the office, should we expect frequency to go up? Should we expect severity to go up from here? How do you think about after you take the $300 million of workers' comp reserve release this quarter, how should we think about just the ongoing reserve position of that book? That's where I'm trying to get to."
},
{
"speaker": "Alan Schnitzer",
"content": "Yes. So, I mean, we've had favorable development in the workers' comp line for many, many, many quarters now. And I don't know what it's going to be next quarter or the quarter after that, but I can tell you that we continue to feel positively about the balance sheet reserves sitting behind the workers' comp book. In terms of frequency and severity, look, frequency has been on a long-term secular decline. And, again, we're not going to project where that's necessarily going, but it's been on a long-term secular decline that the pandemic and the work from home that's followed it, it's probably too early to make a call on it, but at the margins, that's been probably positive. And if people came back to work and it ticked up a little bit, that wouldn't be particularly troubling for us because as we think about where frequency and severity go from here, as we've always done given the duration of the liability, we are very respectful of those two things. And so we continue to book frequency and severity as if it's going to go back to long-term trends. And so, we feel fine about the line and where lost trend is and where it could go."
},
{
"speaker": "Unidentified Analyst",
"content": "Okay got it. If I can just sneak into the last one. We've all around that New Jersey homeowner price. I know that pricing was up significantly. Just curious as to what the rationale about the New Jersey's homeowner pricing increase, if there is any."
},
{
"speaker": "Alan Schnitzer",
"content": "You're asking about New Jersey Homeowner price increases?"
},
{
"speaker": "Unidentified Analyst",
"content": "Yes, sir."
},
{
"speaker": "Alan Schnitzer",
"content": "I mean, pricing in homeowners broadly is up, driven by rate. New Jersey is actually been a challenging place from a homeowners pricing standpoint. And it's one of the reasons we're actually dramatically shrinking the book of business in that state. And it's really driven by the loss environment. So, New Jersey is been, again, a challenging environment from a loss standpoint, and the regulatory challenges there are really the driver of our need to shrink that book. If we could get approval for the rate that we think we need then we'd be happy to write business there, but right now the regulatory dysfunction is a significant challenge."
},
{
"speaker": "Unidentified Analyst",
"content": "Really appreciate that. Thank you very much."
},
{
"speaker": "Alan Schnitzer",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "And that concludes our question-and-answer session. I will now turn the conference back over to Ms. Abbe Goldstein for closing comments."
},
{
"speaker": "Abbe Goldstein",
"content": "Thank you very much for joining us. And as always, if there's any follow-up, please feel free to reach out to Investor Relations. Have a good day."
},
{
"speaker": "Operator",
"content": "And this concludes today's conference call. Thank you for your participation, and you may now disconnect."
}
] |
trv | 2,024 | 1 | [
{
"speaker": "Operator",
"content": "Good morning, ladies and gentlemen. Welcome to the First Quarter Results Teleconference for Travelers. We ask that you hold all questions until the completion of formal remarks, at which time you will be given instructions for the question-and-answer session. As a reminder, this conference is being recorded on April 17, 2024. At this time, I would like to turn the conference over to Ms. Abbe Goldstein, Senior Vice President of Investor Relations. Ms. Goldstein, you may begin."
},
{
"speaker": "Abbe Goldstein",
"content": "Thank you. Good morning, and welcome to Travelers discussion of our first quarter 2024 results. We released our press release, financial supplement, and webcast presentation earlier this morning. All of these materials can be found on our website at travelers.com under the investors section. Speaking today will be Alan Schnitzer, Chairman and CEO; Dan Frey, Chief Financial Officer; and our three segment presidents; Greg Toczydlowski of Business Insurance; Jeff Klenk of Bond & Specialty Insurance; and Michael Klein of Personal Insurance. They will discuss the financial results of our business and the current market environment. They will refer to the webcast presentation as they go through prepared remarks and then we will take your questions. Before I turn the call over to Alan, I'd like to draw your attention to the explanatory note included at the end of the webcast presentation. Our presentation today includes forward-looking statements. The company cautions investors that any forward-looking statement involves risks and uncertainties and is not a guarantee of future performance. Actual results may differ materially from those expressed or implied in the forward-looking statements due to a variety of factors. These factors are described under forward-looking statements in our earnings press release and in our most recent 10-Q and 10-K filed with the SEC. We do not undertake any obligation to update forward-looking statements. Also in our remarks or responses to questions, we may mention some non-GAAP financial measures. Reconciliations are included in our recent earnings press release, financial supplement and other materials available in the Investors section on our website. And now, I'd like to turn the call over to Alan Schnitzer."
},
{
"speaker": "Alan Schnitzer",
"content": "Thank you, Abbe. Good morning everyone, and thank you for joining us today. We are very pleased to report excellent top and bottom line results for the quarter. Core income was $1.1 billion or $4.69 per diluted share, generating core return on equity of 15.4%. After-tax core income increased by $126 million, despite a $211 million one-time tax benefit in the prior year quarter. On a pre-tax basis, this year's core income was $413 million or 45% higher year-over-year. Strong core income is driven by record net earned premiums of $10.1 billion up 14% compared to the prior year period and an excellent combined ratio 93.9%. The combined ratio improved 1.5 points notwithstanding elevated catastrophe activity primarily in the central and eastern regions of the United States. The underlying combined ratio improved 2.9 points to an outstanding 87.7% driven by strong underlying results in each of our three segments. Looking at the two commercial segment together, the aggregate BIBSI [ph] underlying combined ratio wasn't excellent 88.8% for the quarter. The underlying combined ratio in personal insurance was 86.1% a 6.8 point improvement over the prior year. Turning to investments, our high-quality investment portfolio continue to perform well generating after tax net investment income of $698 million for the quarter driven by strong and reliable returns from our growing fixed income portfolio and higher returns from our non-fixed income portfolio. Our underwriting and investment results together with our strong balance sheet enabled us to grow adjusted book value per share after returning $620 million of excess capital to shareholders through dividends and share repurchases and making important investments in our business, as we notched another quarter of successful execution on a number of important strategic initiatives. In recognition of our strong financial position and confidence in the outlook for our business, I'm pleased to share that our board of directors declared a 5% increase in our quarterly cash dividend to $1.05 per share marking 20 consecutive years of dividend increases with a compound annual growth rate of 8% over that period. Turning to the top line, we grew net written premiums by 8% to $10.2 billion in the quarter. All three segments and excellent execution by our colleagues in the field contributed to our top line success. In Business Insurance, we grew net written premiums by 9% to $5.6 billion. Renewal premium change remained very strong at 10.6%, our retention remained high. The combination of strong pricing and retention reflects deliberate execution on our part and a marketplace that continues to be generally disciplined in the face of persistent headwinds. The segment generated a very strong $691 million of new business in the quarter, a reflection of the fact that our customers and distribution partners value the products and services that we offer and the experiences that we provide. In Bond & Specialty Insurance we grew net written premiums by 6% to $943 million. That was driven by strong retention of 90% and record new business in our high quality management liability business along with excellent production in our market leading surety business, where net written premiums were up 15%. Given the attractive returns, we are very pleased with the strong production results in both of our commercial business segments. In Personal Insurance, continued strong pricing drove 9% growth in net written premiums. Renewal premium change was 16.6% in our auto business and 13.4% in home. You'll hear more shortly from Greg, Jeff and Michael about our segment results. Before I turn the call over to Dan, I'll share that more than a hundred of my Travelers colleagues and I just returned from our Travelers leadership conference, TLC as we call it. It's a multi-day event that we host every year for the principals and senior leaders of our most significant distribution partners. Most of our guests have been coming for years, some for decades. We're also pleased every year to host a number of first timers. The represented firms are industry leaders and collectively account for more than half of our premium volume. We all returned home with the continued confidence that our relationships with these business partners and their firms are as strong as ever. We confirm that they remain very supportive of the strategic initiatives that we have underway and we took away valuable feedback on how we can accomplish even more together. The independent agent and broker channel remains a robust and growing part of our industry. At Travelers, we proudly partner with more than 15,000 agent broker firms across their 35,000 locations. We're a top three market for the majority of these firms that's a critical advantage because distributors place a disproportionate amount of their business with their top few carriers. We don't take these relationships for granted. As we've shared before, the vision for innovation agenda includes optimizing our value proposition as an indispensable partner to our agents and brokers. We continue to make significant investments to ensure that we realize that vision by offering best-in-class products, services, and experiences. Case in point, in our Bond & Specialty business, we recently conducted a blind survey of agents and brokers, ours and others, to determine how we ranked on the 10 attributes they identified as most likely to impact their placement decisions. Among our key competitors, we ranked first or tied for first in each of the 10 categories. We are over and over again that Travelers deep specialization across a wide range of modernized, simplified, and tailored products, along with a broad and consistent appetite are major differentiators for us in the market. For example, in Business Insurance, we offer a wide variety of coverages and product solutions. Admitted and DNS, across industries representing more than 85% of domestic GDP. Everything from a bought product for a local florist to a package solution for a main street middle market account to a loss sensitive workers compensation for a large national account. Across our three business segments, our distribution partners generally don't need to go to multiple carriers to satisfy customers' insurance needs. And the more lines per account we write, the higher the lifetime value of the customer. The primary focus of ours has been digitizing the value chain, in part to create value and provide great experiences for our agents and brokers, and in part to create efficiencies for them and for us. I'll share a few examples. In Business Insurance, we believe we were the first to offer agents and brokers a comprehensive portfolio loss data exchange, which allows us to digitally transfer to a small commercial or middle market distributor, loss information on their entire book with us. This capability enables our distribution partners to efficiently develop important insights into their books of business and supports their marketing efforts. In our middle market business, we believe we were the first carrier to offer multi-line digital submission capabilities. In our small commercial business, agents can transact with us through APIs or through our new quote and issue platform Travis, which is reduced quoting time by 25% for our leading BOP product. Across Business Insurance, nearly all of our largest distributors are currently leveraging one or more of our digital capabilities. In Personal Insurance, earlier this year, we added our proprietary aerial image reviewer to our agent portal. This advanced capability integrates a high resolution, over time photo series of a home into agents quoting workflow. This gives our partners a bird's eye view, helping them to better understand the customers or prospects insurance needs and how they may have evolved. We bring our franchise value directly to agents and brokers through distribution, underwriting, sales and claim professionals in more than 80 local offices. Through our expansive and empowered field organization, we foster deep relationships with our partners and are well-positioned to deliver the strength and expertise of travelers at the local level. We're also investing in our distribution partner’s workforces by providing education and training programs to their up and coming producers. Our Flagship Travelers agency leadership program and agency producer school provide in-person training to invited participants. We also offer larger virtual programs that have trained thousands of producers, including more than 3,000 just last year. We remain deeply committed to our vision of being the undeniable choice for the customer and an indispensable partner to our agents and brokers. Our pole position with this, with leading distributors is a significant competitive advantage and one that's hard to replicate. To sum it up, the year is off to a terrific start with strong profitability and production in all three segments, as well as higher investment income. In short, we're firing on all cylinders. We also continue to invest in important strategic initiatives. We have demonstrated success in executing our innovation strategy, which has contributed to superior returns with industry low volatility, both in our premium base and higher adjusted book value per share. With this momentum and the best talent in the industry, we remain well positioned for success this year and beyond. And with that, I'm pleased to turn the call over to Dan."
},
{
"speaker": "Dan Frey",
"content": "Thank you, Alan. Core income for the first quarter increased by 13% to $1.1 billion. And core return on equity was 15.4%. The growth in core income was driven by higher net investment income, and despite the one-time tax benefit in the prior year that Alan mentioned, higher underlying underwriting income, partially offset by a higher level of catastrophe losses. Our pre-tax underlying underwriting gain of $1.2 billion was up 50% from the prior year quarter, reflecting higher levels of earned premium and an underlying combined ratio that improved by 2.9 points to 87.7%. The underlying combined ratio was among our best ever and featured continued strong results in both Business Insurance and bond and specialty, complemented by a strong result in personal insurance, reflecting another quarter of significant improvement. We were pleased with the first quarter expense ratio of 28.7%, which was flat year-over-year despite the impact of Corvus, for which we had a full quarter of expenses, but very little earned premium, as there was no unearned premium carried in from the closing of the transaction on January 2nd. For the full year, we remained comfortable with an expense ratio expectation of 28% to 28.5%. We reported net favorable prior year reserve development of $91 million pre-tax in the first quarter. There was no net prior year reserve change in Business Insurance, as favorable development and workers comp of nearly $100 million was largely offset by modest increases for liability coverages in recent accident years, along with modest charges in our runoff book. In Bond & Specialty, net favorable PYD of $24 million pre-tax was driven by better than expected results across multiple lines. Personal Insurance recorded net favorable PYD of $67 million pre-tax, with improvements in both auto and home. After-tax net investment income increased 25% from the prior year quarter to $698 million. Fixed income NII was higher than in the prior year quarter and in line with our expectations, benefiting from both higher levels, higher yields, and a higher level of invested assets. Returns in our non-fixed income portfolio were also up from last year's quarter. Our updated outlook for fixed income NII, including earnings from short-term securities, is $640 million after-tax in the second quarter, growing to approximately $665 million in the third quarter, and then to around $690 million in the fourth quarter. Regarding income taxes in the first quarter, recall that last year's quarter included a one-time tax benefit of $211 million related to the repeal of Internal Revenue Code Section 847, and that's the main reason you see a higher effective tax rate in this year's quarter. Turning to capital management. Operating cash flows for the quarter of $1.5 billion were again very strong, and we ended the quarter with holding company liquidity of approximately $1.6 billion. As interest rates increased during the quarter, our net unrealized investment loss increased from $3.1 billion after-tax at year-end to $3.7 billion after-tax at March 31st. Remember, the changes in unrealized investment gains and losses do not impact how we manage our investment portfolio. We generally hold fixed income investments to maturity. The quality of our fixed income portfolio remains very high, and changes in unrealized gains and losses have little or no impact on our cash flows, statutory surplus, or regulatory capital requirements. Adjusted book value per share, which excludes unrealized investment gains and losses, was $125.53 at quarter end, up 2% from year-end, and up 8% from a year ago. Share repurchases this quarter included $250 million of open market repurchases. We had an additional $138 million of buybacks in connection with employee share based compensation plans. We have approximately $5.8 billion remaining under prior board authorizations for share repurchases. Dividends were $232 million in the quarter, and as Alan mentioned earlier, our board authorized a 5% increase in the quarterly dividend to $1.05 per share. In summary, the quarter's strong results once again demonstrate the significant earnings power of our ability to grow premiums across our well-diversified book of business while maintaining very attractive margins, along with steadily increasing net investment income from our growing and fixed income portfolio. And with that, I'll turn the call over to Greg for discussion of Business Insurance."
},
{
"speaker": "Gregory Toczydlowski",
"content": "Thanks, Dan. Business Insurance continues to deliver exceptional results with a strong first quarter of 2024 in terms of both the top and bottom lines. Segment income of $764 million was up from the first quarter of 2023 driven by higher net investment income and higher pre-tax underlying underwriting income. We're once again particularly pleased with the quarter's exceptionally strong underlying combined ratio of 89.2% among our best ever. Net written premiums increased 9% to an all-time quarterly high of $5.6 billion. Renewal premium change was once again historically high at 10.6% with renewal rate change of 7% driving most of the strong pricing. Retention remained excellent at 86% and new business of $691 million was an all-time first quarter high. Let me give you a little more texture on the continued strong pricing environment. Renewal rate change remained high, coming in at 7% or higher for the fourth quarter in a row. It was also up almost 2.5 points from the first quarter of 2023. In our select and core middle market businesses, renewal rate remained consistent with the fourth quarter. Renewal rate change in our national property book was strong and in the double digits, but down a couple points sequentially. That's an appropriate result threading the needle between healthy returns in the business and continued weather volatility. From a line perspective, umbrella, property, and auto led the way. All with renewal rate change in or very close to double digits. Renewal rate change was higher compared to the preceding and prior year quarters in GL, Umbrella, Auto, E&CMP [ph]. In workers' comp, renewal rate change was about half a point more than negative than the preceding and prior year quarters. With continued healthy exposure, renewal premium change in comp continues to be positive in the low single digits. Again, an appropriate result given the strong results in the line. Retention remained healthy across the board. We're pleased with our production results, the exceptional granular execution by our field organization, and the resulting growth in top line and attractive margins. As for the individual businesses, in select, renewal premium change remains strong at 10.4% with renewal rate change of 4%, consistent with the fourth quarter and up more than two points from the first quarter of 2023. Retention also remained strong at 84%, while new business increased 22% from the prior year quarter to $156 million, driven by the continued success of our BOP 2.0 product. We're also encouraged with the impact we're seeing from Travis, our new front end rate, quote, and issue interface platform that Alan mentioned. In middle market, renewal premium change was 10% with renewal rate change of 7%, consistent with the strong fourth quarter result and up close to three points from the prior year quarter. Retention remains strong at 87%. To sum up, Business Insurance had a great start to the year. We continue to grow our profitable book while investing in capabilities to enhance our position as the undeniable choice for the customer and an indispensable partner for our agents and brokers. With that, I'll turn the call over to Jeff."
},
{
"speaker": "Jeffrey Klenk",
"content": "Thanks, Greg. Fund & Specialty started the year with another quarter of strong returns in our 29th consecutive quarter of profitable net written premium growth. Segment income was $195 million, driven by strong earned premiums and a combined ratio of 84.5%. Underneath the combined ratio, the underlying loss ratio improved 2.7 points to an excellent 46.4%. As Dan mentioned, the expense ratio was elevated compared to recent periods, primarily due to the Corvus acquisition. We expect that to continue to be the case for the next several quarters as we integrate and earn in Corvus' business. Turning to the top line, we grew net written premiums by 6% in the quarter. In our high quality domestic management liability business, we again delivered excellent retention of 90% with slightly higher sequential renewal premium change. We grew new business by 34% from the prior year quarter to a record $91 million, driven by Corvus production. As a reminder, we are in the midst of transitioning Corvus' $200 million profitable book of business onto Traveler's paper, which will continue to be reflected in our new business production in the coming quarters. Net written premiums in our market-leading surety business grew a terrific 15%, reflecting continued strong demand for our surety bonds. So we're pleased to have once again delivered strong top and bottom line results this quarter. And now I'll turn the call over to Michael."
},
{
"speaker": "Michael Klein",
"content": "Thanks, Jeff, and good morning, everyone. I'm pleased to report Personal Insurance generated first quarter segment income of $220 million and a combined ratio of 96.9%, both of which are significantly improved relative to the prior year quarter. The underlying combined ratio of 86.1% reflects a 6.8 point improvement compared to the prior year quarter, driven by higher earned pricing in both automobile and homeowners and other. Net written premiums grew 9% as a result of continued price increases in both auto and home. In automobile, the first quarter combined ratio of 94.6% improved 10 points compared to the prior year, primarily reflecting a lower underlying combined ratio, as well as favorable prior year development. The underlying combined ratio of 94.9% improved 8.5 points compared to the prior year, driven by the benefit of higher earned pricing. At the same time, vehicle severity trends moderated, and the quarter also included a modest frequency benefit from the mild winter. As a brief reminder, the first quarter underlying combined ratio is typically our seasonally lowest in auto. We are very pleased with the trajectory of auto profitability. In homeowners and other, the first quarter combined ratio of 99.1% was impacted by higher catastrophe losses, reflecting an active cat quarter, with 19 PCS designated events for the industry, more than 50% higher than the long-term average. The underlying combined ratio of 77.6% improved 5 points, primarily driven by the impact of earned pricing. Turning to production, our results demonstrate continued disciplined execution of rate and non-rate measures to balance profitability and growth. In domestic automobile, retention of 82% remained strong, and renewal premium change of 16.6% was consistent with our expectations. Given the improving profitability of our book, we continue to expect renewal premium change to moderate throughout 2024. New business premium was consistent with the prior year quarter. Underneath this headline number, new business volumes grew in states where we have achieved written rate adequacy. In homeowners and other, retention of 84% remained strong and was consistent with recent quarters. Renewal premium change of 13.4% reflected higher renewal rate change, and was consistent with our expectations, as we have largely closed the gap in insurance to value. We expect renewal premium change to remain at these levels throughout 2024, as we continue to seek rate in response to elevated loss costs. The declines in homeowners' new business and policies in force reflect our ongoing efforts to thoughtfully deploy capacity, as we continue to manage rate adequacy, catastrophe risk, and regulatory risk. Personal Insurance team has made notable progress on improving the underlying fundamentals of our business, while sustaining investments in key capabilities for the future. We're moving closer to our goal of delivering target returns. Auto profitability continues to improve. We have reached written rate adequacy in all but a few states, and are continuing to temper non-rate actions accordingly. For homeowners, we remain focused on managing growth, while improving profitability. At the same time, we're delivering key strategic capabilities. In February, we completed two noteworthy product launches, Quantum Boat 2.0 in the U.S., and Optima Home in Canada. Quantum Boat 2.0 delivers a better agent and customer experience, with improved segmentation, and strengthens our position as a provider of total account solutions, building on the success of Quantum Auto 2.0 and Quantum Home 2.0. Optima Home is an extension of our market-leading Quantum Home 2.0 property product, enabling us to deliver a more robust total account solution in the Canadian market. Both product launches mark further progress on our journey to modernize our products and platforms, making us an even more compelling choice for customers and distributors. To sum it up, I'm very pleased with the positive start to the year in Personal Insurance and grateful to our team. Now I'll turn the call back over to Abby. Now I'll turn the call back over to Abbe."
},
{
"speaker": "Abbe Goldstein",
"content": "Thank you. We're ready to open up for questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Your first question comes from the line of David Motemaden of Evercore. Your line is open."
},
{
"speaker": "David Motemaden",
"content": "Hi. Thanks. Good morning. I had a question just on the more recent accident year reserve increases in Business Insurance and some of those liability lines that Dan was highlighting. I'm wondering, is there any more detail you can provide here with regards to specific accident years? It sounded like GL. Also, I don't think you guys are alone in seeing some adverse on these years. I think everyone had thought that these were better priced years relative to 2019 and prior. Could you just talk about what exactly is the disconnect here and why there's some adverse coming on those years?"
},
{
"speaker": "Dan Frey",
"content": "Hey, David. It's Dan. Sure. I'll take that. Yes. By more recent accident years, we're not talking about 15 through 19. We're talking about years more recent than that. I guess the thing I'll reiterate from my comments is we're talking about some pretty small movements here. We had some adverse in those recent accident year liability lines. We also had some modest charges in the runoff book. I think what we're doing here, David, is trying to be reactive to all the information we're seeing those recent accident years in the liability lines, which tend to take longer to develop and be on the books for a while, are more leveraged to IB&R. We're just trying to get some more IB&R into those lines to recognize that uncertainty."
},
{
"speaker": "Alan Schnitzer",
"content": "David, its Alan. The other thing I'd add is there's not any significant new developments here. These are generally the same trends we've been talking about for a long time, a little more of the same. Again, to reiterate Dan's comment, when you look at the overall reserves we have for these lines, these are very small adjustments."
},
{
"speaker": "David Motemaden",
"content": "Got it. Okay. That's helpful. Then, maybe just switching gears to the personal auto business, Michael, I think you had mentioned that there was maybe some benefit just from mild frequency given a warmer than typical first quarter. Is there any way you could size that just to help us think about the sustainability of the improvement in the auto business?"
},
{
"speaker": "Michael Klein",
"content": "Yes, sure, David. I think the mild frequency impact on the underlying combined ratio was a little less than a point."
},
{
"speaker": "David Motemaden",
"content": "Great. Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Gregory Peters with Raymond James. Your line is open."
},
{
"speaker": "Gregory Peters",
"content": "Good morning, everyone. For the first question, I'll focus on the Business Insurance segment. In the comments and in the stats, I think there's 7% or higher renewal rate change for four consecutive quarters. Retention seems to be holding up, maybe slipping a little bit. Maybe you could step back and give us some context about, or texture I think is the word you used, about the competitive environment. Curious, given all the rate change that's coming through, why we haven't seen more aggressive actions on behalf of some of the competitors yet, or maybe there's still reconciling previous year's results as well. I don't know. Just some color there would be helpful."
},
{
"speaker": "Alan Schnitzer",
"content": "Good morning, Greg. It's Alan. I'll start and then turn it over to Greg. Hard for us to comment for competitors, but we do think that in the pricing we've been able to achieve with these retentions, you do see a reflection of the competitive environment. I'd say that everybody is, well, what we would speculate is that everybody's reacting to the same things that we're reacting to. There's returns in a much better place after years of pricing and improvements in terms and conditions, but there are some headwinds and some uncertainty out there. All the things we've talked about, there's social inflation, economic inflation, a tight labor market. Weather, geopolitics, I think, puts a certain lens over the way we all see the world. I suspect what you have is a marketplace that's reacting to an overall level of risk and uncertainty."
},
{
"speaker": "Gregory Peters",
"content": "I guess I'll pivot then. If you look at the proxy statement, I know ROE targets are a very important metric for you all. I think the target was 12.8% for 2023 up from 11.6% from 2022. Can you talk about how you're looking at the ROE targets for the company for 2024, please?"
},
{
"speaker": "Gregory Toczydlowski",
"content": "Yes, I don't think we're going to share that target. It gets competitively sensitive and close to pricing. But I will say we think about that in terms of the overall outlook for our business. We think about the rate at which the interest rate environment is earning into the fixed income portfolio, which turns over on a lag basis. And we think about really what we want to achieve as a margin over both the 10-year treasury and our cost of equity. So those are the things we think about as we put the plan together. Dan, anything else I'm missing there?"
},
{
"speaker": "Dan Frey",
"content": "No, you got it all."
},
{
"speaker": "Gregory Peters",
"content": "Got it. Thanks."
},
{
"speaker": "Dan Frey",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Elyse Greenspan with Wells Fargo. Your line is open."
},
{
"speaker": "Elyse Greenspan",
"content": "Hi, thanks. My first question is on personal auto. I think you guys said that Q1 is seasonally the lowest combined ratio quarter, but you still have a good amount of rate earning in the book. So shouldn't that obscure some of the seasonality, or would you expect Q1 to be better from a combined ratio perspective on the underlying side relative to the other three quarters of the year, even knowing you have rate to earn in?"
},
{
"speaker": "Michael Klein",
"content": "Sure, Elyse. It's Michael. So just taking a step back and talking about auto, the seasonality comment is a long-term average comment. Typically, Q1 is roughly three points lower than the overall combined ratio for the year. But that's, again, a long-term average and largely an all-else equal environment. So that three points doesn't adjust for earned effective pricing potentially having impact in the back half of the year. And so you have to make an adjustment for that, no question. But, again, I would just take a step back and maybe put a little more color around my response to David as well. So the mild winter weather benefit we would view as sort of a one-off in the quarter that we wouldn't expect to continue, we don't see any reason to assume adjusted for that. That seasonality is any different today than it was historically. And at the end of the day, to the premise of your question, the earned effective pricing is far and away the biggest driver of the improvement in the quarter, and there's more of that to come going forward."
},
{
"speaker": "Elyse Greenspan",
"content": "Thanks. And then my second question, I wanted to go back to the liability reserve increase in the quarter. Could you give us a sense, if there were some additions, I know the numbers are modest, like you guys said, on accident year 2023. And then, given the additions you see here, are you adjusting your longer trend, long-term loss trend assumption for the liability lines following this?"
},
{
"speaker": "Dan Frey",
"content": "So, Elyse, it's Dan. I'll start with the PYD piece and avoid the temptation of splitting what is a small number to begin with into its individual accident years. So we're not going to do that. I do think if you look at the results in Business Insurance, we talked about the fact that you saw some improvement in the underlying combined ratio, including in the underlying loss ratio. You have the benefit of pricing and a couple of other things like mix, which we talked about last quarter. The same time, like in any quarter, you've got some puts and takes, and one of those puts and takes in this quarter is booking a little bit more IB&R in the current accident year to reflect some of the uncertainty that we're seeing. Not big numbers, but we are reacting to it."
},
{
"speaker": "Elyse Greenspan",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Brian Meredith with UBS. Your line is open."
},
{
"speaker": "Brian Meredith",
"content": "Yes, thanks. First one for Michael. Michael, I'm just curious, one of your competitors in the personal auto space is showing some pretty strong growth in policy and so forth, really kind of capitalizing the market. I'm just curious, are you in a position at this point to kind of go after and get some growth given how your results have improved so much?"
},
{
"speaker": "Michael Klein",
"content": "Sure, Brian. Thanks for the question. Certainly, again, underneath the results in the quarter, if you look at it on a state-by-state basis, the states where we have achieved written adequacy, we've achieved written adequacy, we did achieve new business premium growth. And consistent with our comments last quarter, what I would say to you is we're executing a very granular state-by-state, geography-by-geography strategy as we look to temper some of the non-rate actions that we had in place in auto. And if you take a step back, if you look at it over the last couple of years, we have a small increase in policies in force in auto over the last couple years or so. We got a small decrease in property, all the while premiums are up 30-plus percent. So we feel pretty good about the starting point. And directly to your question, our focus in auto is on profitably growing auto on a go-forward basis. Our focus on home remains on improving profitability, and so that's why we talk about sort of balancing profitability and growth across the whole portfolio."
},
{
"speaker": "Brian Meredith",
"content": "Makes sense. Thanks. And then a follow-up on the Business Insurance. Alan and Greg, I wonder if you could kind of dissect kind of the competitive landscape, kind of large, middle, small. Are any of them kind of incrementally more competitive? It feels like small, middle seems to be a little more stable right now than maybe the large from what we're hearing in the marketplace."
},
{
"speaker": "Alan Schnitzer",
"content": "Brian, let me just comment and I’ll turn it over to Greg. I think all of these markets are always competitive all the time, and that's sort of the way we think about it. So I'm not sure. I mean, as Greg shared in his prepared remarks, to the extent that you're thinking about, renewal price change as a proxy for competition, and I don't think it is, by the way. That did come down a couple of points, but, again, still among our highest rate achieved in any line, and, double digits and a reflection of terrific returns in the line. So I don't think there's been any sea change in or any significant shift, among those businesses. I'd say competitive business that we have. I don't know, Greg."
},
{
"speaker": "Gregory Toczydlowski",
"content": "Yes, maybe I'll touch on new business since Alan just hit on rate. And you can see in the new business we had a real strong quarter in small commercial up 22%, so that we are seeing a little more dislocation in that market than we are in middle market. But the combination of our new segmented product, BOP 2.0, and our new commercial automobile product, we feel terrific about, our position there and where we're writing that new business and what returns we're going to achieve there. Middle market still had, the delta wasn't as big on new business, but we had a record result on the first quarter of the prior year, so really strong new business levels. So not as much dislocation, Brian, in the middle market, but really feeling good about the combination of where the returns are and our field team staying really active on the new business front."
},
{
"speaker": "Brian Meredith",
"content": "Terrific. Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Ryan Tunis with Autonomous Research. Your line is open."
},
{
"speaker": "Ryan Tunis",
"content": "Hey, thanks. Good morning. I just had a couple, I guess, on exposure acting as rate. So, yes, exposure acting as rates clearly been a tailwind in particular for margins. It's been flagged, for the past couple years, especially in the workers' comp line. But this is the first quarter in a long time I think, I've seen that workers' comp NPW shrink year-over-year. So curious sort of, what dynamic might be going on there?"
},
{
"speaker": "Gregory Toczydlowski",
"content": "Yes. Good morning, Ryan. How you doing? This is Greg. Yes, exposure continues to be strong, down somewhat as you look at the businesses. Not a surprise to us as the Fed has been very active in curtailing inflation. So definitely we're seeing some of that in workers' comp. But the primary driver of the down in comp is, we do still have rate reductions, as I shared in my prepared comments, relative to the other products. And as we're an account solution, we're going to remain very active and disciplined with our underwriting. And as we invoke both of those dynamics in the business, that's what drove the overall net written premium change in the comp line."
},
{
"speaker": "Ryan Tunis",
"content": "Got it. And I guess if I look at the overall, the exposure is still positive across the book. So clearly something else is picking that up. On the property side, are you guys still getting positive exposure adjustments from like insured value adjustments? Or is that really just kind of a 2023 catch up thing that's already happened?"
},
{
"speaker": "Gregory Toczydlowski",
"content": "Yes, as you can imagine, it's somewhat linear with inflation, Ryan. So 2023, we had some record results of trying to keep up with the replacement costs and building materials. So it's down somewhat from 2023, but still up overall."
},
{
"speaker": "Alan Schnitzer",
"content": "Hey, Ryan, as a macro comment, if you look at that exposure, it's easy to get very focused on recent periods. But if you look at that number over time, it's a pretty healthy number that I think is consistent with what is today a pretty healthy economy."
},
{
"speaker": "Ryan Tunis",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Meyers Shields with KBW. Your line is open."
},
{
"speaker": "Meyers Shields",
"content": "Great, thanks. If I can stick with property for a second, last year when we tracked renewal pricing changes, it sort of peaked in the second and third quarter. And I'm wondering whether there's a seasonal element to that or we should just sort of follow that curve to anticipate smaller rate increases because of the reduced indicated need over the course of 2024?"
},
{
"speaker": "Alan Schnitzer",
"content": "Meyer, yes, there really isn't a seasonal element of pricing overall. Our field underwriters are going to look at the exposure at hand and the renewal book will change over time as we write incremental new business. And so overall, it's dependent on the exposures that come up for that particular quarter. That's more of the dynamic than any seasonality."
},
{
"speaker": "Dan Frey",
"content": "Yes, Meyer, it's Dan. I'll just add in case your question is not just seasonality of pure price change, but within the property line, there's some seasonality of its mix on a written premium basis. And to your point, and you can see it in the financial supplement, the second and third quarters tend to be relatively higher levels of commercial property compared to what comes up in Q1 and Q4."
},
{
"speaker": "Meyers Shields",
"content": "Okay, that's very helpful. Thank you. If I can switch gears, I wanted to talk a little bit about workers' compensation reserve releases because based on the statutory numbers, there were like 900 million of releases in 2023. And I think you said less than 100 this quarter. So that's slowing down. I was hoping you could maybe break that down either by accident year or the difference between actual claim emergence versus indications."
},
{
"speaker": "Dan Frey",
"content": "Yes, Meyer, it's Dan. So again, I'm going to resist the temptation to do it by accident year. It's multiple accident years in comp as it normally is. We're really just going through the same robust and disciplined review process every quarter in comp and in every line. We'll go through the latest data. We'll look at how it might have varied from what our actuarial models would have expected. And we'll do our best to determine the reasons why the actual varied from expected and book the necessary adjustments accordingly. And the number is just sort of going to be what it's going to be. And if you think about this quarter versus last quarter or this quarter versus next quarter in any particular line, prior reserve development might be more, might be less. We'll wait and see what the data tells us. But it's more of the same in terms of thematically what's coming through. We have continued to make assumptions around what long-term severity is going to be. We have assumptions around what frequency is going to be. And that of those things has been some more good news in the first part of this year."
},
{
"speaker": "Alan Schnitzer",
"content": "Meyer, I'll also add that as we, one part of our consideration process as we go through this is to make sure that we're appropriately reflecting our thoughts about uncertainty. So that's, just something to keep in mind."
},
{
"speaker": "Meyers Shields",
"content": "Okay. That's very helpful. Thank you so much."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Mike Zaremski of BMO. Your line is open."
},
{
"speaker": "Mike Zaremski",
"content": "Okay. Great. Good morning. On the, maybe question on the Business Insurance segment, when we look at the underlying combined ratio, it's, it's shown a nice trend of, I guess improvement versus prior years. And that's kind of despite you all kind of topping off IB&R and kind of adding to reserves on recent vintages. And so just curious about that dynamic, how is it that your view of kind of the underlying has stayed excellent kind of, and not kind of drifted a bit higher as you've taken some just small actions? Is it just pricing powers been, you think just much higher than loss cost trend or any color you have would be helpful?"
},
{
"speaker": "Alan Schnitzer",
"content": "Let me, let me start and I'll turn it over to you, Dan. So we understand that sometimes the investment community can get very focused on a couple of metrics as you think about what drives it, but, but that's really not the way it comes together. It comes together through all the things that, that impact margins. And so, if you look at the excellent result this quarter earn pricing was a significant benefit favorable mix was a little bit of a benefit and there was some small items going the other way that that partially upset some of that benefit. As Dan mentioned, we booked a little bit more IB&R as a reflection of uncertainty, a little bit of non-CAT weather a little bit of discrete large loss activity none of those things significant and as you can tell from the fact that it was an excellent and improving number but every quarter there's there are just a bunch of factors that add up and puts and takes."
},
{
"speaker": "Dan Frey",
"content": "Yes, that's right. And I think the only thing I’d add to that and I'd sort of confirm your premise in the question Mike is it's really a very strong pricing environment if you go back and look at the i-commentary over the last year or two it's one of the reasons we've been so pleased to see retention remain as a strong as it has because we love the profile of the book and we're trying to, so we're happy to be retaining it, happy to get pricing on top of it and that's improving margins and then in any quarter it's going to be impacted by some of the things that Alan just mentioned."
},
{
"speaker": "Mike Zaremski",
"content": "Okay that's helpful. My last follow-up is on maybe more on homeowners' personal lines. Given the, what seems like continued trend of higher task losses, any changes you're seeing in the industry or the travelers trying to implement on terms and conditions such as roof replacement, are there any trends there we should be thinking about? Thanks."
},
{
"speaker": "Michael Klein",
"content": "Sure, Mike. It's Michael. Absolutely. I think if you, if you dig underneath our comments around non-rate actions, there's a variety of things that we're executing on, and many of which we're seeing across the industry. And examples include, first of all, eligibility, right, based on an evaluation of the exposure also eligibility on age of roof, underwriting restrictions around things like roof condition and tree overhang. Our primary approach on sort of risk sharing, if you will, is really to focus on AOP and wind-hail tornado deductibles. We've implemented higher wind-hail tornado deductibles in virtually every severe convective storm exposed state across the country. I think the last count were up to, I think, 21 states where we've increased deductibles to help to deal with the exposure. And then, managing distribution and managing appetite to manage aggregation of exposure, within a local or a state-by-state geography. So really, those are some examples of the variety of actions we're taking from a non-rate perspective, which is really what we're referring to when we talk about managing growth and improving profitability and property."
},
{
"speaker": "Mike Zaremski",
"content": "Thanks."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Michael Phillips with Oppenheimer. Your line is open."
},
{
"speaker": "Michael Phillips",
"content": "Thanks. Good morning, everybody. Totally different turn here. Florida homeowners market, obviously, market has not been a big player. And I'm wondering if any of the reforms that have been taking place in the past couple of years have given you pause to maybe revisit that?"
},
{
"speaker": "Michael Klein",
"content": "Sure. Great question and certainly something that we spend time evaluating. What I would say is certainly reforms in Florida, some of the depopulation of citizens in Florida are certainly things that make Florida look better than it has in the past. But it is still a highly CAT exposed geography. It is still a place where we think the risk-reward is not in balance. And one of the things, frankly, in Florida that remains a significant concern is the potential assigned risk obligation in the event of a significant catastrophe. And so, and I think Alan's referred to this in the past. We see signs of improvement in the state, but it's going to take more than what we've seen. And one of the things that it causes you to think about is whether or not you can compete in Florida on an admitted basis versus an excess and surplus lines basis. So those are all some of the considerations around Florida. The upshot for us is while we do see those signs of improvement, we haven't seen enough change to cause us to change our perspective on wanting to, reopen for new business and property in Florida."
},
{
"speaker": "Alan Schnitzer",
"content": "Yes, the TOR [ph] reforms that they enacted we think were an excellent start. We certainly love other states to follow suit because we think regulatory reform is important as it relates to affordability, not just insurance, but of home ownership and autos. But there are some other structural things in the state that are, just make it difficult at the moment. We'll continue to reevaluate it."
},
{
"speaker": "Michael Phillips",
"content": "Okay, great. Thank you guys. Thanks for the color. Second question, personal auto. Are you seeing any sign there of kind of just higher attorney [ph] involvement in personal auto that give you [Indiscernible] concern?"
},
{
"speaker": "Alan Schnitzer",
"content": "Sure, Michael. I would say that, in Q1, it's, first of all, bodily injury is where most attorney involvement occurs. And in Q1, it's the longest tail element of the exposure we see in personal insurance. So concluding anything based on what we saw in the quarter from a bodily injury standpoint is a challenge. But the same, sort of social inflation, litigation, abuse challenges that Greg has talked about a lot in Business Insurance, we're not immune from in personal insurance. We have seen over a longer period of time increased attorney involvement impact bodily injury. But all that said, if we look at bodily injury results in the quarter, bodily injury loss trends were pretty consistent with what we expected."
},
{
"speaker": "Michael Phillips",
"content": "Okay. Thank you very much."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Michael Ward with Citi. Your line is open."
},
{
"speaker": "Michael Ward",
"content": "Thanks. Good morning. I was just curious, the growth in commercial auto accelerated pretty meaningfully. Was that mostly price or how should we think about the pricing environment in that line?"
},
{
"speaker": "Michael Klein",
"content": "Good morning, Michael. Yes, it was. I think most of the growth that happened from a net written premium change was due to RPC. One thing I would point out, and I referenced a little bit earlier, we do have our new automobile product that we've rolled out across all Business Insurance in our express select underwriting route model and also in our transactional middle market business, our TCAP [ph] product. So we feel, terrific about that latest segmentation and that should ultimately improve the return profiles on that business overall. But the biggest change was RPC."
},
{
"speaker": "Michael Ward",
"content": "Great. Thank you. And maybe just back to GL, you noted the charges were relatively modest. I guess just compared to last year's charges, are they similar, less, or any other color around that? Thanks."
},
{
"speaker": "Dan Frey",
"content": "Hey, Michael. It's Dan. I guess I'll say if you just look at the comment being that, comp was approaching 100 million, the segment was zero, some of it was runoff, you could get to an implication of sort of a box around how much the GL must have been. And for whatever it's worth, and I'm not sure how much it's worth, that would tell you that the first quarter number was probably less than some of the magnitude that we saw in last year. But again, we'll do a full evaluation again next quarter and the number will be more or less favorable or unfavorable depending on what the data tells us."
},
{
"speaker": "Michael Ward",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Robert Cox with Goldman Sachs. Your line is open."
},
{
"speaker": "Robert Cox",
"content": "Hey, thanks. So we saw some data potentially indicating a slowdown in premium growth in the E&S market. And I know Travelers has about 2.5 billion in E&S and you guys have indicated that margins there are quite attractive. Just curious if you saw any changes in competitive dynamics in E&S or pricing."
},
{
"speaker": "Gregory Toczydlowski",
"content": "Hi, Robert. This is Greg. Yes, as we've shared with you, underneath that 2.5 billion, we have quite a bit of diverse businesses that drive that. And we didn't really see any material slowdown in the segments that we compete in."
},
{
"speaker": "Robert Cox",
"content": "Okay, got it. And maybe secondly, I'm curious as I think you've started to go through some of the re-underwriting of the Corvus book, if you've learned anything material and if there's any major takeaways."
},
{
"speaker": "Jeffrey Klenk",
"content": "Yes, thanks, Robert. It's Jeff. We're 3.5 months now into our integration. We're feeling really good about bringing and leveraging the capabilities of both organizations. I would tell you that we feel really good about the quality and the profitability of the Corvus book of business. It's consistent and we're taking some of those capabilities. We've already completed the scans using their proprietary technology to the existing Traveler's book of business. Really comfortable with what we're seeing. Thanks for the question."
},
{
"speaker": "Robert Cox",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "We have time for one more question. It will be from Paul Newsome of Piper Sandler. Your line is open. Paul Newsome, your line is open."
},
{
"speaker": "Paul Newsome",
"content": "Hi, good morning and thanks for squeezing me in. Maybe just a couple of quick personalized questions. Is it fair to say that the renewal premium change for both auto and home, given what you've already filed and the fact that you're getting closer to or you've gotten most states to adequacy, that we should see that decelerate fairly meaningfully in the next couple of quarters? Just any thoughts about that so that we aren't surprised?"
},
{
"speaker": "Michael Klein",
"content": "Sure, Paul. It's Michael. I would separate auto and home. For auto, you'll see RPC moderate as we go throughout the year. I wouldn't suggest it's going to be a sharp decline. One of the things that I think is important to think about as you think about RPC over time for us is we write mostly 12-month policies in auto. While someone who writes a lot of six-month policies is going to see RPC accelerate quickly on the front end, they're going to actually see it decelerate more quickly on the back end. Ours is going to be a more gradual increase and then a more gradual decrease because we file a rate in May of 2023. We're still renewing policies at that same higher rate in April of 2024. So just a little bit of context for why I say it's going to be more of a gradual deceleration in auto RPC. In property RPC, we don't anticipate a deceleration. We're going to continue to drive rate into the property portfolio in response to increased loss costs. I would expect RPC to remain relatively consistent through the balance of 2024 in property."
},
{
"speaker": "Paul Newsome",
"content": "I did notice that the renewal rate in home did come down quite a bit, at least sequentially. Is that just sort of an anomaly or is it something to note?"
},
{
"speaker": "Michael Klein",
"content": "Sure, Paul. The RPC drop from Q4 to Q1 in property is what we were referring to last year when we talked about the fact that we've made a lot of progress on insurance to value in home. So when you think about renewal premium change in personal lines property, it's really driven by two primary things. One is rate and then the other is increasing the coverage limit on the dwelling. And in 2022 and 2023, we made dramatic increases in property coverage A limits in home that drove a decent amount of the property RPC. In my prepared remarks, that's why I mentioned that when you look at that 13.4%, it actually reflects improvement in rate from last quarter to this quarter. And the drop is really because we've essentially caught up on insurance to value in property. So that's why I say you're not going to see a further incremental change in RPC due to that coverage A limit dynamic because that's just going to stay the same. And now what you're looking at is mostly our outlook for rate in property for 2024, which again is to keep it pretty consistent."
},
{
"speaker": "Paul Newsome",
"content": "Thank you. That helps always much appreciated."
},
{
"speaker": "Operator",
"content": "Thank you. I will turn the call to Ms. Goldstein for closing remarks."
},
{
"speaker": "Abbe Goldstein",
"content": "Thank you all very much again for joining us this morning. And as usual, if there's any follow up, please feel free to reach out directly to Investor Relations. Have a great day."
},
{
"speaker": "Operator",
"content": "This concludes today's conference call. We thank you for joining. You may now disconnect your lines."
}
] |
tsco | 2,024 | 4 | [
{
"speaker": "Operator",
"content": "Good morning, ladies and gentlemen, and welcome to Tractor Supply Company's conference call to discuss Fourth Quarter and Fiscal Year 2024 Results. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will follow at that time. [Operator Instructions] Please note that the queue for our question-and-answer session did not open until the start of this call. Please be advised that reproduction of this call, in whole or in part, is not permitted without written authorization of Tractor Supply Company. And as a reminder, this call is being recorded. The host for today's call is Mary Winn Pilkington, Senior Vice President of Investor and Public Relations for Tractor Supply Company. Now, first up is a year-end video. [Video Presentation]"
},
{
"speaker": "Operator",
"content": "I would now like to pass the call to our host, Mary Winn Pilkington. Mary Winn, please go ahead."
},
{
"speaker": "Mary Winn Pilkington",
"content": "Thank you, Alisa. Good morning, everyone. We appreciate your time and participation in today's call. On the call today are Hal Lawton, our CEO; and Kurt Barton, our CFO. Following our prepared remarks, we'll open the floor for questions. Seth Estep, our Chief Merchandising Officer, will also be available during the Q&A session. Please note that a supplemental slide presentation has been made available on our website to accompany today's earnings release. Now, let me reference the Safe Harbor provisions under the Securities Litigation Reform Act of 1995. This call may contain certain forward-looking statements that are subject to significant risks and uncertainties, including the future operating and financial performance of the company. In many cases, these risks and uncertainties are beyond our control. Although the company believes the expectations reflected in its forward-looking statements are reasonable, it can give no assurance that such expectations or any of its forward-looking statements will prove to be correct, and actual results may differ materially from expectations. Important risk factors that could cause actual results to differ materially from those reflected in the forward-looking statements are included at end of the press release issued today and in the company's filings with the Securities and Exchange Commission. The information contained in this call is accurate only as of the date discussed. Investors should not assume that statements will remain operative at a later time. Tractor Supply undertakes no obligation to update any information discussed in this call. As we move into the Q&A session, please limit yourself to one question to ensure everyone has the opportunity to participate. If you have additional questions, please feel free to rejoin the queue. We appreciate your understanding and cooperation. We will also be available after the call for any further discussions. Thank you for your time and attention this morning. And now it's my pleasure to turn the call over to Hal."
},
{
"speaker": "Hal Lawton",
"content": "Good morning, and thank you to everyone for joining our call today. Before we begin, I would like to acknowledge the recent wildfires and winter storms. Our thoughts and prayers are with all those affected. I'd also like to express our deepest appreciation to the first responders who worked tirelessly to protect our communities during these challenging times. Our Tractor Supply team has and will continue to stand with our communities as they recover from these events. The opening video, I think, did an excellent job highlighting the key accomplishments of the Tractor Supply team in 2024. And my sincere appreciation and gratitude go out to the team the team for all they do. Over the year, our consistently executed with distinction and delivered solid results in a tepid retail environment. Additionally, the team made progress against our Life Out Here strategy, enabling continued market share gains and future growth. Now, let's go through some of our highlights specific to the fourth quarter and the fiscal year, starting with financials. In the fourth quarter, our net sales grew 3.1%, and comparable store sales increased 0.6%, driven by strong comp transaction growth of 2.3%. And our fourth quarter diluted EPS was $0.44. For the fiscal year, we achieved record financial results on both the top and bottom-line. Net sales were nearly $14.9 billion, growing 2.2% versus 2023 with a comp store sales increase of 0.2%. Diluted earnings per share were also a record $2.04 on a split-adjusted basis. And our digital business reached another year of record sales, topping over $1.1 billion. And I'll note, these results are on top of record performance over the last four years. In 2024, we also generated a record $1.4 billion in operating cash flow. And we use this cash flow to fund the business and attractive growth opportunities. In 2024, we opened 80 new Tractor Supply stores and 11 Petsense stores. The team has done a fantastic job opening highly productive new stores as this remains a core strength and competency of Tractor Supply. Other business investments we made in 2024 include a new distribution center in Maumelle, Arkansas, and more than 160 Fusion remodels. After funding our business in these initiatives, for the fourth consecutive year, we returned more than $1 billion to our shareholders through the combination of dividends and share repurchases. And 2024 marked the 15th consecutive year of dividend growth for Tractor Supply. And finally, at the conclusion of the year, we successfully acquired Allivet, and we look forward to integrating Allivet into our business and offering it to our millions of Neighbor's Club members who are pet owners. In addition to these financial results and even more importantly, perhaps, our team member and customer engagement has never been stronger. Frontline team member attrition is at a record low. Total active customer accounts are at record highs. High-value customer retention is at record levels. Customer service scores continue to hit all-time highs. In our Neighbor's Club, one of the largest loyalty programs in retail continues to attract record levels of new customers and we're exiting 2024 with all-time highs in both retention rates and retained customer counts. Neighbor's Club is truly a key differentiator for Tractor Supply, and we're committed to continued enhancements. For example, in 2024, our members benefited from more personalized offers, new tiers, and more meaningful rewards. Additionally, the expansion of Neighbor's Club to Petsense by Tractor Supply continues to drive strong customer engagement. This expansion is allowing us to deepen relationships with existing customers and help attract new pet customers to both banners. Neighbor's Club membership currently represents over 85% of sales at Petsense with continued momentum. The Petsense shopper is also cross shopping Tractor Supply at an impressive rate of 50%, an increase of nearly 3 points year-over-year. Overall, Neighbor's Club membership now exceeds 38 million, and as a percent of our sales reached a record 80%. With our Life out Strategy, we have built on Tractor Supply's long-standing commitment to invest in our powerful flywheel. We've substantially transformed our business and are operating from a higher level of performance. We've not given back any of the gains that we've made over the last five years, and we delivered against our strategy, and we're very excited about the future. As we planned for 2025, we're forecasting strong net sales growth of 5% to 7% and comp sales performance of 1% to 3%. We anticipate that the headwinds we've been facing will moderate as we move through the year and that we continue our share gains. We expect product deflation should be relatively neutral by mid-2025, and additionally, we see signs of stabilization in both personal consumption expenditure and the balance of goods versus services as well as in the pet food category. As it relates to the new presidential administration, while there are many unknowns that we acknowledge, for example, tariffs, we are confident in our ability to navigate these circumstances as they evolve. Additionally, I'll note that many of these unknowns are not Tractor Supply specific. And on most fronts, our business profile is attractive on a relative basis to other retailers and companies. As we shared at our recent investment community day in December, we remain confident in our long-term targets and expect to return to them when market conditions return to neutral. Tractor Supply is a unique and highly differentiated retailer. We have a history of executing with discipline on our strategy, delivering strong financial results and continue to expand our competitive moat. We continue to gain market share across our major product categories and our customer metrics remain incredibly healthy. We're excited about the continued evolution of our Life Out Here strategy that builds on our strengths, continues the momentum of our existing strategy and launches new initiatives that increase our total addressable market to $225 billion. We're entering the New Year with momentum and opportunity. And with that, I'll now turn the call over to Kurt."
},
{
"speaker": "Kurt Barton",
"content": "Thanks Hal and hello to everyone on the call. Let's start with some key insights for the fourth quarter and full year. I'll spend the bulk of my time on our outlook for 2025. We had a solid performance given the overall conditions for the fourth quarter. Comparable store sales increased 0.6%, driven by strong comparable average transaction increase of 2.3%, partially offset by a comparable average ticket decrease of 1.7%. Of note, unit volumes were solid and the ticket pressure was principally from average unit retail. For the fourth quarter, we always believe that weather trumps the holiday. Typically, the winter weather has a much greater impact to the fourth quarter. And once again, that is how this year played out. In addition, we continue to face the ongoing headwind of deflation in key product categories. We estimate that deflation had approximately 100 basis point drag on our comp sales performance in the quarter. Most of the deflation pressure came from commodity-based products consistent with the recent trends. As we progressed through the quarter, we saw a positive impact from the early October hurricanes. While the warmer-than-usual temperatures in late October and November presented some challenges, December had a modest improvement in the weather and solid holiday performance, demonstrating our resilience and ability to adapt to varying conditions. Turning the category performance for the quarter. We had strong comps in our seasonal department as well as truck tool and hardware with both performing better than chain average. Our consumable, usable and edible products performed in line with chain average. Notably, we had mid-single-digit unit growth as we continue to believe we are gaining share in these categories overall. The strength of our unit growth in Q was offset by ongoing deflation. No doubt the warm weather in November and to a lesser extent, December weighed on our winter seasonal business. Overall, our spring and summer seasonal categories drove positive comp sales with Zero Turn and front-engine mowers, both up double-digits. This is indicative of the unseasonably warm weather we had in the quarter. Cold weather-related categories, such as insulated outerwear and heating modestly underperformed chain average due to the warm weather conditions. Big ticket performance continued to outperform in the low single-digits. We experienced strength in hurricane response categories like generators. Additionally, grilling, mowers, trailers and truck toolboxes all performed well. Although our business is not primarily driven by holiday sales in Q4, we were encouraged by our performance during the holiday season, including recording our highest sales day of all time, on the day after Thanksgiving and strong performance for the holiday season. Moving on to gross margin. Gross margin decreased nine basis points to 35.2% from the prior year's fourth quarter. It is worth calling out that we were lapping our most difficult gross margin comparison of the quarter with 129 basis points of expansion in the prior year. Our performance was relatively in line with our expectations. As a percent of net sales, SG&A expenses, including depreciation and amortization, increased 60 basis points year-over-year to 26.8%. This increase was primarily attributable to our planned growth investments, including higher depreciation and the onboarding of a new distribution center and modest deleverage of our fixed costs, given the level of comparable store sales growth. These factors were partially offset by the team's disciplined focus on productivity and our ongoing emphasis on cost control. We did have a modest benefit from our ongoing sale leaseback strategy. This quarter, we had a similar number of existing store sales as the prior year with a slightly higher average gain per store. Operating margin declined 69 basis points for the quarter to 8.4%. Now, let's move to our outlook for 2025. As I have previously shared, navigating economic cycles is in our DNA. We have a long track record of successfully managing through diverse market conditions. The needs-based nature of our business, combined with our deep understanding of these dynamics, allows us to proactively adapt to the market conditions. The same can be said about tariffs. As Hal commented in his opening remarks, there are certainly a number of unknowns at this time on this important topic. This is a team that has been cycle tested with lessons learned from the prior administration. For instance, we have continued to diversify our country of origin for imports. We have been scenario planning and are prepared to address as any proposed actions take effect. It is important to remember that this is a topic that affects all of retail. We are differentiated as we only have about 12% or so of our sales that are direct imports and have a large key business that is domestically sourced. Given the fluid nature of the discussion on tariffs and the number of unknowns, our guidance does not assume any changes in tariffs at this time. We successfully managed through tariffs in prior cycles, we will remain flexible and nimble to adapt to the changing environment. For fiscal 2025, we are forecasting net sales growth of 5% to 7% to $15.6 billion to $15.9 billion. Approximately four points of this growth is driven by new stores and Allivet. With a purchase price of $135 million, we anticipate Allivet adding more than $100 million to our net sales and accretive to earnings. Comparable store sales are anticipated to increase 1% to 3%. We expect modest gross margin expansion of about 20 to 40 basis points from continued supply chain efficiencies, benefits from effective cost and price management and our exclusive brands and retail media initiatives. We anticipate a relatively stable and consistent overall transportation market. We forecast the gross margin expansion to be offset by SG&A deleverage due to a couple of primary factors. First, depreciation and amortization is anticipated to increase about 10% with a higher growth rate in the first half as compared to the second half of the year. While this is an improvement from recent underlying growth rates, as our investments in our strategic growth initiatives moderate, we will deleverage as D&A grows faster than sales. Second, we are investing in our Life Out Here 2030, strategic initiatives. In order to launch our direct sales and Final Mile initiatives, we are planning a net investment of about 15 to 20 basis points of operating margin into these exciting opportunities for growth. In 2025, we will continue our planned strategic sale-leaseback program to sell some of our existing owned stores. As we recently indicated at our Investment Community Day, we expect to sell an incremental two to four existing stores to fund the step-up in new stores from 80 to 90 in 2025. We anticipate these sales will occur across the year with a similar EPS contribution as in 2024 in total. For the year, we forecast an operating margin of 9.6% to 10%, centering around our 2024 performance. We are forecasting interest expense of approximately $65 million to $70 million. We plan to maintain a healthy leverage ratio of a little over two times. We expect our effective tax rate to be in the range of 22.2% to 22.5%. Diluted EPS is forecast in a range of $2.10 to $2.22. Net capital expenditures are forecast to be $650 million to $725 million or about 4% to 4.5% of sales. This net amount reflects the anticipated proceeds from the sale of existing and newly developed Tractor Supply stores. Gross capital expenditures are forecast to be around $1 billion. Our capital plans reflect a ramp in our new store openings to approximately 90 Tractor Supply stores. We anticipate opening about 10 Petsense stores this year. Our new store pipeline remains exceptionally strong, continue to exceed historical averages in both sales and profitability. We expect our store opening cadence to be in line with 2024. As we announced this week, we anticipate starting construction of our 11th distribution center in Idaho later this year with operations commencing in late 2026 or early 2027. This is an exciting expansion of our DC network that will allow us to more effectively service our existing stores and new store growth opportunities in the Pacific Northwest. We remain committed to returning cash to shareholders through the combination of a growing dividend and share repurchases. For 2025, we anticipate share repurchases in a range of $525 million to $600 million which is estimated to have a benefit of a net reduction in weighted average shares outstanding of approximately 1% to 2%. Now, I'd like to walk through a few items consider for the calendarization of our expectations. As always, we believe the best way to look at our results is in halves and not quarters due to the nature of our business. We expect comp sales for each of the quarters to be in a relatively tight range, consistent with our overall 2025 guidance. We anticipate that comp sales will be modestly stronger in the second half of the year as our compares ease and the headwind from deflation continues to moderate. We are planning for positive comp transactions for the year, along with flat to slightly positive average ticket. We anticipate that deflation will be a modest headwind in the first half of the year. We believe we are nearing trough now having successfully managed through the deflation of 2023 and 2024. As to earnings, we expect our EPS growth to be relatively consistent between the first half and second half of the year. As we see it today, our forecast calls for the first half of the year to have marginally better operating margin performance than the second half as we begin to cycle recent transportation efficiencies. Specific to the first quarter, we've had a solid start to the year given the recent cold weather trends. As a reminder, January last year was also very cold with strong comps. We are seeing good momentum as we start the first quarter, recognizing we have a lot of quarter ahead of us. Overall, we are anticipating positive comp sales for the first quarter. Our first quarter diluted EPS is anticipated to be relatively consistent with the prior year as our positive sales growth is somewhat offset by our investments in the business. We are planning for continued gross margin expansion to be offset by incremental investments to launch our strategic initiatives and the operational costs for our new Arkansas distribution center, which opened in mid-2024. As a consequence, operating margin is anticipated to be flat to slightly below prior year. To wrap-up, we have clearly defined strategic priorities and are investing to capture the long-term opportunities in our market. We are committed to driving productivity and making appropriate trade-offs to fuel our investments while we protect our operating profit margins and earnings. We intend to maintain this focused approach through 2025 as we self-fund our Life Out Here 2030 initiatives. We are committed to continuously striving for stronger results. With that, I will turn the call back over to Hal."
},
{
"speaker": "Hal Lawton",
"content": "Thanks, Kurt. As we shared in December at our Investment Community Day, we're embarking on the next leg of growth for Tractor Supply with our Life Out Here 2030 strategy. This strategy is designed to continue invest in what's working as well as begin investments in several new opportunities, creating horizons of growth that we expect to last through the end of the decade. Key initiatives in our Life Out Here strategy will continue to be our Project Fusion and Garden Center rollouts. Both of these projects are working well and delivering compelling returns through improved space productivity. In 2025, these initiatives will be complemented with enhanced localization capabilities. Specifically, the team has developed data-driven archetypes that tailor approximately 25% of store space to better reflect customer need and further optimize the incremental sales opportunity of each unique site. Going forward, all new stores and our Fusion remodels will have localized space allocation and assortment based on their respective architypes. Turning to our Neighbor's Club. We have significant plans in place to continue to capitalize on this unique, strategic asset. A significant focus for us this year will be to bring our members PetRx through our recent Allivet acquisition. The acquisition of Allivet expands our total addressable market by $15 billion to $225 billion. Allivet has a proven platform to make pet ownership easier by providing convenient access to brand-name medications, expert pharmacy advice and convenient reordering with its AutoShip program. Our efforts in Q1 are focused on integrating Allivet's catalog onto tractorsupply.com and updating a member's Neighbor's Club profile to include their prescription and veterinarian information. We look forward to providing our 38 million Neighbor's Club members with a value-added pet and animal prescription service and introducing Tractor Supply to Allivet's customers. As Kurt mentioned, we're investing in this year in several new key strategic initiatives, especially direct sales and Final Mile. It is critical to get them off to a strong start, and the team is keenly focused on our multiyear journey to capture the significant opportunity with these initiatives. In direct sales, our efforts in the first half are focused on building a scalable field sales model and launching Version 1 of our business-to-business selling platform. In Final Mile, our efforts in the first half are focused on hardening our existing delivery hubs, activating inventory across more locations and bringing bulk online orders in-house for delivery. While our long-term strategy sets the foundation for sustained growth, our 2025 operating plans are designed to deliver measurable results today, ensuring we continue to meet our evolving customers' needs and build momentum towards achieving our long-term goals. As mentioned, the year has started solid, and our teams have been busy supporting our customers for all their winter needs as the dependable supplier of the Out Here Lifestyle. From heating fuel and heating pellets to insulated winter clothing to livestock feed, we are highly engaged in ensuring our customers have what they need to deal with the recent winter storms and recovery. As the calendar will soon turn to spring, we've already transitioned over 600 of our stores to our spring sets and the remainder will do over the next couple of months. Our merchant teams have done an excellent job bringing value and innovation to our lineups for spring. Examples include expanding Weber grilling to all stores and launching exclusive zero-turn mowers from Cub Cadet and the second year of the Toro Havoc as well as introducing new national live goods programs. And we have so much more, and I look forward to sharing more details on spring in our Q1 earnings call. As always, we are laser-focused on our C.U.E categories. In our Companion Animal segment, we're pleased to launch new products, both in-store and online. We recently launched 4health shreds. We expanded our temptations assortment in cat, and we introduced new freeze-dried and shelf-stable treats. In the market now, we have our annual Pet Appreciation days with a month of targeted savings offers and in-store events to drive excitement. Additionally, we will continue to leverage our over 1,000 pet wash locations. And last year, we conducted over 1.8 million pet washes, including a record-breaking 500,000 plus in Q4. Our pet aisle is more robust than ever, featuring familiar favorites as well as new unique offerings that deliver the quality our customers expect at incredible value. In our Animal segment, spring at Tractor Supply means it's time for our annual spring Chick Days. The arrival of chicks at our stores is a sure sign of spring and creates strong retail theater in our stores. Backyard poultry continues to see significant engagement with our customers, highlighting a shift towards sustainable and self-reliance living. Whether as pets or as a source of eggs, chicks are both a practical and enjoyable hobby for many and are often referred to as the third pet. We have more shopping trends and insights than ever on our poultry customers and are able to build out more targeted campaigns based on where they are in their journey. As our customers build and maintain their flocks, we have everything they need for feed, treats, toys and an exciting lineup of new chicken coops. Our retail philosophy is that Chick Days is a great gateway for our customers to deepen their relationship with Tractor Supply, and that enables Tractor Supply then to be viewed as a resource for all things related to homesteading beyond the poultry category. Earlier this week, we announced a multiyear strategic licensing partnership with Field & Stream. Beginning in June, Tractor Supply customers could shop a variety of hunting and outdoor Field & Stream branded products. We're excited about the opportunity this partnership presents and look forward to providing more details in future earnings calls. As the season turns to spring, I hope you get a chance to visit our stores and see the actions and initiatives coming to life. Our future remains exceptionally bright and exciting. Our upcoming initiatives, scale and capabilities demonstrate our ability to meet the evolving needs of our customers. We're excited about the future and look forward to continuing our journey of growth and innovation in the channel. I'd like to close where I started, by extending my gratitude to our team members for their unwavering dedication to each other and to serving our customers. I'd also like to thank our customers for choosing us as their trusted supply for Life Out Here, and also call -- plus communities for embracing us as an integral part of our hometowns. With that, operator, we'd now like to open the line for questions."
},
{
"speaker": "Operator",
"content": "Thank you. We will now begin the question-and-answer portion of today’s call. [Operator Instructions] The first question comes from the line of Simeon Gutman with Morgan Stanley. Your line is now open."
},
{
"speaker": "Simeon Gutman",
"content": "Good morning, everyone. I wanted to focus my one question on comp transactions, which were positive and a good sign of health. Can you talk about transaction breadth in two ways, geographically and then if you can look at it across immature and mature stores, how balanced is it?"
},
{
"speaker": "Hal Lawton",
"content": "Good morning Simeon, and thanks for the question. We were pleased with our comp transaction growth in Q4. And the breadth was widespread across both categories and geographies. What I would say is where we had weather activity, we saw stronger comp transactions as one would imagine. But our comp transaction growth was strong, particularly as it relates to average ticket growth across all regions of the country and across our categories as well. I'll note the numerous call outs I made on customers, customer counts and customer activity and customer retention as well. But we were very pleased with the comp transaction growth and expect comp transactions to continue to be strong force in 2025. And really, as you know, comp transactions have been one, a key component of our growth over the last five years, around half of our total growth over the last five years has been driven by comp transactions. And I think it's a hallmark and a differentiator for us as it relates to the rest of retail. On the new store front, new stores continue to perform right in line with our expectations. New store openings are in that 4.2, 4.3 range on a first-year basis, very much in line with our expectations. The IRRs are performing in line, the operating profit margin rates are performing in line and that's if you look at our 2021, 2022, 2023 and 2024 classes across the Board, the 2021 far outperformed given the moment of time we were in, but 2022, 2023 and 2024 have all been very consistent. And, of course, that is the vast majority of the customers that shop our new stores are new and drive a number of incremental transactions. Of course, that wouldn't be in our comp transaction number that would be a non-comp. But very pleased with the transactions and new customer counts coming along with our new stores and their kind of their opening profile."
},
{
"speaker": "Simeon Gutman",
"content": "Thanks, I mean for the question. Thanks for the question. Good luck."
},
{
"speaker": "Hal Lawton",
"content": "Yes."
},
{
"speaker": "Operator",
"content": "Thank you. The next question is from the line of Steven Forbes with Guggenheim. Your line is now open."
},
{
"speaker": "Steven Forbes",
"content": "Good morning, Hal, Kurt, Seth. Kurt, you mentioned localization initiatives and the Field & Stream partnership as well. So I was hoping maybe if you can walk us back to the Analyst Day where you explored the customer segmentation work that you guys executed upon. Any way to sort of reframe up the opportunity as you think about localization and sort of what drove the strategic partnership with Field & Stream. How do we sort of contextualize the product category opportunities, the potential lift in sales per square foot that you see in the back of localization? Just any sort of color for us that helps us think about what it means for comp transactions and new store productivity as well as the maturation curve of the stores themselves."
},
{
"speaker": "Seth Estep",
"content": "Hey, Steven, this is Seth. Thanks for the question. I would separate both of those kind of individually, and I'll spend a little bit on both. First and foremost, just kind of going back to the localization commentary. I would say it remains really consistent with what we said at ICD and what we said in prepared remarks. Relative to just knowing the amount of opportunity we have to adjust particularly our macro space floor planning when we go out to our Fusion and our new stores to just maximize that space productivity. And like we shared at ICD, anticipate that we'll continue to deliver likely an incremental low single digits lift as we go to implement those as we adjust, call it, 25% of the floor plans as we start to roll those out. We're always looking at ways that we can localize our assortments. And if we were to go back to 2019 and to where we are today, one of the things that we continue to see is that the wildlife and hunting categories for us in recreation have been among the fastest growing, and it's where a lot of our consumers are continuing to respond with us. So, we were looking for ways in which we could continue to drive some meaningful assortments, meaningful partnerships, specifically in that space because it's been very strong growth, but we know that we have a tremendous amount of growth opportunity in front of us. So, we're very excited about the Field & Stream partnership that we announced yesterday and Hal mentioned prepared remarks. It really will be a multiyear journey for us starting midyear this year, specifically tailored more towards that wildlife category. And then as we roll into late this year and then into next year, it will start to be expanded into like an exclusive line of apparel and other things that the brand really resonates with our shoppers. And then also, there's some very unique marketing opportunities where our collective brands can come together across all the channels. So, I do think the partnership is reflective of how we're looking at both localization and our category assortments in general, but very excited about both those opportunities. Thanks for the question."
},
{
"speaker": "Steven Forbes",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. The next question is from the line of Peter Keith with Piper Sandler. Your line is now open."
},
{
"speaker": "Peter Keith",
"content": "Hey. Thanks, guys. You mentioned the poultry category, and I'm wondering, one of my favorite topics with backyard chickens, if the rising egg prices here is starting to drive some acceleration in that category. And as we think about egg prices potentially continuing to go up this year, maybe reflect back on what you saw in 2023 when there also seem to be meaningful chicken demand. And what did you see in your results in terms of like customer acquisition and traffic."
},
{
"speaker": "Seth Estep",
"content": "Yes. This is Seth, Peter. Thanks for the question. Backyard poultry, Backyard Flock, like as you mentioned, it's one of your favorite topics you said, it's also one of ours, its core to our customers, as we mentioned. About one in five of our current shoppers participate in the hobby. It's well above the national average. We are very excited about this year's Chick Days. It's a chance for not only for our current shoppers as we continue to dive in with personalization to grow their flocks with all the unique guidance and expanded items that Hal talked about here at the end of the prepared remarks. But one thing that we also saw like back in 2023 was also a great entry point into the hobby when we saw egg prices continue to elevate at the same time. So, as we look at this year's event, we're very excited about our current customers continue to expand, the flock continue to engage with us, to be their primary destination, but also are excited about the potential opportunity to continue to engage new shoppers in the category which then that we see over time, it just continues to deepen that relationship with them, so more to come. Look forward to discussing the results of Chick Days as it continues to roll out over the next few weeks, and it will be in stores here shortly."
},
{
"speaker": "Peter Keith",
"content": "Sounds great. Thank you very much."
},
{
"speaker": "Operator",
"content": "Thank you. The next question is from the line of Seth Sigman with Barclays. Your line is now open."
},
{
"speaker": "Seth Sigman",
"content": "Hey guys, good morning. So, you discussed macro headwinds potentially moderating through 2025, and it seems like that's what's reflected in the comp guidance for the year. Can you just elaborate on what that means specifically for Tractor Supply? Because in a lot of ways, your business has been much more stable this year than a lot of other cyclical businesses. So, what categories have really under-punched, any signs that maybe that's starting to improve? And then if you could also speak to big ticket, perhaps in that context, big ticket has been a nice outlier for you this year, low double-digit growth, although it did moderate in the fourth quarter. So, if you could just speak to that and remind us on how you're thinking about some of categories. Thanks so much."
},
{
"speaker": "Hal Lawton",
"content": "Good morning, Seth, and thanks for the question. I reference back to my prepared remarks and kind of highlight three factors that really have weighed on our business over the last 18 to 24 months and then comment on our outlook for those in 2025. Those three factors that I'd highlight would be the in PCE, the reversion from goods to services spend, the second would be underlying deflation in our commodity-related items. And then the third would be stabilization of the pet category. All 3 of those, as you know, are headwinds that we've been facing. And we've been very kind of transparent on the impact those have had on our business on things like average ticket, et cetera. As we look into 2025, we do see modernization, neutralization, stabilization, kind of pick your word as more so as it goes through the year. So, if you look at goods and services, it's basically reached its pre-COVID levels now. It's mid-68 versus mid-31. That's very much back in line, maybe 0.5 point to go there. On pet, the kind of stabilization or neutral nature of that industry over the last 12 months has been well documented. We do see that business recovering to low single-digit growth this year and our business accordingly growing alongside of that as we are a share gainer in that category. And then as it relates to deflation, we are -- we see light at the end of the tunnel on that. If we just take our average unit cost, our average unit retails across our commodity-related items, we hit the -- we start comping over top of all that between April and May of this coming year. And then I'd also just point out on that at steady state point in time. If you look at the commodity markets right now, if anything, they're kind of surging up. If you look at, say, like corn prices, which we've talked about is the commodity that we're most correlated with corn is trading now in kind of that high-400s, 490 range, really at like a 15-month high now. We aren't seeing that make its way into pricing yet. But if anything, I'd say that is a potential tailwind. So, as we look out, we do see kind of light at the end of the tunnel on these macro factors that have been headwinds for us. And we think as we get into the year, those forces will become less and less of a headwind. That's reflected in our guidance for the year, which is a comp of 1% to 3%. And we said that we expect kind of sequential improvement from our comps from the first half to the second half as well. And the final thing I'll call out is we have had a solid start to the year, which gives us more confidence in our guidance. Of course, we've got 11 months still to go, but it's been nice to have the cold winter weather in the first month of the year to particular help us lap last year's cold weather and start out with a relatively solid start to the year. So thanks, Seth. I appreciate the question."
},
{
"speaker": "Kurt Barton",
"content": "Hal, I'll just mention his -- Seth's last question on big ticket, which I think is a great topic as well. So, Seth, this is Kurt. As we've talked about through all of 2024, I mean, the merchants did an excellent job coming off of two years of declining big ticket sales with newness, innovation competitive pricing, great financing. And so we recognize in our guidance that we're cycling strong big-ticket comps in 2025. But a lot of 2024 was a comeback of some of the lack of newness and the customers responded. And we see that big ticket as more at its new stabilized platform, and we look at 2025 as we're bringing together all the reasons, the newness, the competitive pricing, love our opportunities in 2025. Big ticket is expected to run positively more in line with chain average in 2025. But what we're bringing in zero-turns, trailers and a number of areas that you'll start to see this year is we've got good reason to be optimistic on our ability to continue to comp, the comp on big ticket in 2025."
},
{
"speaker": "Seth Sigman",
"content": "Very helpful. Thank you both."
},
{
"speaker": "Operator",
"content": "Thank you. The next question is from the line of Kate McShane with Goldman Sachs. Your line is now open."
},
{
"speaker": "Kate McShane",
"content": "Hi. Good morning. Thanks for taking our question. We wondered if we could focus our question on the operating margin guide. I think the lower end of it maybe seems a little bit lower than what you were talking to in December, which we thought was around flat. First, is that right? And if so, what's driving the change? And then can you talk to the range? Is that range concurrent with what you expect to do on the top line in 2025? Or are there other things that we should consider driving that range of outcomes?"
},
{
"speaker": "Kurt Barton",
"content": "Yes. Hey Kate, this is Kurt. Thanks for the question. On operating margin, as I mentioned in my remarks, we estimate and forecast that our 2025 operating margin would be more in line and center pointed around the 2024 operating margin. To your second part of your question, the operating margin range that we gave is more concurrent and proportional with the comp sales range of 1% to 3%. So, allowing for the appropriate flow-through under the low-end and high-end scenarios on the comp sales range, the 9.6% to 10% operating margin reflects that. We've got a significant opportunity for growth in this business as we've talked about the 2030 initiatives. So, we are purposely investing to be able to launch those programs. And we're self-funding those with gross margin expansion and efficiencies that we have achieved and continue to target on the SG&A side. So, we're excited about 2025. We're going to continue to strive to hit the high end of our targets. We believe we've got gross margin expansion that allows us in this year to be able to do both things, grow the business and be able to maintain the operating margin. And that's the key message on both the top and bottom-line."
},
{
"speaker": "Operator",
"content": "Thank you. The next question comes from the line of Michael Lasser with UBS. Your line is now open."
},
{
"speaker": "Michael Lasser",
"content": "Good morning. Thank you so much for taking my question. My question is on the outlook for this year, which you noted that the business has already started off with a solid beginning given some of the weather and you're guiding to an acceleration over the course of the year. And then on top of that, you outlined some positive drivers for -- that could impact the business. So, A, should we interpret the 1% to 3% comp outlook as conservative or what would stand in the way of potential upside from that? And B, if there is comp upside, how should that flow to the bottom-line? Meaning, would you choose to potentially proactively reinvest some of the upside back in further investments in your initiatives such that there may not be as much upside even if the comps outperformed? Thank you."
},
{
"speaker": "Hal Lawton",
"content": "Hey Michael, thanks for the question. I'll answer in two parts the way you ask it. On our comp first, obviously, when we set our guidance, we try not to be impacted too much by the first three or four weeks of the year in terms of sales and try to look over a full 52-week period. With that as context, we certainly see the broader macro conditions like talked about with Simeon's question at the beginning, kind of more neutralizing and some of them, perhaps, even becoming positive in nature for us as we get through the year. And so I think that's what leads us to the kind of sequential improvement as the year goes on. And that's without any sort of consideration for the aberrations of weather and how they might impact one month here and there through the year. But we feel very good about our 1% to 3%. We think that's -- we're highly confident in it, and we think it's the right place to start here at the beginning of the year. What I -- as it relates to if we had comp upside, I think, obviously, there's a variety of scenarios that that we'll evaluate as we go through the year and would be a great scenario for us to be considering. What I would say is, I referenced kind of back way the way we've thought about it in the past, and we've had comp outperformance, we'll evaluate our current initiatives, how they're running, how their investments in those initiatives are going. If we were to lean more into these initiatives, what would be the result of that incremental investment, and/or what other needs do we have in the business. And then obviously, we would evaluate the flow-through as well. But as we've indicated long-term, when we see our comp growth rates in our long-term guidance range, in that 3%, 4%, 5% range, we do expect to leverage on operating margin rate and have that improve. And so I would also say that if you saw comp outperformance in the year, you would see operating margin flow towards the higher end of our guidance, and we would update you accordingly through the year on that. But again, just stepping back, we're very, very excited about the beginning of the year. We feel good about our plans for the year and have some good momentum as we head into 2025 here. We've got a lot of new initiatives to embark on top of some really, solid existing initiatives or creating real value for our shareholders and excited about the horizons for growth that we have over the next few years. Thanks, Michael, for the question."
},
{
"speaker": "Michael Lasser",
"content": "Thank you very much. Good luck."
},
{
"speaker": "Operator",
"content": "Thank year-over-year. The next question comes from line of Peter Benedict with Baird. Your line is now open."
},
{
"speaker": "Peter Benedict",
"content": "Hi, guys. Good morning. Thanks for taking my question. Kurt, maybe just jumping around the Allivet. Is there any seasonality in that business that we should think about? And I know you said it's going to be accretive or slightly accretive to the earnings this year, just on how it maybe impacts the P&L. There's -- I would assume it's higher gross margin, but kind of curious your view there. And then if you can even frame maybe the magnitude of the earnings lift that you get here in year one from Allivet. Thank you."
},
{
"speaker": "Kurt Barton",
"content": "Yes, Peter, for the most part, Allivet is pretty consistent and stable. There's some seasonality. You might not be able to see it significantly with the size of Tractor Supply. But if you think about the spring summer, there is a bit of a peak on flea, tick and some of those type categories. But I -- we look at it as it's a pretty stable, consistent business. It's got a solid operating margin. Over the long-term, we expect that while it's accretive to earnings that we have the ability to grow their operating margins. And the long-term outlook is that that Allivet, when you look at level of business on the Rx side of it, over this five-year period of time, we can see Allivet equaling and even surpassing Tractor Supply level operating margins because it's that strong of business. Right now, when you think of 2025, our focus is on the top line and getting Neighbor's Club members onboarded onto Allivet that, their platform, their subscription model. And so there'll be -- while accretive, there'll be some investments in the onboarding and the transition year, and we'll be able to share more beyond 2025 as how we see that growing in the future, but great platform, a great team. We purchased, as Hal mentioned, the technology, the resources, license in all the states enable for us to be able to ramp quickly with them. So very excited about this opportunity, which is certainly, we believe, a one plus one is certainly more than two."
},
{
"speaker": "Peter Benedict",
"content": "Sounds good. Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. The next question is from the line of Karen Short with Melius Research. Your line is now open."
},
{
"speaker": "Karen Short",
"content": "Hi. Thanks very much. I wanted to just focus on comp in general. So can you give a sense of what the comp waterfall contribution is or the new store waterfall contribution is to the comp and how you think about that going forward? And then tie that in with how to think about new store productivity?"
},
{
"speaker": "Kurt Barton",
"content": "Yes, sure. Hi, Karen, on new stores hitting both comp and new store productivity, first, when we -- I'll hit new store productivity first. When we talk about new store productivity, profitability, we look at it on a net of cannibalization. That's how we view its impact. That's how we view its IRR. And we've continue to be consistent that our new stores, while there's a mix, some we drop into existing markets, some into brand-new markets, there's some cannibalization, and we continue to have net contribution to comp after cannibalization from new stores. It's a modest contributor. If I would say of all the contributors we talk about that build up to our comp sales from the strategic initiatives, it is a modest level. But we are net contribution to our comp sales. And so as we as we ramp up, we've planned in 2025 from like 80 to 90, and ramped up from 70 to 80, you're seeing the non-comp growth from new stores, continuing to increase. And that has, over time, in that five-year maturation, we view it while we're talking 5, 10, 15 type level basis points. But over the next five years, that's a comp contributor as our new stores ramp from 70 up to 100 over the next few years. And then Hal mentioned earlier, new store productivity, I can't reiterate more while I acknowledge in the last 18 months with Orscheln and refining some of the square footage, new store productivity has been extremely consistent and right in line from all of our targets over the last three or four years, and we are consistently performing at or above our markets and excited about the production and the performance of our new stores."
},
{
"speaker": "Karen Short",
"content": "Great. Thank you."
},
{
"speaker": "Mary Winn Pilkington",
"content": "Alice, I think we've got time for one more question, please."
},
{
"speaker": "Operator",
"content": "Certainly. The next question is from the line of David Bellinger with Mizuho. Your line is now open."
},
{
"speaker": "David Bellinger",
"content": "Hi. Good morning. Thanks for the question. It's on the gross margins, which are down very slightly year-over-year this quarter. I think that was the first time since late 2022. We were just a little unclear on the drivers other than the difficult comparison in the prior year. Just any more detail you can help us with anything on the promo activity and the shorter holiday, how that played into it? And then just secondly, how should we think about the year-on-year gross margin progression throughout 2025. Any specific drivers you've got baked in, like retail media or some other factors?"
},
{
"speaker": "Kurt Barton",
"content": "Yes. Thanks David. On gross margin for the fourth quarter, as I mentioned, it came in very much in line with our expectations. The Q3 call, I forecasted that we were anticipating flat year-over-year gross margin, knowing that we were up against 129 basis point growth. There was probably 20 to 30 basis points back in the prior year that was very unique to that quarter -- in fourth quarter 2023. So we continue to have solid performance in gross margin. We were cycling that. There really wasn't much that was unique, and it wasn't promotional. While there was a step-up in promotional in fourth quarter year-over-year, for us, we had targeted promotions. We had vendors' partnership that helped to maintain the gross margin. So, there's a little bits and pieces here and there that shifted from flat to nine basis points. Part of that is mix in the quarter. And that's probably the only meaningful items I can mention. It gives us all the confidence on our gross margin plan. As you think about 2025, as I mentioned, gross margin in the first half, slightly more favorable than the back half. And what you'd see is, we're going to start lapping some of the last or most recent transportation efficiencies by about midyear. And we'll begin to see a little bit more benefit though in the back half from exclusive brands, which Seth has talked about launching, the retail media is a little more beneficial, but the net-net is, in our expectations for gross margin, you'll see a modest -- we forecast today a more modestly higher gross margin performance in the first half and in the second half."
},
{
"speaker": "David Bellinger",
"content": "Great. Thank you."
},
{
"speaker": "Mary Winn Pilkington",
"content": "I think that -- thanks, David. Just to wrap our call up. So, I'm around all day and coming up next week as well if anybody needs anything. So, please don't hesitate to reach out and look forward to talking to you on our Q1 call in April. Thank you."
},
{
"speaker": "Operator",
"content": "This concludes today's conference call. Thank you all for your participation. You may now disconnect your lines."
}
] |
tsco | 2,024 | 3 | [
{
"speaker": "Operator",
"content": "Good morning, ladies and gentlemen, and welcome to Tractor Supply Company's Conference Call to discuss Third Quarter 2024 Results. [Operator Instructions] Please be advised that reproduction of this call in whole or in part is not permitted without written authorization of Tractor Supply Company. And as a reminder, this call is being recorded. I would now like to introduce your host for today's call, Mrs. Mary Winn Pilkington, Senior Vice President of Investor and Public Relations for Tractor Supply Company. Mary Winn, please go ahead."
},
{
"speaker": "Mary Winn Pilkington",
"content": "Thank you, operator. Good morning, everyone. Thanks for taking the time to join us today. On the call today are Hal Lawton, our CEO; Kurt Barton, our CFO. After our prepared remarks, we'll open the call up for your questions. Seth Estep, our EVP and Chief Merchandising Officer, will join us for the question-and-answer session. Please note that we have made a supplemental slide presentation available on our website to accompany today's earnings release. Now let me reference the safe harbor provisions under the Private Securities Litigation Reform Act of 1995. This call may contain certain forward-looking statements that are subject to significant risks and uncertainties, including the future operating and financial performance of the company. In many cases, these risks and uncertainties are beyond our control. Although the company believes the expectations reflected in its forward-looking statements are reasonable, you can give no assurance that such expectations or any of its forward-looking statements will prove to be correct, and actual results may differ materially from expectations. Important risk factors that could cause actual results to differ materially from those reflected in the forward-looking statements are included at the end of the press release issued today and in the company's filings with the Securities and Exchange Commission. The information contained in this call is accurate only as of the date discussed. Investors should not assume that statements will remain operative at a later time. Tractor Supply undertakes no obligation to update any information discussed on this call. Given the number of people who want to participate, we respectfully ask you to please limit yourself to one question. If you have additional questions, please feel free to get back in the queue. I appreciate your cooperation. We will be available after the call for follow-ups. Thank you for your time and attention this morning. Now it's my pleasure to turn it over to Hal."
},
{
"speaker": "Hal Lawton",
"content": "Thank you, Mary Winn, and good morning, everyone, and thank you for joining us today. My sincere thanks and appreciation go out to my fellow 50,000 Tractor Supply team members. I know we all have been watching the devastation over the last few weeks that's been wrecked by Hurricane Helene and Milton with great concern and heartbreak. Hurricane Helene struck particularly close to the heart for me, given my roots in East Tennessee. Tractor Supply has taken a multitude of actions, big and small to take care of our team members, customers, and communities during this difficult time. I'd like to give a special thank you to all our team members who rallied to help the communities impacted by this storm season. We will continue to be there for our team members, customers from our communities in the days and months ahead for the recovery process. I would also like to thank our many vendor partners who are stepping up in the recovery effort. As it relates to a sales benefit from our response, we had no material benefit in Q3, but have seen an impact in Q4 and additionally have been somewhat encouraged by the recent change of seasons. This morning, we shared some exciting news that we've entered into a definitive agreement to acquire Allivet, a leading online pet pharmacy. This is a company we know very well as they've been excellent partners to us in fulfilling our pet subscription business for the last couple of years. This is a great opportunity for us to bring another benefit to our 37 million Neighbor's Club members. Allivet offers a convenient and cost-effective way to get medications and specialty items for their pets and livestock. The addition of Allivet allows us to expand our total addressable market by about $15 billion. Allivet is a best-in-class platform with an excellent management team and a strong financial profile. This is a great example of a strategic tuck-in acquisition. We anticipate that Allivet will be accretive to earnings in 2025, and we look forward to welcoming the Allivet team to Tractor Supply. We are planning to host an Investment Community Day in New York City on the afternoon of Thursday, December 5th. At that time, we look forward to providing more details on our Life Out Here strategy for the second half of the decade, including our plans to leverage Allivet online and in stores. So now let's shift to the quarter. For the third quarter, the macro retail environment was in line with our expectations and our customer remained resilient. While the overall economy remained strong as evidenced by a 3% Q2 GDP, overall retail sales continued to moderately underperform. The primary driver of this underperformance is the continued shift of consumer spend to services. As a consequence, we estimate that retail sales growth was nearly flat in our third quarter. It is our estimate that the Farm & Ranch channel was modestly negative in the quarter and that we continue to be a share gainer. I would describe the sentiment of our customer as relatively stable as supported by the recent jobs report and the current unemployment rate of 4.1%. Consistent with prior quarters, our consumer continues to be judicious with their spending focused on innovation, newness, and needs-based products. Year-to-date through the third quarter, the macro retail environment is running in line with the subdued expectations that we had as we entered the year. Also, as expected, our team has managed our business exceptionally well. Correspondingly, our sales and profitability to continue to run in the range of our beginning guidance and have allowed us to consistently raise the lower end of our outlook. Let's turn to some highlights of our performance for the quarter. We grew net sales by 1.6% with comparable-store sales down a slight 0.2%. Diluted EPS was $2.24. Our comparable-store sales performance was driven by transaction growth of 0.3%, offset by average ticket decline of 0.5%. Emergency response, as mentioned earlier, had no material impact on Q3 comp sales. As we shared on our last call, we anticipated that the quarter would be in line with our full-year guidance. As we move through the quarter, many of the same trends from the first half of the year continued to play out. Notably, our customer engagement remains strong. The investments we've made in our Neighbor's Club, our world-class loyalty program are a competitive advantage for us as we continue to see solid growth in customer counts and retention. Our Neighbor's Club comp sales continue to outpace our overall sales growth. At the same time, we reached an all-time high on our sales penetration and a record membership of more than 37 million members. Our Neighbor's Club retention rate remains remarkably consistent as our best customers continue to shop us more frequently and remain extremely loyal. Our Hometown Heroes program has gained traction with our customers as our store team members have rallied around this unique benefit as an opportunity to engage with veterans and first responders in their local communities. Additionally, our new customer data platform has gone live for all stores and digital platforms, which will allow for greater data integrity, a 360-degree view of our customer, and deeper personalization. Overall, our Neighbor's Club offerings continue to drive meaningful wins with our members. At Tractor Supply, we continue to invest in customer service as we believe is it a differentiator for us. Our customers come to us for trusted advice. Our commitment to excellence and service and investments in training, tools, and technology are being recognized by our customers. Our scores continue to run at all-time highs with improvements year-over-year every month for 40 consecutive months. Turning to our category performance. Strong positive comps in big-ticket items continued for the third quarter, notably in Zero-turn, and Front Engine Riding lawnmowers as well as recreational vehicles. This year, our team did a tremendous job bringing newness and innovation with attractive pricing to these categories and our customers have responded positively to the new product lineup and our investment in inventory. As we experienced last quarter, we anticipated our consumable, usable, and edible products would run modestly below in the chain average in the third quarter as deflation weighed on our average unit retail. The needs-based demand-driven nature of our product categories continues to drive unit velocity in this segment of our business. Specifically in Pet Food, industry data suggests the category was slightly positive in Q3, consistent with trends through the first part of the year as the category disinflates and pet ownership trends remain soft. Our business in this category, while moderating from historical trends, continues to be a share winner in both households and dollars, although this is a small number math at this point. A couple of data points on share. Tractor supply was 2 times the category growth rate in Q3 and nearly 6 times that of the grocery channel. Again, pointing back that this is small number math relative to the previously higher-growth rates that this category has seen in the last few years. In the quarter, in the Pet business, we invested in in-stock inventory rates, maintain our emphasis on EDLP, leveraged our customer service to drive basket building, and focused our marketing on the newness and innovation we've added to our lineup. In our most recent all-store meeting, we invested in training for our nearly 45,000 store team members on selling techniques for pet food and driving treat attachments. We also had a very successful Pet Appreciation Days where we marketed newly introduced brands like ACANA and Real Mesa and our exclusive brands such as Retriever, 4health, and MuttNation by Miranda Lambert. In Equine, livestock, and poultry feed, we continue to gain market share. While average unit retails are down mid-to-high single-digits in these categories, we had unit or pound growth across all species. And as large animal counts continue to be pressured, we are certainly a shared winner with our strong unit performance. Much like the first half of the year, categories that performed below our comp sales growth were in our discretionary businesses such as clothing, footwear and outdoor living as well as in hardlines products such as ag fencing and pet kennels. Additionally, seasonal businesses such as heating, heating fuel, and insulated outerwear were negative. Our customer continues to respond to newness and innovation. A great example is the strong start to our Halloween Decor, which included a differentiated and expanded assortment such as the six-foot rooster skeleton that went viral. Another great example is in wildlife supplies, we're a destination for deer corn and have expanded this year into trail cameras and feeders. Our digital sales continue to outperform with double-digit growth. The team has made substantial improvements in search and checkout. We continue to accelerate our digital sales with platforms that set the standard for our customers and rival best-in-class retail experiences. We opened 16 new tractor supply stores in the quarter, bringing our year-to-date total to 54. Our new-store productivity continues to perform very well. Our pipeline for '25 and into '26 remains very robust with significant runway for low-risk, value-creating organic growth ahead of us. As we exited the third quarter, we've achieved some significant milestones in our Life Out Here strategy. We now have 45% of our chain in our Project Fusion layout and more than 550 garden centers. These are capital investments that provide a multi-year runway for growth and extend the terminal value of our stores. They help us to be more relevant to both our core and new customers, allowing us to garner a greater share of their spending and be the dependable supplier for their lifestyle. I commend the team on these investments and results given the scope and scale of these initiatives. It is hard to identify another retailer that has made this substantial investment in their store base in such a short period of time. We've also made major investments in our supply chain. Over the last four years, the team has added 2 million square feet to our DC capacity with the seamless opening of two new distribution centers. These new DCs have allowed us to service our existing store base while providing flexibility for future volume and new-store growth. The addition of 10 mixing centers, bringing our total to 16 has improved our service levels to our stores. A new import distribution center has also allowed for greater flexibility to flow our seasonal goods. As a result, we have had a 20% structural improvement in our STEM models and corresponding cost savings. Our DC productivity has also reached strong levels. In conclusion, the team is performing admirably short term and long term. True to truck supply style, we are efficiently managing the elements within our control and advancing our Life Out Here strategy. As we enter the fourth quarter, we are raising the low end of our guidance for the fiscal '24 sales and earnings to reflect our performance year-to-date and our outlook for the fourth quarter of the year. The fourth quarter has started out well as we benefited from emergency response sales for Hurricane Helene and Milton, both of which were fourth quarter events for us. This sales benefit is reflected in our guidance for the year. As we plan for the fourth quarter, we continue to anticipate that our customers remain prudent with their spending as is typical in an election year. We are capitalizing on our strengths and enhancing our competitive edge in the market with the support of our team members, their strong connections with our customers, and our successful strategic initiatives, we continue to outpace our competitors. Now, I'll turn the call over to Kurt to provide more color on our performance and outlook."
},
{
"speaker": "Kurt Barton",
"content": "Thank you, Hal, and good morning to everyone on the call. As Hal mentioned, our third quarter top-line results were consistent with our expectations and in line with the results in the first half of the year. We saw continued strength in big ticket sales, while our discretionary categories remained pressured. Our seasonal category performance, exclusive of big ticket, was in line with chain average at a modest decline to prior year. Similar to the first half of the year, we saw strong performance in seasonal categories such as live goods, mulches and soils, grilling, and wildlife supplies. This was offset by softness in ag fencing, heating, outdoor living, and lawn and garden tools. As we expected, our C.U.E. performance was slightly below the chain average given the retail price deflation and moderating pet category trends the industry is experiencing. Retail price deflation, which was approximately 1% was in line with our expectations. The vast majority of this deflation came from our C.U.E. categories. As Hal mentioned, we are pleased with our unit movement in C.U.E. as we successfully managed through the impact of deflation this quarter and are now starting to lap the beginning of this deflationary cycle from last year. Our comp sales growth was relatively consistent across all regions of the chain within a range of down 2% to up modestly. The strongest regional performance was in Texhoma due to inventory investments made in big ticket, easier compares, and better overall weather compared to last year. This strength was offset by pressure in the Far West, Midwest, and Commonwealth as the summer heat lingered and a lack of the change of season to fall in these areas. As to the cadence of the quarter, all months were also in a relatively tight band of essentially plus or minus 1%. Weather was generally a net neutral factor in the third quarter comparable sales results. Extreme heat persisted throughout the quarter in certain regions with no shift to cooler weather in the northern regions. Hurricane Helene and other storms in the last two weeks of the quarter did not produce net incremental sales to Q3 as any pre-hurricane demand was more than offset by softer volume in the South as a result of heavy rains and continued intense heat in the Far West and Midwest regions. We do believe this created a timing shift that has benefited early Q4 sales. Moving down to our income statement. Our gross margin increased 56 basis points compared to last year. We continue to be very pleased with these results, which were driven primarily by ongoing lower transportation costs along with disciplined product cost management and the continued execution of an Everyday Low Price strategy. These improvements were partially offset by the mix impact from strong growth in big ticket categories, which have below-chain average margins. As a percent of net sales, SG&A expenses increased 119 basis points to 27.8%. This increase was primarily attributable to our planned growth investments, which included the onboarding of a new distribution center and higher depreciation and amortization, as well as modest deleverage of our fixed costs given the decline in comparable-store sales. The new DC was approximately a 25 basis point headwind on SG&A for the quarter. We were also lapping a one-time depreciation expense benefit in the prior year of approximately 35 basis points or $11 million. These factors were partially offset by strong productivity and cost control and to a lesser extent, a slight benefit from our ongoing sale-leaseback transactions. For the quarter, operating profit margin was 9.4%. Diluted EPS was $2.24 compared to $2.33 last year, which included a $0.08 benefit from the depreciation change I mentioned earlier. Turning now to our balance sheet. Merchandise inventories were $3.1 billion at the end of the third quarter, representing an increase of 4.3% in average inventory per store. Last quarter, we shared that we had strategically invested in inventory as we look to improve our in-stock position in queue and support the strength in our big-ticket sales. We effectively controlled our inventory as we reduced our average inventory growth per store by more than 50% sequentially from the second quarter. Our inventory levels and in-stock rates are in excellent shape as we enter the fourth quarter. With strong annualized cash flows, we continue to maintain a healthy balance sheet with a leverage ratio of around 2 times. Our announced acquisition of Allivet fits perfectly with our tuck-in M&A strategy and is highly complementary to our business. Given that we have significant financial flexibility, this acquisition will be financed by our balance sheet. Year-to-date, we have returned more than $760 million of capital to our shareholders through share repurchases and dividends. Looking ahead, we are updating our fiscal 2024 guidance to raise the lower end of the range on both the top line and earnings. We now anticipate net sales to be in the range of $14.85 billion to $15 billion. We expect comparable-store sales to be between flat-to-up 1%. We are forecasting an operating margin rate of 9.8% to 10.1%. Our net income is expected to be between $1.09 billion to $1.12 billion, and we anticipate diluted earnings per share of $10.10 to $10.40 compared to our prior guidance of $10 to $10.40. As I see it today, our outlook for the remainder of the year is appropriately described as right down the middle of the fairway. At this time, we believe that our EPS will more likely be at the midpoint of the range, allowing for a breadth of possibilities that remains quite varied for Q4. As Hal mentioned, the fourth quarter is off to a solid start with the most significant sales weeks of the quarter still ahead of us. We continue to see the quarter having a wider range of potential outcomes on comp sales given the easier compares while acknowledging that we could see more volatility in consumer spending. On the high end of our outlook range, in addition to the easing compares, factors we considered include a more normalized start to winter, lapping net deflation, which began in the fourth quarter of 2023, and the emergency response activity from the recent hurricanes. On the low end of the range, dynamics we contemplated include moderation in big-ticket trends, potential consumer uncertainty due to the federal election, and a shorter holiday selling season with five less selling days between Thanksgiving and Christmas. Our outlook on gross margin, SG&A, and operating margin remain consistent with past commentary. In the fourth quarter, we'll be lapping our most difficult gross margin comparison with 129 basis points of expansion in the prior year, where we began to see the benefits from lower transportation costs and our product cost management initiative. As to SG&A, we anticipate better performance than in the third quarter given our comp sales outlook. We continue to forecast the return of capital to our shareholders in the range of $1 billion, reflecting the strength of our cash flow and the confidence we have in the long term. In conclusion, we are confident in our ability to deliver on our financial outlook for the year. At Tractor Supply, our philosophy is to stay on offense and remain proactive. We're enthusiastic about the progress of our Life Out Here strategy, maintaining our industry leadership and expanding our legacy of generating long-term value for our shareholders. Now, I will turn the call-back over to Hal to wrap up."
},
{
"speaker": "Hal Lawton",
"content": "Thank you, Kurt. I continue to believe that the structural backdrop remains very attractive for Tractor Supply. We participate in a large, attractive, fragmented, and growing market. We're a consistent share gainer and have numerous tailwinds, including our Life Out Here strategic initiatives, our market being a beneficiary of continued net rural migration, and high-return new-store growth opportunities. Short-term and long-term, Tractor Supply is extremely well-positioned as the leader in Life Out Here. As we look to close the always important fourth quarter, we have exciting plans in place to drive sales. We're in the midst of launching our first Hometown Heroes Days. Veterans and first responders over-index in our communities and Tractor Supply is uniquely positioned to celebrate those who keep us safe and make Life Out Here possible. The event starts on Saturday with a chain-wide event with our stores hosting their community to interact with fire trucks, K-9 units, and ambulances as well as food trucks and local farmer markets. Over the two weeks, we will be offering special promotions to our hometown heroes, including 10% off on First Responders Day and Veterans Day. Hometown Heroes Days is the perfect way to drive excitement for this program and for Neighbor's Club more broadly. This is a unique event, which will further support and strengthen this important customer segment's shopping affinity with Tractor Supply and is a great way for us to give back to them. We have an exceptional lineup of innovative and new products as well as enticing values and fresh offerings for the fourth quarter. In big-ticket, highlights include Massimo golf carts, Liberty Safes, Tractor Cam cameras, even Ember patio heaters, and Blackstone Grills. In our CUE business, we're expanding our cat food assortment, testing new items such as freeze-dried sacks, adding exclusive SKUs and Nutrena Triumph Equine Feed, and launching exclusive brand extensions such as 4health Shreds. In tools, we're offering notable deals across our tool shop event on brands such as DeWalt Porter Cable and it introduced new tailgating truck boxes just in time for the outdoor season. Our garden centers will be transformed to a winter wonderland with live Christmas trees, set is reeves and tractor eyes seasonal decor. And while the holiday merchandising is fun and brings great retail theater to our stores, what is most important in the fourth quarter to driving our business is the weather. And so to this year, as always, we'll be offering our customers all the things they need to weather the winter, including log splitters, snow throwers, chainsaws, and more. And if and when the winter comes, our customers know they can count on us for these critical supplies to get through the winter as well as products like propane and alternative heating sources. With strong inventory levels, we're committed to being the dependable supplier for Life Out Here. Our stores are well-stocked with the key products our customers depend on for their home and maintenance needs in the winter months. I hope you get a chance to get in our stores this season to see firsthand the great merchandising initiatives we have in place. As I mentioned earlier, please mark your calendar for our investment community today to be held on the afternoon of Thursday, December 5th. The team is excited to share our growth strategy for the back half of the decade. We're confident in our ability to navigate the challenges and seize the significant opportunities we see ahead. And with that, let's open the call for questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Our first question comes from the line of Zach Fadem with Wells Fargo. Your line is now open. Please go ahead."
},
{
"speaker": "Zach Fadem",
"content": "Hi, good morning. So now that about 25% of your stores have lawn and garden centers and roughly half of your stores are converted to Fusion. Curious if that historical mid-single-digit lift for the combination is still holding in this environment, which if it is, it would mean about 150 basis-points to the comp, if that's right. And then how should we think about the outlook for lawn and garden Fusion and any other store initiatives that you have planned for '25?"
},
{
"speaker": "Hal Lawton",
"content": "Hi, Zach, it's Hal Lawton and good morning, and thanks for joining us on the call. Yes, great milestone for us that we've reached with over 1,000 stores now in our Fusion format and 500 stores in our Garden Center format, over 500 stores. You think back to where we were in August of -- I mean, October of 2020 when we had zero of each. So come a long ways in a short amount of time. As we look forward, we feel good both about the pace that we're doing on our remodel program, which is between 175 and 225 stores a year. We've been consistently running at that pace the last couple of years. Of course, all new stores are built with the Fusion concept. And then between half and three-quarters of the stores just depending on a variety of factors are receiving the Garden Center a bit more on the new stores because we have a little more control of the setup, but the same on existing store remodels as well. And then, yes, we are continuing to be very pleased with the performance of Fusion. Those stores do continue to outpace the broader chain. Additionally, they continue to have higher customer scores on key areas of things like store environment, clean and uncluttered, those sorts of things. They also tend to have a higher female as well as a younger shopper base as well. So all the both quant and qual metrics that we've shared historically on Fusion continue to occur and we continue to be very pleased with the Garden Center business, while it's been a couple of years now of tougher spring/summer weather, we continue to have strong performance in live goods, as we talked about as well as all the other ancillary products that go around it. And then this year, we'll be using, as I talked about in our prepared remarks, the Fusion setup even to bring even a heightened and more well-done, fall execution as well as Winter Wonderland execution. So all in all, very good progress. And just to wrap it up. In my prepared remarks, I talked about the Farm and Ranch channel being negative in the kind of low to kind of mid-single digits, call it a minus 2%, minus 3%, maybe minus 4%. And you look at our overall growth of 1.6% and would point to many of our competitive advantages and strategic initiatives we have been implement -- that we've been investing in as the reasons for that share gain. And one of the important ones is Fusion as you -- as we just went through the numbers. So I think it's Fusion is doing well. It's a major contributor to our share gain and we're excited to continue the initiatives we turn into the back half of the decade."
},
{
"speaker": "Zach Fadem",
"content": "Appreciate your time, Hal."
},
{
"speaker": "Hal Lawton",
"content": "Thanks, Zach."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question is from the line of Chris Horvers with JPMorgan. Your line is now open. Please go ahead."
},
{
"speaker": "Chris Horvers",
"content": "Thanks, and good morning. So I just want to talk about the weather and the storms. So can you talk about what the storms have done for your business so far and sort of what's embedded into the balance of the quarter? It seems like you're targeting about a roughly 2% comp in the fourth quarter. And then on the -- just on the margin front, you start to lap the transportation cost tailwinds as you talked about. Does the emergency response create some headwinds in gross margin that we should think about in the fourth quarter and does that DC headwind go away in SG&A? Thank you."
},
{
"speaker": "Kurt Barton",
"content": "Oh. Hi, Chris, it's Kurt. In regards to I was taking notes on what I think there's about three points in there. There is the question on the storms. There's a question in regards to the margin on DC headwinds and or DC benefit and when does that turn in the emerging response. So let me just try to hit those things. In regards to the weather, I'll just mention Q3 first as I had mentioned some of that in prepared remarks. Leading up till about mid-September, just as an example, the business was running at a slight positive comp sales trend. And in the back two weeks, while we did see benefit like in emergency response from generators and others at the front-end of Hurricane Helene because that's one of those storms that really straddles both quarters. It was offset or more than offset by -- in that particular storm across most of the South and Southeast, just blanketed with storms. And so that dampened a bit of the overall traffic in the last week or two of September. As I mentioned, I see that more as a positive because that just defers some of the demand on the business. So both Helene and Milton have had net for the full year in Q4, a benefit to us. We'll have -- we have so many of the important weeks ahead of us. I won't quantify exactly what we expect from these storms, but generally, hurricanes have a modest level of benefit on each hurricane, and we anticipate that for Q4. Emergency response has a mixture of product, some of the bigger ticket generators lower, but has a mix of higher margins. So we do not anticipate the storm's emergency response really having an impact on margin in the fourth quarter. And yes, the distribution center been a headwind to SG&A in 2024 does start to cycle out as you get about 9 months to 12 months out. It really takes about that much time to be able to even out the inventory and be able to have the other distribution centers have a productivity offset to it. So we'll share more information on 2025 in regards to that in our January call."
},
{
"speaker": "Operator",
"content": "Thank you. The next question is from the line of Chuck Grom with Gordon Haskett Research Advisors. Your line is now open. Please go ahead."
},
{
"speaker": "Chuck Grom",
"content": "Hi, good morning. Thanks very much, guys. In the past on your third quarter calls, you've provided some early framework for the out year in terms of store count, margin, puts and takes, et cetera. Is there anything we should be mindful of as we build out our models for next year? And then along those lines, you have a long-term comp algo of 4% to 5%. I'm sure you don't want to underline getting to that next year, but can we think about the puts and takes over the next 12 months to 18 months on the comp front? Thank you."
},
{
"speaker": "Hal Lawton",
"content": "Hi, Chuck. Good morning. I think on the two things I'd say as it relates to looking out into next year and beyond. One, I think we've got a very clear recipe of how we're operating our business right now in terms of, this year we increased from 70 new stores to 80 new stores, and we've talked about how we're moving to 90 new stores next year. And that is the recipe that we're planning on. We have an exciting portfolio of high-return new-store opportunities out there. We've been challenged by many of our investors to go capture that value sooner. And we're kind of moving in that direction. We talked earlier about our consistent remodel approach somewhere between 175 and 220 stores a year. If you think about that it kind of the average of that at 200 with 2,300 stores roughly right now. That means about every 10 years, we're remodeling a store, which is I think, a nice healthy run rate for a retailer. And other than that, there's no real outliers on how we're thinking about the business as we turn into next year as it relates to our long-term comp algorithm. I'd point to the same commentary we had on the last call, which is we look to return to that as quickly as possible and the two major factors impacting our doing so is inflation, deflation, and consumer spending nominally between services and goods. If you look at deflation, inflation, Kurt had some comments on that earlier and we start to lap some of that around now, and we'll continue to lap that over the next 6 months to 9 months and then start to really be through that cycle. And if we all look at the low price for corn was really middle of this year and we would -- but we also had the big dip down that we took last year starting in October. And then on goods to services, the consumer continues to have to shift a number of a good bit of their spend into services right now. If you look at whether it's rent, insurance costs, those sorts of things, I mean, services continues to outpace the spend on goods, somewhere in the range of 6 to 7 points versus, say, 1 to 2 points on goods. And you can see that kind of correspondingly into retail sales. And as I talked about in the call, we think retail sales were slightly positive in the 1%-ish, 1.5% range for Q3, our fiscal Q3 and our sales were right in line, if not slightly above that at the 1.6% range. So that's kind of how we see the macro-environment shaping up right now and what we see as we turn the corner to 2025. Thanks, Chuck."
},
{
"speaker": "Chuck Grom",
"content": "Great. Thanks, Hal."
},
{
"speaker": "Operator",
"content": "Thank you. The next question is from the line of Karen Short with Melius Research. Your line is now open. Please go ahead"
},
{
"speaker": "Karen Short",
"content": "Hi, thanks. Great to talk to you again and look forward to seeing you in December. So my question is, looking at 4Q when you look at the range of outcomes on sales and gross profit dollars and gross margins, it's pretty wide. So wondering if you could address that. And then also looking to -- so and commenting on more specifically puts and takes on 4Q on gross margins and SG&A. But then wanted to address more specifically the longer-term algo and when you think you can return to that? And I assume you'll address that at the Analyst Day, but any preliminary comments would be great."
},
{
"speaker": "Hal Lawton",
"content": "Yes. Hi, Karen. On the long-term algo, maybe hit that one first. I very much, as I've said just a moment ago, look-forward to getting back to our long-term algo. We don't see any internal issues in terms of returning to our long-term algo. Our market continues to be incredibly favorable in terms of just the overall optics of our market, the strength of our markets, attractiveness of our markets. Our position and competitive differentiation in the market is as strong as it's ever been. We think the combination of those two absolutely in normal operating kind of circumstances lead to our long-term algo. We're very confident in our ability to return to that long-term algo and the two main things that we're watching in the context of returning to that are, as I mentioned earlier, the goods to services split on overall consumer expenditures. And then two, how inflation, deflation plays out and then that plays into our average ticket. As we've talked about in the past, our recipe is really a 50% growth based on average ticket, 50% growth based on comp transactions. The goods to services shift is much more about a transactions type of headwind. And then the inflation, deflation, obviously being an average ticket headwind. We do see that both the pressure, the headwinds on both of those dissipating into 2025. I think the question is to what degree and over what period of time through '25. And we will share more of that, a little bit of that in our Investor Day. And then certainly, you'll hear our perspective on that in our Q4 earnings call. As it relates to the range of outcomes in sales in Q4, I'll address that and then Kurt can speak to some of the gross margin ins and outs. But on the range of sales, I'd start with in the month of October has played out much like what we expected with the one addition being the hurricanes that Kurt talked about previously, all right. Those will provide a modest benefit to Q4. As Kurt shared in the past, we've seen maybe 20, 30 basis points of benefit for a hurricane of those sizes. And I think something to that effect is what's in our guidance in Q4. The other major things that are going to play into Q4. One is going to be weather and it needs to get cold for our business to really perform well in Q4. We saw a lot of heating pellets. We saw a lot of heating fireplaces. We saw a lot of insulated outerwear and a lot of other products in our business that are cold-weather related. We've had about a week, week-and-a-half of cold-weather this quarter so far. When that hit, it was very good. It's now probably -- if everybody can think about where they're sitting right now, it's very warm right now. And so by consequence, people aren't buying heating and insulated out of ware. So we've had a bit of a mix in October, and that's typically what you can expect in October. As you look forward into the last two months, it really comes down to the continuation of cold weather, do we get it in November? Do we get it in December? Last year, we got cold weather in neither month. The second comes down to holiday shopping. We've got five less days this year. Historically, customers have been able to compress for the most part, but the question will be just how does the calendar play-out this year? And does that occur? Also with Christmas being on a Wednesday, you've got a unique setup where online is able to play much more strongly in on that final Super Weekend than it has in the past. And then, of course, you've got the federal election and we do expect that consumer spending leading up to the federal election will be dampened both just with distraction as well as a little bit of just wait-and-see mode. And so then you've got to see how does that pick back up. But at the end of the day, as I said on my prepared remarks, while the holiday sales are important of our business, the make or break for our business is the -- is how we support our customers with what their needs are, particularly during the cooler weather season. So that's what's most indicated -- will be most indicative of our sales in Q4. And I'll turn it over to Kurt for some comments on margin."
},
{
"speaker": "Kurt Barton",
"content": "Yes, Karen, here's how we look at the gross margin and the SG&A in the fourth quarter. And I'd start by saying the all year, the business has been remarkably consistent. And so I'll refer to Q4 versus some of the highlights of Q3. We had 56 basis-points of benefit in Q3 as it was really the last quarter before we start to lap the significant benefit we started to see last year in fourth quarter on both transportation and our cost-saving and our cost-cutting initiatives. And so we'll have only a modest level of benefit remaining on transportation and cost in fourth quarter, that will for the most part likely be offset by product mix. So gross margin is relatively, give or take a bit more flattish year-over-year in Q4. And then on the SG&A side, the -- a lot of the puts and takes are similar other than in Q3, we were cycling 35 basis points benefit of a one-time depreciation. In Q4, we'll still have roughly 20 basis points, 25 basis points of pressure on the new distribution center. We anticipate a little bit more leverage on the comp sales as we anticipate positive comp sales for the fourth quarter. So you really see yourself moving in that in about a 50, 60, 65 basis points of pressure from SG&A in the fourth quarter as it's a -- it does not have as much of the one times as, say, Q3 does. So net, that does put operating margin in an unfavorable decline from year-over-year, but that's always been in our expectations for fourth quarter as we were lapping the strongest performance year-over-year."
},
{
"speaker": "Karen Short",
"content": "Thank you. Hopefully, you just bring women's wranglers to your stores."
},
{
"speaker": "Kurt Barton",
"content": "We'll make a note of that."
},
{
"speaker": "Operator",
"content": "Thank you. The next question is from the line of Michael Lasser with UBS. Your line is now open. Please go ahead."
},
{
"speaker": "Michael Lasser",
"content": "Good morning. Thank you so much for taking my question. My question is how one of the key debates is can Tractor Supply get back to the historic levels of 1% to 2% growth in traffic. It seems like what you're suggesting is the ability to get back to that level of traffic growth on a consistent basis is going to be macro dependent where it will be influenced by the shift from services to goods. Yet, Tractor being a more needs-based retailer that has more consistent trends in areas like consumables CUE have held up relatively well. So what specifically do you see as influencing the assortment or category performance that will improve in a more robust economic environment, more robust retail environment to drive that traffic growth? And as you see a little bit less gross margin expansion because of some of the drivers from this year stayed, would you be willing to sacrifice some gross margin in order to drive the traffic growth? Thank you very much."
},
{
"speaker": "Hal Lawton",
"content": "Hi, Michael, thanks for the question. First-off, I'd -- maybe I'll just step back, if I look at our growth over the last five years post-COVID, which I think is the second-highest in all of retail -- major retailers out there, the key to that has been strength in both average ticket and comp transactions. So it's not -- comp transaction growth has not only been a highlight of Tractor Supply for the last 30 years, 20 years, but also in the last five. And I would say of most retailers out there, we're one of the few that have been -- that have strong positive like double-digit positive comp transaction growth over a multi-five-year period. So I'd put our transaction growth over the last five years up against anyone. Second of all, I think if you look at retail right now, overall transaction growth in retail is either flat to negative in general right now. And so when you look at our modestly positive comp transactions, you combine that with overall transactions given our new-store growth and our comp transactions, I would argue we are in the top-quartile right now of retail in terms of overall transactions. So I look at --- I'm very pleased with how we've grown our transaction last five years, how we've held those transactions and even in the context of this environment that we're in, how we're modestly positive comping transactions and then with our new stores having strong couple of points of transaction growth. Then as I look forward, I think it really does all come down to the goods-to-services shift and then our customers having a little bit more money to spend on items in our stores. And that's going to make its way into that extra half of transaction a year to them and it's also going to make its way a little bit into the units per transaction. But I think what we're seeing on our comp transactions being muted a bit is very comparable to what's happening in all the rest of retail. And I certainly believe as retail moderates back to its normal levels, rising tides will lift all boats. And those of us that continue to have positive comp transactions will continue to see stronger positive comp transactions as that occurs. Anyway, I'll just -- I'll leave it at that. Thanks, Michael."
},
{
"speaker": "Michael Lasser",
"content": "Thank you very much."
},
{
"speaker": "Operator",
"content": "Thank you. The next question is from the line of Steven Forbes with Guggenheim Partners. Your line is now open. Please go ahead."
},
{
"speaker": "Julio Marquez",
"content": "Good morning. This is Julio Marquez on for Steve. Hal, curious if you could expand on how the 37 million Neighbor's Club members informed the decision to acquire Allivet. Any -- I guess, how many Neighbor's Club use an online solution for the pet pharmacy needs? And any other color you can help contextualize the opportunity there would be great. Thank you."
},
{
"speaker": "Hal Lawton",
"content": "Yes, thanks. We are really excited about the acquisition of Allivet. I think it's a great example of kind of a tuck-in acquisition. They've been a partner to us for a few years now as our pet Rx provider. What we've observed over those few years has been best-in-class in terms of both their nationwide prescription licensing capabilities, their distribution centers and their ability to get product shipped out in 24 hours, their ability to get prescriptions approved and partner with the veterinarians, their excellent website, their strong management team and importantly also excellent financial condition. So we feel all-around. It's a great business, one that we're excited and thrilled to welcome into the Tracker Supply family and we look forward to bringing that feature of a low cost affordable, wide array of prescriptions for pets and animals to our customers. As you said, we have 37 million-plus members of our Neighbor's Club program. It's a highly engaged membership program, one that we continue to add value in and our customers continue to further and further become loyal around. And we think the combination of Allivet with our Neighbor's Club is going to just be a great mix and we look forward to over the next few years, getting the deal done, approved, closed, and then starting to bring that to our Neighbor's Club members in the ways that we've brought the additional features and benefits that we have to them. Very excited about it and more to come at our Investment Community Day on that topic on December 5th."
},
{
"speaker": "Julio Marquez",
"content": "Great. And just a quick follow-up. Kurt, following two years of flattish comps, has there been any change to the building blocks behind that 10.10% to 10.6% long-term EBIT margin guidance, realizing productivity plays a role? But are there any margin factors there that are maybe structurally higher today than where you originally framed it?"
},
{
"speaker": "Kurt Barton",
"content": "No, really, there's not anything significant in our algorithm to attend 1 to a 10.6% and recognizing that we're going to continue to invest for the long term. The last two years, the comp sales puts pressure on our ability to leverage the SG&A and it's really been the difference. The team has just done a phenomenal job though, finding ways to offset that. And there are a number of cases on productivity in both our stores and our logistics distribution team that have just done a phenomenal job finding new opportunities for productivity. So the team has done well to be able to maintain that 10-plus operating margin in the last couple of years. So the algorithm is still intact. And Hal has mentioned all the different reasons of our expectations of being able to get back to the long-term algo and that just gives a better opportunity to avoid the pressures of SG&A. So I feel very confident with the long-term algo still at this point."
},
{
"speaker": "Operator",
"content": "Thank you. The next question is from the line of Peter Benedict with Baird. Your line is now open. Please go ahead."
},
{
"speaker": "Peter Benedict",
"content": "Hi, good morning, guys. Thanks for taking the question. Maybe one for Seth. Just around the big ticket strength, it certainly continues to be unique relative to most of retail. You talked about some innovation, I think some sharp pricing on these items. I'm just curious if you could expand on it. Any other factors helping here? I don't know the use of private credit has been playing a role. And how do you guys think about like replacement cycles for some of those bigger ticket categories? Is that potentially starting to tick in here? I'm just kind of curious if you expand on that a little bit. Thank you."
},
{
"speaker": "Seth Estep",
"content": "Yes. Hi, Peter. Thanks for the question. Just overall with big ticket, as we mentioned, we definitely are very pleased with the performance there as Q3 really was much in line with the strength of the performance as we exited Q2 and we really were able to maintain that. You know, the third quarter, it was our third consecutive quarter of big ticket growth and as you mentioned in some of the categories that we've had, whether it be like Zero-turns, Front Engine Eiders, Rec Vehicles, and a couple of other categories. I would point to a couple of things that have really differentiated us a little bit from the market, I believe. I would start with just the product lineup itself. I think the merchants have done a fantastic job of line structure in these categories where we are offering quality, high-value products across multiple brands, bringing innovation. We are working on differentiation with exclusive features and they're really built and tailored to our customer, right, and their customer needs with kind of the large animal or the large acre ownership across a lot of our customers. The next thing I would say is just some of the strategic inventory investments that Kurt mentioned earlier as well. When we exited Q2, we made sure we saw some of the strength here and we're looking at the weather patterns and we placed inventory in those -- in these categories to make sure that we can continue to maintain that as we went after it. And then the last thing I would just say is private-label credit card. Our private-label credit card momentum has been very strong, with that, our supplier base are partnering with us to continue to drive that. And when you just kind of combine those things together, whether it be the lineup itself, the value quality proposition, designing programs specific to the lifestyle of our customer, and then coupling that with things like our offerings, both with private-label credit cards and leveraging our Neighbors Club, it's really a combination of all those together that's really playing on it. Team is building 2025 right now either I think you'll see they'll continue to expand on those things and really excited about the lineup as we move into next year."
},
{
"speaker": "Operator",
"content": "Thank you. The next question is from the line of Peter Keith with Piper Sandler. Your line is now open. Please go ahead."
},
{
"speaker": "Peter Keith",
"content": "Hi, thanks. Good morning, everyone. Congrats on the continued market share gains. I wanted to ask about technology. So Hal, you had referenced some greater data integrity and personalization with Neighbor's Club. I was wondering how you're leveraging technology and AI to provide those solutions and anything that we might think about going into next year that could perhaps provide some type of sales benefit."
},
{
"speaker": "Hal Lawton",
"content": "Yes, good morning, Peter, and thanks for the question. I'd say we are infusing machine learning, data science, AI, really across the business both in our own analytics frameworks, also in leveraging our -- software providers capabilities, whether that's in things like Reflexis on inventory management or whether that's with our new CDP in terms of customer insights and personalization. And then I'm really proud that we're also building solutions internally to drive, as I've shared earlier, kind of better customer service in our stores. And whether that's through things like tractor vision, where we're upgrading our camera software and hardware technologies to be able to leverage our cameras to drive improved customer service through a variety of use cases, whether that's at the register on the apron in our garden centers or whether that's through our Hey GURA tool that we have that all of our team members are able to use to ask to get further knowledge inside of our stores when they're dealing with customers or when they just want to educate themselves. But we have a broad variety of things that we're using all really to drive improved customer service productivity with our team. Also in our distribution centers, we're doing that. We're using vision technology to be able to look at the packing of trucks, to look at left-offs of trucks to watch, to use it to manage the yard. So whether it's operationally in our DCs, whether it's for customer service in our stores or whether it's in our merchants or marketing use it for behind-the-scenes analytics and personalization. We're leveraging data science and machine learning and AI across the board. Thanks, Peter, for the question."
},
{
"speaker": "Peter Keith",
"content": "Thank you."
},
{
"speaker": "Mary Winn Pilkington",
"content": "Operator, we'll have time for one more question."
},
{
"speaker": "Operator",
"content": "Thank you, Mary Winn. Our final question comes from the line of Scot Ciccarelli with Truist. Your line is now open. Please go ahead."
},
{
"speaker": "Scot Ciccarelli",
"content": "Good morning, guys. Thanks for squeezing me in. First, a quick clarification. I think it might have been on Chuck's question. Are you expecting this year's same-SKU deflation to flip to same-SKU inflation in '25? And then kind of related to that, are you able to quantify to any degree the pressure on your business from the decline in farm income that we've seen because of commodity deflation? Thanks."
},
{
"speaker": "Kurt Barton",
"content": "Hi, Scott, this is Kurt. On deflation, for the first-nine months of the year, it's generally ran in-line with our plan and expectations. We have seen a bit of a additional step-down, modest on some of the commodities. I expect Q4 to have a similar but slightly less deflationary impact than Q3. But it really looks like today, if you're trying to peg when is there a point neutrality that that's been punted out anywhere from three to six months and you will have a much better view in January on what the expectation is on 2025. All indication is we are shifting out of a deflationary environment towards an inflationary one. The timing of when that conversion flips, we first thought it would be late 2024, early 2025, that could be Q1, Q2 of next year. And then in regards to your second question, remind me again that point?"
},
{
"speaker": "Scot Ciccarelli",
"content": "Yes, just farm income broadly has been under pressure because of commodity deflation and just trying to figure out, have you guys been able to quantify the impact on your bills? Thanks."
},
{
"speaker": "Kurt Barton",
"content": "Yes. For years, we've looked at the farm income level in strong years and soft years. And it can have either an indirect slight halo or overhang on there and we really don't see much of a correlation to that. And as you know, I'll just point out our majority of our customers are not professional farmers. It's not their number-one source of income. And they if anything, we look sometimes at the overall market area and if there's an indirect benefit to that market area and how the non-farmers may spend. At this point, we're not really seeing anything that points to that in our business today."
},
{
"speaker": "Mary Winn Pilkington",
"content": "All right. Well, that will get us to the top of the hour and wrap-up our Q&A for today. As always, we're available for any follow-up calls. Please be on the lookout for the invitation to our Investment Community Day in December that Hal referenced earlier and please reach-out if you need any further information. We look-forward to the event and thank you for your interest in Tractor Supply."
},
{
"speaker": "Operator",
"content": "This concludes today's conference call. Thank you all for your participation. You may now disconnect your lines."
}
] |
tsco | 2,024 | 2 | [
{
"speaker": "Operator",
"content": "Good morning, ladies and gentlemen, and welcome to Tractor Supply Company's Conference Call to discuss Second Quarter 2024 Results. [Operator Instructions] Please be advised that reproduction of this call-in whole or in-part is not permitted without written authorization of Tractor Supply Company. And as a reminder, this call is being recorded. I would now like to introduce your host for today's call, Ms. Mary Winn Pilkington, Senior Vice President of Investor and Public Relations for Tractor Supply Company. Mary Winn, please go-ahead."
},
{
"speaker": "Mary Winn Pilkington",
"content": "Thank you, Victoria. Good morning, everyone. Thanks for taking the time to join us today. On the call today are Hal Lawton, our CEO; and Kurt Barton, our CFO. After our prepared remarks, we'll open the call up for your questions. Seth Estep, our EVP and Chief Merchandising Officer, will join us for the question-and-answer session. Please note that we have made a supplemental slide presentation available on our website to accompany today's earnings release. Now let me reference the Safe Harbor provisions under the Private Securities Litigation Reform Act of 1995. This call may contain certain forward-looking statements that are subject to significant risks and uncertainties, including the future operating and financial performance of the company. In many cases, these risks and uncertainties are beyond our control. Although the company believes the expectations reflected in its forward-looking statements are reasonable it can give no assurance that such expectations, or any of its forward-looking statements will prove to be correct and actual results may differ materially from expectations. Important risk factors that could cause actual results to differ materially from those reflected in the forward-looking statements are included at the end of the press release issued today and in the company's filings with the Securities and Exchange Commission. Information contained in this call is accurate only as of the date discussed. Investors should not assume that statements will remain operative at a later time. Tractor Supply undertakes no obligation to update any information discussed in this call. Given the number of people in the Q&A, we would like to ask that you please limit yourself to one question and please get back in the queue if you have any additional questions. I appreciate your cooperation. We will be available after the call for follow-ups. Now it's my pleasure to turn the call over to Hal."
},
{
"speaker": "Hal Lawton",
"content": "Thank you, Mary Winn and good morning, everyone, and thanks for joining us. As always, I'd like to begin by expressing my thanks and appreciation to my fellow 50,000 plus Tractor Supply team members for their commitment to each other and our customers, and for their dedication to serving Life Out Here. And this quarter, I'd like to give a special shout out to our technology team, who did a tremendous job recovering our business from the CrowdStrike outage without a material impact. So let's start with the operating environment for our business before I discuss our second quarter results. Overall, the macroeconomic indicators that we all follow continue to be rather mixed for the consumer in the second quarter. While in-line with our expectations at the beginning of the year, I would characterize the health of the consumer as modestly more cautious than last quarter, but certainly still within the range of our forecast at the beginning of the year. Consumer spending on goods appears to be fatigue across income cohorts. While we've seen improvements in the consumer inflation rate, unemployment has ticked upwards to the highest rate since late 2021. Additionally, consumer sentiment and consumer confidence are both subdued and the consumer spending landscape continues to be rather choppy. Additionally, in the recent personal consumption expenditures report, we saw another soft month for goods. While in-line with our expectations, the ongoing shift in spending from goods to services continues to be a headwind for our business. The mix of goods as a share of PCE is still about 90 basis-points above the pre-COVID average. As it relates to retail sales for the second quarter, U.S. retail was flat to modestly positive with growth in non-durable categories, which was in-line with our performance as a company. And in the farm and ranch channel, we estimate that, that channel experienced mid-single-digit declines, which is indicative of our continued share gains in the channel. With that said, our business for the first half of 2024 has performed right down the middle of our guidance. For instance, half of the months of the year have had positive comp sales and our year-to-date comp sales are up about 0.2%. And overall, our profitability is also right in-line with our expectations and the team has continued to manage our business exceptionally well. As we look at our business in half and reflect back on the spring season, as we always talk about, weather can certainly shift sales between quarters. And given this year, the early Easter and then a couple of weeks of warm weather that we had there in late March, we estimate a potential pull-forward of $15 million to $20 million in sales from the first quarter -- from the second quarter into the first quarter. And so if you think about this kind of balances out our performance across the two quarters. And additionally, we thought we'd have some potential for an elongated spring, particularly in late June, but that did not materialize. On the customer front, of note, we did see our higher income customers moderate just modestly, as spending for vacation travel has surged for this group. And conversely though, our lower income customer cohort moderated up sequentially from the first quarter. And net-net, our overall customer base though continues to grow and be very strong. Now let's shift to some performance highlights for the quarter. We grew net sales by 1.5% with a comparable-store sales decline of 0.5%. Diluted EPS was $3.93. Our comparable-store sales performance was driven by a modest transaction decline of 0.6% with our average ticket coming in at 0.1% positive. As we shared on our last call, we anticipated that the quarter would be in-line with our full year guidance. As we moved through the quarter, many of the same trends from the first quarter continued to play-out. Importantly, we continue to see healthy customer engagement. The investments we've made in Neighbor's Club our world-class loyalty program, are a competitive advantage for us as we continue to see solid growth in both customer counts and customer retention. If you recall, in the first quarter, we significantly enhanced our Neighbor's Club offerings. The changes were implemented with the goal to have members receive rewards faster and lower the spending required for tier qualifications. This quarter, as part of our ongoing and continued improvements in the program, we launched Hometown Heroes, which recognizes military service members, veterans and first responders. And this program brings together under one banner our long standing support for the selfless men and women who serve America. A highlight of the program is that our Hometown Heroes received the highest level status and benefits of our Neighbor's Club loyalty program. And while still very early, we're pleased with the enrollment. Of note, about 20% of our Hometown Heroes to-date are new to Neighbor's Club and about 15% are new to Tractor Supply. Once again, our Neighbor's Club comp sales outpaced our overall sales growth. At the same time, we also reached an all-time high on our sales penetration and record membership of more than 36 million members, and that means we've added nearly 5 million members over the last 12 months. And our Neighbor's Club retention rate remains remarkably consistent as our best customers continue to shop us more frequently and remain extremely loyal. At the same time, though, we are seeing a slight disengagement of our non-core customers, is down just modestly. We believe this is attributable to the overall macro headwinds that I mentioned in my opening remarks. And given that this customer is not as highly engaged in the kind of Life Out Here lifestyle, our belief is that this customer cohort is a little sluggish or fatigued given the duration of inflation and higher cost of living since 2022, and just being judicious in their spend. And as we look forward, though, our Neighbor's Club is laser focused on this opportunity as we improve our personalization capabilities, particularly with our customer data platform that we'll be implementing later in the year. Our customer service scores continue to run at all-time highs, with improvements every week for more than 2.5 years. Customer service is a consistent differentiator for Tractor Supply, and our commitment to excellence in customer service and investments we've made in training, tools and technology are really paying off with our customer. And these efforts have also though received national recognition by various third-parties, including USA Today and Forbes. Also, it's worth noting that the team received a CIO 100 Award recently for our groundbreaking work to utilize AI to enhance the customer experience in our stores. Just a great job by everyone around on our customer service. Moving to category performance, a highlight was the strong positive comps in big ticket items in the second quarter, notably in categories like riding lawnmowers, recreational vehicles and sporting goods. And the commonality in these categories is strong innovation in newness and our customers really responded to this. Additionally, we continue to be pleased with our live goods performance, which comps well above the chain average despite the hot weather that impacted many of our other seasonal categories. As we shared last quarter, we anticipated our consumable, usable and edible product would run modestly below the chain average in the second quarter as deflation weighed on our average unit retail. We once again grew units in these categories and we believe we're continuing to gain market share. The needs-based demand-driven nature of our product categories -- these product categories continues to drive unit velocity in this segment of our business. Clicking down into our CUE categories. In pet food, recent industry data suggests that the overall category was flat to negative in Q2. As it relates to our business, we continue to take share, but we have seen growth continue to moderate as the category disinflates and pet ownership trends remain soft. Our customer shopping trip in this category is highly differentiated. We offer a broad assortment from value to super premium across national and exclusive brands in a pet-friendly environment, which now includes more than 900 pet wash locations. Through the second quarter, we've had strong double-digit growth in our pet wash service. Additionally, the value of our mobile pet vet clinics is another great gateway for pet customers to find Tractor Supply. Year-to-date, we also have seen mid double-digit growth rates in visits to our clinics, offered across more than 1,600 stores. The two of these in combination with the rest of our services and product benefits creates a great opportunity to reinforce our value proposition. Additionally, pet ownerships benefit from the one-stop-shop convenience of our lifestyle retail format, in particular from the cross purchasing synergy with animal feeds. As we've mentioned, the vast majority of our customers have both an animal and a pet. In aqua livestock and poultry feed, we continue to gain market share. While our average unit retails were down mid-to-high single-digits in this category in Q2, conversely, we had strong mid-single-digit unit growth across all species. As large animal counts continue to pressure, we are certainly a share winner in the large animal categories with our strong unit growth. And in poultry, our annual Spring Chick Days was another positive highlight in the quarter. The event builds on our reputation as the destination for backyard enthusiasts. From economy to organic feed as well as our assortment of premium breeds, our lineup continues to resonate with our customers. Much like the first quarter, categories that performed below our comp sales were in our discretionary businesses, such as clothing, footwear and decor and also in the hardlines products of the business, such as things like ag, fencing and pet kennels. Our digital sales continued to trend from last quarter of double-digit growth. We've accelerated our digital capabilities and that's fueling engagement of our customers and also improving our conversion rate. Our 10th and largest distribution center in Maumelle, Arkansas opened during the second quarter. The startup of the distribution center was right on-schedule and shifting began last month. It's a great job by the team. Once again, we are capitalizing on the opportunity to realign with store servicing areas across the DC network to balance transportation costs and DC capacity, while improving service levels to our store. Our supply chain investments over the last four years have provided us with a structural gross margin benefit from the reduction in spend miles. Our garden centers had strong performance during the important second quarter. We now have more than 500 garden centers across the chain. The merchants did a great job with a differentiated assortment and strong in-stocks on top of the planting season. With more variety and live goods as well as adjacent categories catering to outdoor living, we saw the customer respond positively to this multi-year growth driver. We opened 21 new Tractor Supply stores and three Petsense by Tractor Supply's in the quarter. Our new store productivity continues to perform very well. In the year since announcing our expanded real estate capabilities allowing for own development, we continue to anticipate material benefits to both revenue growth and operating margin rate. Our team has built-out capabilities to allow us to scale this initiative. We now have nearly 50% of our pipeline in own development with our first locations already open. This development allows us to have rent reductions of 15% or more compared to our traditional build-to-suit. And we continue to believe that we have a robust pipeline of low-risk organic growth opportunities ahead of us. To wrap-up, I believe the team is pleased but not satisfied with our first half performance. We set high expectations for ourselves. Customer trends are relatively in-line with our expectations. The team is executing well. In typical Tractor Supply fashion, we are effectively managing the factors that we can control and making progress on our Life Out Here strategy. As we plan for the second half of the year, we anticipate that our customers remain prudent with their spending as-is typical in an election year. At the halfway point of the year, we are narrowing our guidance for fiscal 2024 to reflect our performance year-to-date and our outlook for the second half of the year. We continue to create more separation between us and our competition, thanks to our team members and the meaningful relationships they have with our customers in combination with our strategic initiatives. Our dedication to serving Life Out Here remains unwavering. We will always strive to do the right thing. And now I'll turn the call over to Kurt."
},
{
"speaker": "Kurt Barton",
"content": "Thank you, Hal, and good morning to everyone on the call. In many ways, our second quarter topline results were consistent with our results in the first quarter, with solid seasonal growth and exceptional big ticket sales, while our year around discretionary categories remain pressured. As we expected, CUE performance was slightly below the chain average given the retail price deflation and moderating pet category trends the industry is experiencing. Retail price deflation, which was just over 1% was in line with our expectations. The vast majority of this deflation came from our CUE categories. As Hal mentioned, we are pleased with our unit movement in CUE as we successfully managed through the impact of deflation this quarter. Our comp sales growth was relatively consistent across all regions of the chain within a range of down 2% to up 2%. The strongest regional performance was in the Northeast and Commonwealth due to easier compares and better overall weather compared to last year. This strength was offset by pressure in the Far West and Texas, Oklahoma for the exact opposite reasons, as they had tougher compares and less than ideal weather conditions this quarter. As to the cadence of the quarter, all months were also in a relatively tight band of essentially plus or minus 1%. As Hal mentioned, we believe April was negatively impacted by the pull forward of Easter into the first quarter as well as a slow start to the spring season. Moving down our income statement, our gross margin increased 43 basis points to last year. We continue to be very pleased with these results, which were driven primarily by ongoing lower transportation costs along with disciplined product cost management and the continued execution of an everyday low price strategy. These improvements were partially offset by the mix impact from strong growth in big ticket categories, which have below chain average margins. As a percentage of net sales, SG&A expenses increased 58 basis points to 23.4%. This increase was primarily attributable to our planned growth investments, which included the onboarding of a new distribution center and higher depreciation amortization, as well as modest deleverage of our fixed costs given the decline in comparable store sales. These factors were partially offset by productivity improvements and strong cost-control. During the quarter, our ongoing sale leaseback strategy benefited SG&A by approximately $5 million net of transaction and repair costs from the sale of two Tractor Supply locations. This transaction and the related benefit represent timing shift out of the third quarter and into Q2. For the quarter, operating profit margin was 13.2%. We had strong cost control as evidenced by our underlying operating profit margin that was essentially flat with prior year. Diluted EPS was $3.93 compared to $3.83 last year. Turning now to our balance sheet, merchandise inventories were $3.0 billion at the end of the second quarter, representing an increase of 10.2% in average inventory per store as we improved our in-stock position in CUE and invested in big-ticket given its strength. Our in-stocks are up nearly four points to our best level since before the pandemic. We are pleased with the quality of our inventory as we enter the second half of the year. With strong annualized cash flows, we continue to maintain a healthy balance sheet with a leverage ratio of around two times. Year-to-date, we've returned nearly $500 million of capital to our shareholders through our share repurchases and dividends. Now let me turn to our updated fiscal 2024 financial outlook. Given our performance in the first half of the year and our forecast for the balance of the year, we believe it's now appropriate to narrow our guidance range. For the year, we now anticipate net sales in the range of $14.8 billion to $15 billion with comp store sales in the range of down 0.5 point to up 1%. Our operating margin rate is expected to be in the range of 9.8% to 10.1% with net income of $1.08 billion to $1.12 billion. Diluted EPS is forecast to be $10 to $10.40. As to the calendarization between the third and fourth quarter, let me share with you a bit more of how we are thinking about the various scenarios. We are approaching the back half with balanced optimism. We are forecasting comp sales in the third quarter to be within a tight band of scenarios and generally similar to the first half of the year. The shift of the season doesn't occur until late in the third quarter and we don't begin to lap the deflationary effect of feed until the fourth quarter. The only meaningful swing factor-in Q3 tends to be weather, particularly large storms, which produce emergency response activity. We see the fourth quarter having a wider range of potential outcomes. For our base case, we do anticipate stronger growth in the fourth quarter given the easier compares, while acknowledging that we could see more volatility in consumer spending. On the high end of our outlook range, in addition to the easing compares, factors we considered include a more normalized start to winter, lapping net deflation, which began in the fourth quarter of 2023 and the potential for greater emergency response activity. Now on the low end of the range, dynamics we contemplated include moderation in big ticket trends, potential consumer uncertainty due to the Federal election and a shorter holiday selling season with five less selling days between Thanksgiving and Christmas. As for the retail price, our plans continue to reflect a headwind from deflation in the third quarter with a moderation towards neutral in the fourth quarter as we start to lap the lower cost, which began in late Q3 of last year. Our guidance reflects ongoing gross margin expansion in the second half of the year. The third quarter is expected to have our best gross margin expansion as we anticipate transportation costs will remain favorable. In the fourth quarter, we'll be lapping our most difficult comparison with 129 basis-points of expansion in the prior year, where we began to see the benefits from lower transportation costs and our product cost management initiative. As a result, we are forecasting our fourth quarter gross margin rate consistent with the prior year. I view our gross margin performance as strong in this current environment. Moving on to SG&A, for the second half of the year, there are a couple of items I would highlight for our expectations, especially for the third quarter. First, please keep in mind that we are lapping last year's depreciation benefit of 35 basis points or $0.08 per share in the third quarter. Second, given our comp sales outlook specific to the third quarter, we anticipate modest fixed cost deleverage. And third, we will continue to see pressure from the startup cost of the new distribution center in both the third quarter and fourth quarter. Thus our SG&A performance will be the softest in the third quarter with more modest deleverage in the fourth quarter. In total, we remain on track for the benefits of our sale leasebacks to be relatively consistent with last year's, albeit with a slight variation by quarter due to the timing shift of two stores into the second quarter. We continue to forecast the return of capital to shareholders in the range of $1 billion, reflecting the strength of our cash flow and the confidence we have in the long term. At Tractor Supply, we believe in playing offense. This is a team that will stay on offense and continue to invest for the long term. We are excited about our Life Out Here strategy progress, our leadership position in the industry and our ability to build-on our track record of long term value creation for our shareholders. Now I'll turn the call over to Hal to wrap up."
},
{
"speaker": "Hal Lawton",
"content": "Thanks, Kurt. Despite the temporary softness in our channel, structural elements remain very attractive for Tractor Supply. We have numerous tailwinds, including our Life Out Here strategic initiative, our market being a beneficiary of continued net world migration, high return new store growth opportunities and ongoing share gains. Tractor Supply is extremely well positioned as a leader in a large fragmented market. Before we go into Q&A session, I'd like to wrap-up with three comments. One, as we head into the back half of the year, I am very excited about our robust innovation pipeline, the compelling values we have in our market and our new brand launches. We just set our annual Deer event and Halloween Decor program and both are off to a strong start. In Pet, we have a number of upcoming activities, including our expanded Pet Appreciation Month, a new lineup for MuttNation by Miranda Lambert and an expansion of 4health, our exclusive brand premium dog food. Additionally, we have an exciting new endcap program as well as new center court and dry wall events that are focused on compelling value that are core to our lifestyle. The second comment I'd have is we continue to believe that as and when economic conditions become more neutral for us that we will return to our long term algorithm. As mentioned, there's really two economic conditions that are impacting us the most. The first is the transition from goods to services in the context of PCE spend and the second is deflation. We believe both of these are transitory. We don't need them to improve, but rather just to normalize for us to return to our long term algorithm. And the third comment is that the team is playing offence. And we're not only executing our existing initiative, but working -- we're working on plans for the back-half of the decade and working on our next growth drivers of our Life Out Here strategy. Tractor Supply does not lack for opportunities and we believe we have multiple new opportunities that can expand on our $180 billion total addressable market. I'm very excited to share more details of the next drivers of our strategy in the near future. Our stores and online are ready for the changes of season as we enter the third quarter. Tractor Supply is well prepared to meet the needs and expectations of our customer. We've invested in our store base, in inventory, in our supply chain, in our digital capabilities and customer service to ensure that we can deliver on on-promise of providing the best products and solutions for Life Out Here. We've also enhanced our Neighbor's Club to provide more benefits and rewards to our loyal customers. We're excited about the upcoming events and promotions that will showcase our unique and differentiated seasonal assortment of merchandise, and we expect to see continued improvements across our categories. To conclude, I'm incredibly proud of our team. Throughout our 85-plus year history, no matter what issue we face, our team members have always come together. We have a unique and special culture. It's our special soft and key differentiator, and it's what gives me great confidence in the future of Tractor Supply. And with that, let's open up the call for questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Our first question comes from the line of Scot Ciccarelli with Truist. Your line is now open."
},
{
"speaker": "Scot Ciccarelli",
"content": "Good morning, guys, Scot Ciccarelli. Historically, when we've had a pretty wet spring, which I think is pretty fair to assume across most of the country, you guys have had a very extended selling season. So do you expect that to be the case for the balance of the year? And then secondly, you mentioned that you're expecting roughly flat, let's call it, comps in the third quarter. Are you currently tracking in line with that or is that just kind of the bogey for the end-of-the quarter? Thanks."
},
{
"speaker": "Hal Lawton",
"content": "Hi, Scot, good morning. To your first question on the wet spring, it was a -- in the normally west spring, particularly in the South -- in the Southwest, Texas, in particular was wet almost the entire quarter. We had hoped that might lead to an elongated spring, particularly in the month of June and into July, it actually be favorable for us given comparison to last year. That's not how it played out. As we all know, the month of June was one of the hottest, if not the hottest month on record ever. And so we went from pretty much a wet -- wet spring to an immediately hot summer. And we did not see, as we called out ag fencing as an example, that's a big category, for us in general and in particularly in Texas. And as an example, we did not see that category recover in June like we had some aspirations for. That said, it's a wet week this week and we are hopeful that, that can pay some dividends as we turn the corner into August and into the fall. And as it relates to Q3, yes, it's basically kind of right down the middle of fairway for us in terms of our guidance range and kind of consistent with the comments Kurt gave at this point. And the one thing I would call out is July is our toughest compares of the three months. It's -- we get sequentially -- sequentially easier and compares to the tune of like a point or two points each of the next two months. So anyway, thanks, Scott, for the question."
},
{
"speaker": "Scot Ciccarelli",
"content": "Great. Thanks."
},
{
"speaker": "Operator",
"content": "Thank you for your question. Our next question comes from the line of Michael Lasser with UBS. Your line is now open."
},
{
"speaker": "Michael Lasser",
"content": "Good morning. Good morning. Thank you so much for taking my question."
},
{
"speaker": "Hal Lawton",
"content": "Hi, Michael."
},
{
"speaker": "Michael Lasser",
"content": "Number one - Hi, Hal. Hi, can you walk us through the thought process on just the changes you've made recently. Do you see any customer impact from some of the social media chatter and how did it impact your same store sales? Thank you so much."
},
{
"speaker": "Hal Lawton",
"content": "Yes. Hi, Michael, and thanks for the question. I'd start out by saying, obviously, it was a difficult situation that played out in a public arena, that's unfortunately is becoming increasingly common in business and the divisive sentiment that we have in our country. And we've got over 50,000 team members and 30-plus million customers and we certainly heard a range of feedback. We learned from others who had gone before us on this and moved fast to try to remove the perceived political and social agendas from our policies. And all that said, we have no evidence that it had a measurable impact on our business. And we continue to look to monitor the situation and look at a variety of datasets, but we do have no evidence at this point that it's had a measurable impact on our business and our results. And if I just step-back, we have a very special culture at Tractor Supply. It's firmly grounded in our well-established mission and values. And while we did withdraw our carbon emissions goals and retired our D&I goals, we did not retire our commitment to treating people fairly with respect, to inclusion, to being a good corporate citizen and certainly not to be stewards of -- and certainly did not retire -- are committed to being stewards of Life Out Here. And Tractor Supply, again, credible culture. We never lose sight of our obligations to be great stewards of our business over the long term. Thanks. Thanks, Michael, for the question."
},
{
"speaker": "Michael Lasser",
"content": "Thank you very much."
},
{
"speaker": "Operator",
"content": "Thank you for your question. Our next question comes from the line of Steven Zaccone with Citigroup. Your line is now open."
},
{
"speaker": "Steven Zaccone",
"content": "Great. Good morning. Thanks, -- great. Good morning. Thanks very much for taking my question. I wanted to go back to the same-store sales trend. And I was curious if we could talk through the guidance adjustment a bit more. I guess, specifically on the second half because you leave open the option that you could still have negative same-store sales in the back half, even though the compares look a little bit easier. So has anything really changed from a ticket perspective, maybe deflation lasting a little bit longer than you expected? And then from a transaction perspective, do you have the view that the pet food landscape is just softening a little bit more than you expected? So maybe that side of the business is also coming a little bit weaker? Thanks very much."
},
{
"speaker": "Hal Lawton",
"content": "Yes, Hi, Steven. Let's start out by saying the first half played out very much in-line kind of right down the middle of our kind of base-case center point of our guidance. I would say most things in the first half were very much in-line with our expectations. I mean, maybe big ticket was a little stronger, and maybe some of the things like ag fencing and dog containment and such were a little bit weaker. But everything else, I would say, animal feed, pet food, our CUE products in general, seasonal. Even the discretionary business, we expected them to be reasonably negative. All those played out very much in line with what we expected. I kind of think about it as a down the middle of fairway based on our expectations first half. As it relates to the second half, we have a similar thesis to the second half right down the middle of fairway. I think Kurt tried to call that out in the prepared remarks. Q3, I think would be much of the continuation of the first half of the year with Q4 being really where there's a higher rate -- a broader range of outcomes. I think Kurt tried to really bring that to life in his prepared remarks to say there's one version of Q4 that could be -- could be strong and start that trend back towards our long term algorithm and there's a some favorable compares there and -- which create a nice setup and we've got a number of activities also going into that -- into the market during that time. On the flip side, there is a kind of a kind of more unfavorable potential outcome in Q4, where if we didn't see some good winter weather and the federal election created a lot of distraction and you've got a shorter holiday season that could lead to a lesser performance in Q4. So really tried to lay out the range of those two, and that's really what drives the Q4 variation, is really what drives the -- really the range of our comp guidance for the balance of the year with a pretty tight range of outcome forecast in Q3. But I would say from the start of the year, the business is really right in the middle of what we expected it could be. And to your kind of kind of question at the end, there's really sitting at this point in time, nothing that we see in the back half that's much different than what we saw at the beginning of the year. It's a pretty, pretty straightforward at this point in terms of our outlook."
},
{
"speaker": "Steven Zaccone",
"content": "Okay. Thanks for the detail."
},
{
"speaker": "Operator",
"content": "Thank you for your question. Our next question comes from the line of Peter Benedict with Baird. Your line is now open."
},
{
"speaker": "Peter Benedict",
"content": "Yes, good morning, guys. Thanks for taking the question. Kurt, I know you addressed inventory briefly during the prepared remarks that you felt comfortable. Can you maybe give us a little more color on the build that you saw in the second quarter and maybe where you would have us expecting inventories to kind of level out over the balance of the year, and why you don't think there's -- you don't have too much? Thank you."
},
{
"speaker": "Kurt Barton",
"content": "Yes, I'll actually let Seth -- Peter give you more of the details on that, and I'll make one reference. We are cycling last year. In Q2, we called out that we were down 1.7% in inventory last year. We knew we needed and wanted more inventory in CUE and even some of the big ticket rec. And so we're very pleased with where we're at. And I think, Seth, why don't you explain further some of where the--"
},
{
"speaker": "Seth Estep",
"content": "Yes."
},
{
"speaker": "Kurt Barton",
"content": "--increase is at and the position on inventory for today and even the back half."
},
{
"speaker": "Seth Estep",
"content": "Hi, Peter, Seth. Thanks, Kurt. Yes, as Kurt mentioned, we were down last year about 1.7%. When we think about this year's inventory position, we have purposely invested in where we're continuing to see growth. So when you look right now, we're continuing to invest in areas like grills, mini bikes, rec vehicles, even like riders where we're continuing to see some strong momentum in various parts across our store base. But we're also in the best in-stock position we've been since pre-pandemic. We're investing in in-stocks. We're up around 400 basis points in in-stocks when you compare to where we are this year versus last. And when you look at our clearance inventory, while we don't give specific numbers, our clearance and aged inventory is actually down versus last year. And I would say both those in-stock positions and you look at our clearance and aged inventory, are both really good indicators of the quality that we have. And I would just say as we look ahead to the back-half, we're committed to making sure we're investing in the categories that are working. We're investing in being a dependable supplier and making sure that we have our key core CUE products on shelf. And I feel really good about the innovation pipeline we're investing and being in a position to drive sales. So quality of inventory remains strong. We're in a great in-stock position and feel good about the inventory position."
},
{
"speaker": "Peter Benedict",
"content": "Great. Thanks so much."
},
{
"speaker": "Operator",
"content": "Thank you for your question. Our next question comes from the line of Chuck Grom with Gordon Haskett Research Advisors. Your line is now open."
},
{
"speaker": "Chuck Grom",
"content": "Hi, thanks. Good morning. Thanks a lot. Hope you guys are well. Just get back to the comp discussion, how -- the past few quarters, comps have been running close to flat. You've got a long term guide of about 4% to 5%. Clearly, the macro has not been your friend, but can you help us think about the building blocks to get back to that level and maybe a potential timeline you see to get there as well? Thank you."
},
{
"speaker": "Hal Lawton",
"content": "Yes, hi, Chuck, and thanks for the question. As I mentioned in the prepared remarks, we still feel very confident in our long term guidance and there's really two main factors that we see as -- that are macro factors that are impacting us right now for performing at that long term guidance rate, namely the shift in consumer spend from goods to services and the second being deflation, inflation. And so now if you hit both of those, if you think about our average ticket for the first half of the year, which is roughly flat, historically, we would have at a minimum kind of a 1.5%-ish maybe average ticket growth, could be 2%, 2.5%. So even if we just had some favorability in average ticket, all of a sudden, that walks you up to nearly a 1.5 or 2 point comp right there. And then if you think about PCE, year-to-date, services are up 6%, 7%, whereas goods are up 1%. If you were to see that normalize, even if goods underperformed services, say, goods are 2.5% or 3% and maybe services are 3%, 3.5%, you get that extra point to 2 points on the goods kind of rising tide, and all of a sudden, you're walking back to a 4%, 4.5% comp right there. And so we really do see it as cleanly as that, is that at some -- kind of in the future, it certainly have confidence that deflation will moderate and we'll get back to a consistent kind of inflation rate in this country and in our business. And then similarly, expect that the good services shift will moderate. I mean, I think that's probably the bigger question. We probably have a better lens as to when the deflation will moderate, because we see that in our business. But on the goods and services, I think that's kind of the open question. It is only 90 basis points away from its pre-COVID levels. So it doesn't have a significantly further to go. But is that six months, is that nine months? Is that three months? I think time will tell there. Thanks, Chuck, for the question."
},
{
"speaker": "Chuck Grom",
"content": "Great. Thanks, Hal."
},
{
"speaker": "Operator",
"content": "Thank you for your question. Our next question comes from the line of Kate McShane with Goldman Sachs. Your line is now open."
},
{
"speaker": "Kate McShane",
"content": "Hi, good morning. Thanks for taking our question. We wanted to talk about the big ticket strength. We know this is something that you saw in the first quarter. Can you remind us how much of sales this represents? And how does big ticket needs change in the second half? What falls into that category for the cooler and winter months versus what you saw in the first half of the year?"
},
{
"speaker": "Kurt Barton",
"content": "Yes. Hi, Kate, good morning. This is Kurt. On big-ticket, I'll share a few specifics on that. As we mentioned, we've been continually pleased this year to see the rebound on big ticket after a couple of years of softness in big ticket. First quarter ran positive high-single-digit big ticket and the ever important Q2 ran a low double-digit growth rate in big ticket. So if -- you hear the commentary from us on our investment in that area of the business, how we're driving the sales through innovation. So very pleased with the results on big ticket. Q2 tends to have the largest portion of our sales on big ticket in the low teens. It averages in the high single-digit as a percentage of our sales for the year. So in the second half of the year, it does become a lesser of an impact. But on a year-over-year basis, we really do see that there's opportunity in the back half of the year in areas that we're winning in that, Seth just mentioned, whether it be recreational vehicles or even riders. And then in the back fourth quarter, really some of the winter-related heating, log splitters, those type, snow blowers, we can continue to win in innovation and our ability to drive great value in big ticket. So it's certainly one of the tailwinds for us. The team has done an excellent job bringing new product to our customers and driving value even through areas like deferred financing as a great value for big ticket. So while not as much of a swing factor in the second half, we do believe that's one of the tailwinds on our comps for the second half of the year."
},
{
"speaker": "Kate McShane",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Thank you for your question. Our next question comes from the line of Brian Nagel with Oppenheimer. Your line is now open."
},
{
"speaker": "Brian Nagel",
"content": "Good morning. Hi, good morning. Thanks for taking my question. So my question, I just want to follow-up a bit on inventory. And I know you discussed this already, but just to be clear, so inventories gets us on face value where you did see coming out of the quarter higher than usual. So is it your expectation then that, over the next, whatever, couple of quarters, your inventory levels will moderate kind of naturally or is there some type of more aggressive action you have to take to get inventories back in line with sales?"
},
{
"speaker": "Hal Lawton",
"content": "Hi, Brian. I'll start by saying, we are very comfortable with our inventory levels right now and the quality of our inventory. And we don't see any actions required on the quality of our inventory as we move forward. Just to be very clear on that. There's two main drivers of our inventory increases, really three main drivers of our inventory increases year-over-year. The first I would call out, as Kurt did, which was easier -- the kind of net -- the lapping of comparison last year. We were down, I think, negative 1.7% on inventory last year. The second is our investment in big ticket. Obviously, those are higher average unit retail items. So that's going to disproportionately drive our inventory dollars up. But we saw the strength in riders, in UTVs, in things like grills and other big ticket categories, we invested into that. And we'll continue to do that into Q3 as well. As an example, we typically have about 800 stores that are kind of go long stores and riders that have an extended season. This year, we've increased that to 1,150 stores. We are seeing the strength in big ticket continue into Q3. So that is a -- that investment is -- is paying-off and we expect it to continue to. The third thing I would call out is just a reiteration of what Kurt and Seth said, which is our investment in in-stock rates. We are 4 points higher year-over-year in in-stock rates. It's our highest in-stock rate since the pandemic. And that is really on the shelves inside of our stores. And as you all know, I spent a lot of time in our stores, been in five different markets in the last five weeks. We have never looked healthier and better since my time at the company in areas like dog treats, in areas like leashes, in hardware, in hand tools, in areas like lubricants and batteries. As Seth called out, our clearance levels are lower than last year at this time and in incredibly good shape. As you all know, our clearance levels have been running at historic lows since the pandemic and continue to do so. The team is doing an excellent job navigating inventory. So anyway, to step back, we feel incredibly good about the quality of our inventory, have no concerns about it in the second half and in fact, feel great about the investments we've made, which are driving in-stock rates and kind of a bit of a go longer strategy in big ticket. Thanks, Brian, for the question."
},
{
"speaker": "Brian Nagel",
"content": "No, thanks, I appreciate all the color."
},
{
"speaker": "Operator",
"content": "Thank you for your question. Our next question comes from the line of Steven Forbes with Guggenheim Partners. Your line is now open."
},
{
"speaker": "Steven Forbes",
"content": "Good morning. How -- it's probably imperfect, but it looks like it's been about a year now where sales per member trends are down significantly. So curious if there's anything notable in terms of learning from the trends within the customer cohorts as we think about explaining away the spread between comp trends or CUE trends versus member trends? And maybe in that -- in that regard, as you think about potential, like how would you speak to the opportunity ahead given where the member base and the member share sits today?"
},
{
"speaker": "Hal Lawton",
"content": "Yes, so maybe I'll talk a little bit about our Neighbor's Club in that -- in that context. First off, I would say we continue to be very pleased, and in fact, it's kind of performing better than what we would expect to gain here in terms of number of members signing-up for Neighbor's Club, as I called out, now at 36 million. The second thing I'd call out is we continue to see retention rates of our Neighbor's Club remain at kind of historic rates. So as you're growing your member base and you're growing retention, I mean, that's a kind of a strong kind of balance there, right, and add -- and multiple -- increasingly added it together. I'd say what we saw was on are higher income cohorts that are our strength, stronger retention, modest moderation by I mostly in kind of the -- as we -- and when we looked at it, a lot of it, we really do core that they are the ones that over indexed on services and on travel and on vacations here in the second quarter. But again, modest moderation there. The group that we continue to focus on, and we called this out last quarter as well is that entry cohort into our Neighbor's Club and we lowered the tier threshold and we increased the type of rewards you could redeem at the last -- in -- in our last quarter and saw nice improvement there. We're continuing to focus on that through the second quarter. As we look towards the back half, we're very excited about the implementation of our customer data platform, how that's going to further accelerate our ability to personalize with customers and our communications and help continue to stimulate all groups, but in particular that kind of entry level group. In addition, we launched this quarter our Hometown Heroes program. It's off to an excellent start in terms of member sign-up. And as we called out, while I don't expect these trends to continue, the early sign-ups have been a significant piece of it is new to Tractor Supply and new to our Neighbor's Club program. So we have -- I think it's one of the best membership programs, loyalty programs -- loyalty programs, excuse me, in the market out there. The team continues to iterate and make it better and better. Our customers continue to give us very favorable marks on it. And we do see Neighbor's Club as instrumental to our success as we move forward."
},
{
"speaker": "Steven Forbes",
"content": "Thank you."
},
{
"speaker": "Hal Lawton",
"content": "Thanks, Steven."
},
{
"speaker": "Operator",
"content": "Thank you for your question. Our next question comes from the line of Oliver Wintermantel with Evercore. Your line is now open."
},
{
"speaker": "Oliver Wintermantel",
"content": "Yes, thanks guys. With the variability of the outcomes in the range for the third quarter and the fourth quarter, maybe it would be helpful if you could walk us through comp ticket and comp traffic expectations for those two quarters. And maybe on the ticket side, maybe you can't break it out in AUR or inflation? Thank you."
},
{
"speaker": "Hal Lawton",
"content": "Hi, Oliver, how are you today? Thanks for the question. I would -- the main driver of the variation for the second half in the range of outcomes for our comp is really what the driver of our range for the first-half was, is transactions. As we've been, I think pretty transparent, we have great insight to average ticket, great insight into our average unit retail. Pending some mix we know exactly what our pricing for our seasonal products are already going to be for the year. We know what our CUE trends are. We obviously have a perspective on how we're going to be pricing CUE into the back half of the year. So we have very good forward-looking view as to our average unit retail. And so I feel like there's probably less variability in ticket and expect that to be reasonably flat throughout the year, although there's some modestly easier compares on average unit retail as you get into the fourth quarter. So a little bit of upside there. But the main driver of our range of outcomes is going to be transactions. And particularly in the fourth quarter and really we think it's all around consumer sentiment and also drivers of need. And if there's some weather events, that will drive need. And depending on the federal election and the shortened holiday season, I think that will drive sentiment. Those two things will come together to drive our transactions. And so anyway, back to your point, I think the variability for the back half of the year is really primarily transactions with maybe a very modest range of outcomes on AUR."
},
{
"speaker": "Oliver Wintermantel",
"content": "Got it. Thanks very much. Good luck."
},
{
"speaker": "Hal Lawton",
"content": "Yes. Thanks, Oliver."
},
{
"speaker": "Operator",
"content": "Thank you for your question. Our next question comes from the line of Zach Fadem with Wells Fargo. Your line is now open."
},
{
"speaker": "Zachary Fadem",
"content": "Hi, good morning. Kurt, you mentioned the election as a potential second half headwind. So first, are there performance callouts during prior elections? And then second, is there any evidence to suggest that your business may perform differently based on the outcome of the election?"
},
{
"speaker": "Kurt Barton",
"content": "Yes. Hi, Zach. In regards to elections, in my history, as we've -- as we've looked at that and we have been through cycles, there is no real meaningful performance change based on the year of a federal election or the outcome of a federal election. Now we have seen, and I think it's well-understood that this is a very intense environment today with this election. What that does to the consumer sentiment is certainly one that we are being conscious of. And I think the election will take a lot of attention and could impact the consumer spending habits, et cetera. But really, over the years, how we've seen the performance of the consumer has really proven to have no strong indication that we should plan for or change our outlook in any particular way. It's just viewed as one that could be a variable in the ranges of outcome. And so we're conscious of that. But we've been able to pivot in either one of these environments. And the one last thing I would just point to is that for us, which I think is different is that it doesn't tend to have much of a change because it's a needs-based business where regardless of the outcome, the lifestyle and the needs that we serve, don't really change that much. So we watch and we're creating strategies under scenarios, but we don't see a specific outcome that we are planning for."
},
{
"speaker": "Zachary Fadem",
"content": "Got it. Thanks for the time."
},
{
"speaker": "Operator",
"content": "Thank you for your question. Our next question comes from the line of Christopher Horvers with JPMorgan. Your line is now open."
},
{
"speaker": "Christopher Horvers",
"content": "Thank you. I'm French now. So Mike, my question is on the commodity side. So corn has come down a lot since the start of the year and even where it was at the end of the first quarter. Historically, you've talked about corn being one of the biggest commodities to watch. So I guess to what extent have you thought about that in terms of affecting your sequential reflation expectations? And does that quickly turn into the sort of the feed category? And then on the pet food side, are you seeing price investment from the big pet food brands? And what are the early reads on that being enough to turn those -- the pet food category, enough elasticity to get that growing more quickly?"
},
{
"speaker": "Kurt Barton",
"content": "Sure. Hi, Chris, this is Kurt. And I'll take the first part of the question on the commodities and then I'll let Seth address your question on pet food. On commodities, just some key points that I think is helpful to reference. Corn, which is the largest commodity impact item. But additionally, when you think of corn, soybean, cotton, steel, they all are commodities that play into our pricing. They have all been at year-to-date or year-over-year in the low teens deflationary point compared to June of 2023. All of them are generally back to 2019 levels. And they are 30% or nearly 40% off of their '22 -- 2022 year highs. So we've been going through a two year cycle of that. And all indications are we are at the 2019 levels. We're at what we believe is the trough. Most of these costs have already been embedded into it. The only other variability that -- and I indicated to that is, you would look at Q4 and see that to be a neutral or potentially even beginning to see an inflationary turn and the way commodities shift, will I think will really derive whether or not Q4 even the Q1 is a shift into some slight inflation or keeps us at a plateau. The corns and soybeans tend to move within about a 60 to 90 day timeframe through our systems. And so they move pretty quickly and impact the cost of goods sold in a really timely basis. I'll turn it over to Seth on the follow-up question on pet food."
},
{
"speaker": "Seth Estep",
"content": "Yes, hi, Chris, Seth. Hi, just as the simplest answer, I would just say when you look at the back-half, we're not seeing any signaling that you're going to see like AUR compression when it comes to pet food, when we look out. Right now, AURs continue to be somewhat flat year-over-year and that's kind of what we see going forward. Relative both feed and pet food, I would say, like as you think about the current environment we're in, and if you continue to see commodities stay where they are, you'll start to see things like you've traditionally seen in the industry where more value packs, more bonus packs, things of that nature will continue to hit the market. So at this point, we see pet food pricing remaining basically stable."
},
{
"speaker": "Christopher Horvers",
"content": "Thanks very much."
},
{
"speaker": "Mary Winn Pilkington",
"content": "Victoria we will take one more question quickly, and then we'll wrap the call after that."
},
{
"speaker": "Operator",
"content": "Of course. Our final question comes from the line of Peter Keith with Piper Sandler. Your line is now open."
},
{
"speaker": "Peter Keith",
"content": "Thank you very much everyone for squeezing me in. So Hal you mentioned in the script that the channel was down negative mid-single. I guess I would agree with that based on our survey work. So it does suggest that Tractor Supply share gains accelerated in Q2 versus prior quarters. And I'm wondering, was there something specific to the quarter or do you think there's more kind of structural benefits based on your initiatives that could keep the share gains elevated in the quarters to come? Thanks."
},
{
"speaker": "Hal Lawton",
"content": "Yes, hi, Peter. Thanks for the question. I'd really point to -- to two things. One, I think structurally, we play a little bit more in big-ticket than a lot of the other farm and ranch competitors on the margins, but I think that helped raise our waterline a little bit on total sales. Also I would say, on the CUE business, in particular on the feed side, well, the CUE business in general, particularly dog food and animal feed, we're gaining share in both. Our share gains in animal Feed, in our view in Q2 were outsized. And I think a lot of that comes down to our scale, our cost position, both with working with our vendors and our partners there, but also our supply chain and whether it's our DCs, our mixing centers, our freight partners and just us having the best cost position in the market, being able to invest that appropriately in price. As you know, we have over 20 price zones. We're able to get really targeted in where we want to price and how we need to price to drive those units. So I think those would be the things I'd speak to. And then the final point would be, of course, our strategic initiatives. And I think as it relates to say like the fusion remodel program, we're approaching half of our store base now being in the fusion remodel program. So I think our store environments relative to the farm and ranch channel are significantly higher-level of a store environment now. Our commitment to customer service, we called that out. So you get, I think a better level of customer service in our stores. And so just all those sorts of things are starting to add up to continue to drive the outsized share gains. Thanks Peter, for the question."
},
{
"speaker": "Peter Keith",
"content": "Thank you."
},
{
"speaker": "Mary Winn Pilkington",
"content": "Victoria, we'll wrap-up our call today. To everyone on the call, we look forward to speaking to you at the time of our Q3 call in October."
},
{
"speaker": "Operator",
"content": "That concludes today's call. Thank you for your participation and enjoy the rest of your day."
}
] |
tsco | 2,024 | 1 | [
{
"speaker": "Operator",
"content": "Good morning, ladies and gentlemen, and welcome to the Tractor Supply Company's conference call to discuss First Quarter 2024 Results. [Operator Instructions]. Please be advised that reproduction of this call, in whole or in part, is not permitted without written authorization of Tractor Supply Company. And as a reminder, this call is being recorded."
},
{
"speaker": "",
"content": "I would now like to introduce your host for today's call, Mrs. Mary Winn Pilkington, Senior Vice President of Investor and Public Relations for Tractor Supply Company. Mary Winn, please go ahead."
},
{
"speaker": "Mary Pilkington",
"content": "Thank you, Alissa, and good morning, everyone. Thanks for taking the time to join us today. On the call today are Hal Lawton, our CEO; and Kurt Barton, our CFO. After our prepared remarks, we'll open the call up for your questions. Seth Estep, our EVP and Chief Merchandising Officer, will join us for the question-and-answer session."
},
{
"speaker": "",
"content": "Please note that we've made a supplemental slide presentation available on our website to accompany today's earnings release."
},
{
"speaker": "",
"content": "Now let me reference the safe harbor provisions under the Private Securities Litigation Reform Act of 1995. This call may contain certain forward-looking statements that are subject to significant risks and uncertainties, including the future operating and financial performance of the company. In many cases, these risks and uncertainties are beyond our control. Although the company believes the expectations reflected in its forward-looking statements are reasonable, it can give no assurance that such expectations or any of its forward-looking statements will prove to be correct, and actual results may differ from expectations."
},
{
"speaker": "",
"content": "Important risk factors that could cause actual results to differ materially from those reflected in the forward-looking statements are included at the end of the press release issued today and in the company's filings with the Securities and Exchange Commission. The information contained in this call is accurate only as of the date discussed. Investors should not assume that statements will remain operative at a later time. Tractor Supply undertakes no obligation to update any information discussed in this call."
},
{
"speaker": "",
"content": "Given the number of people who want to participate in the Q&A session, we respectfully ask that you limit yourself to 1 question. If you have additional questions, please feel free to get back in the queue. I appreciate your cooperation. We will be available after the call for follow-up. Thank you for your time and attention this morning."
},
{
"speaker": "",
"content": "Now I'll turn the call over to Hal."
},
{
"speaker": "Harry Lawton",
"content": "Thank you, Mary Winn, and good morning, everyone, and thank you for joining us today. 2024 is off to a solid start with first quarter results in line with our expectations. I would like to thank the Tractor Supply team for their ongoing commitment to each other and our customers. As evidenced by our continuation of record high customer satisfaction scores, the team is always there for our customers as the dependable supplier [ for ] life out here."
},
{
"speaker": "",
"content": "Before I get into our review of the first quarter's results, I want to take a moment to share what we're seeing in the macroeconomic environment and its impact on our business. In our view, the U.S. economy remains strong. Unemployment continues at a low level, wages are growing at a steady clip. In spite of sticky inflation, consumer spending remains strong, and mobility has slowed as a consequence of a challenging housing market, with that said, we continue to see outsized population growth in rural markets."
},
{
"speaker": "",
"content": "As it relates to consumer spending, the shift of spending from goods to services continues to be a headwind for our business. In the first 2 months of the calendar year, consumer services spending growth was nearly 7%, whereas consumer spending on goods growth was less than 1%. As a result, the mix of goods as a share of PCE are now only 100 basis points above their pre-COVID average. This progressive shift is in line with our expectations as we enter the year."
},
{
"speaker": "",
"content": "Also, as expected, inflation has remained sticky by outsized increases in shelter, food, away from home, energy and insurance. As a consequence, consumers continue to be anxious about inflation, particularly the lower-income consumer."
},
{
"speaker": "",
"content": "In the first quarter, our upper income consumer over-indexed in big ticket categories and recreational purchases compared to our lower income consumer, who is prioritizing their spend on needs."
},
{
"speaker": "",
"content": "In our needs-based, consumable, usable and edible categories, we see very little difference in our performance by income cohort. Once again, our business is proving to be durable, stable and very consistent."
},
{
"speaker": "",
"content": "Broadly speaking, in our economy, goods continue to disinflate and are generally running low single digits with some categories having moderate deflation. With the first quarter behind Tractor Supply, we have now successfully lapped our 2 most challenging compares due to the inflationary benefits that we had over the last 18 months that have substantially benefited our top line. We do not see additional downward deflationary pressures in the current environment. The transition from an inflationary cycle to a disinflationary cycle is playing out as we anticipated."
},
{
"speaker": "",
"content": "In spite of a very challenging housing market, we continue to see positive migration trends to our markets. While rural migration trends have moderated from the recent peaks, rural America again gained population in 2023. This marks the fourth consecutive year of growth in rural population. It is our view that the sense of community found in our markets, and perhaps more importantly, the ability to secure a piece of property at a reasonable price has ensured the rural migration trend is one that's here to stay for the time being."
},
{
"speaker": "",
"content": "So with that, let's now turn to a review of the business for the first quarter. We grew net sales by 2.9%, with comparable store sales up 1.1% and diluted earnings per share up 10.9% to $1.83. Our comparable store sales growth was driven by transaction growth of 1.3% offset by a small decline in average ticket of 0.2%. These results were very much in line with our expectations that we shared with you as we started the quarter and year."
},
{
"speaker": "",
"content": "Overall, our customer base remains healthy and highly engaged. Total customer count grew mid-single digits with growth in active, new and reactivated customers as we invested in our Neighbor's Club program and customer service."
},
{
"speaker": "",
"content": "Neighbor's Club continues to represent the majority of our sales. During the quarter, we significantly enhanced our Neighbor's Club offering. As our points-based program enters its fourth year, it was appropriate for us to refresh our offering based on insights and customer feedback. The changes we made were all implemented with the goal to have customers receive rewards faster and to lower the spending required for tier qualifications. Our Neighbor's Club members have responded positively to these changes. For example, the new rewards redemption at a $2 and $5 level down from $10 is working as we designed and is driving greater customer engagement and trips for this cohort. The initial response from our customers on the collective changes has been very positive, and we're seeing increased spending across the board."
},
{
"speaker": "",
"content": "In addition, we continue to improve relevancy to our members through more personalized offers and tailored incentives and experiences based on their interest and shopping patterns. With more than 34 million members, Neighbor's Club should continue to build our customers' loyalty and affinity for Tractor Supply as we go forward."
},
{
"speaker": "",
"content": "Our customer service scores continue to run at all-time highs. This is an area where we have strategically invested in training, compensation, benefits, tools and technology to help elevate our customer service. This has garnered the attention of our customers, and I believe, helps strengthen our scores."
},
{
"speaker": "",
"content": "The strength of our portfolio products and shopping missions was evident very much so in the first quarter. We had robust growth in our seasonal categories. Our consumable, usable and edible products performed in line with our chain average. Our performance this quarter was on top of the robust growth we've experienced over the last 4 years as our CUE customer trends remain strong as we continue to gain market share. Our customers were certainly in the mindset to prepare for spring as we had strong big ticket growth in the mid-single digits and strength in other early spring preparedness categories. Categories that performed below our comp sales growth were more in our discretionary businesses such as clothing and gifts and truck tool and hardware."
},
{
"speaker": "",
"content": "In our pet food and livestock categories, we continue to grow our market share. In pet food, we've seen growth moderate as the category disinflates and pet ownership moderates. Our customers' shopping trip in this category is highly differentiated, so we offer a broad assortment from value to super premium across private and exclusive brands in a pet-friendly environment, which now includes about 900 Pet Wash locations. Additionally, pet owners benefit from the one-stop shop convenience of our lifestyle retail format, in particular, from the cross purchasing synergy with animal and livestock feed."
},
{
"speaker": "",
"content": "In animal and livestock feed, we offer exclusive brands like DuMORs and Producer's Pride, along with the national brands from Purina, Cargill, Triple Crown and more. We continue to innovate across our key categories of equine, cattle and poultry in trends like organic and snack. And we bring a unique retail experience in these categories with events like our annual spring Chick Days. This year, the event is on track to have strong results. We continue to see growth from existing customers who are building out and adding to their flock. Organic feed and our assortment of premium breeds continue to lead the category and growth."
},
{
"speaker": "",
"content": "Tractor Supply is the destination for backyard poultry. Today, nearly 2/3 of our backyard chicken owners consider them to be pets, and our customers over-index the poultry ownership with nearly one in five customers having chickens."
},
{
"speaker": "",
"content": "Stepping back, we have a market share of about 20% in bagged livestock feed, and we continue to take share, and we are consistently outperforming the market across our 2 categories. After nearly 2 years of pressure on our big ticket comps, we were pleased to see big ticket categories turn positive in the quarter. We experienced broad-based strength across seasonal categories, including zero-turn tractors, recreational vehicles and outdoor power equipment."
},
{
"speaker": "",
"content": "Our digital sales returned to double-digit growth in the quarter with increases in visits and an improved conversion rate. Nearly 80% of our orders were whether picked up in store or fulfilled by a store. Almost 20% of our sales came through our mobile app. The team made excellent feature update such as New Express Checkout feature and the addition of estimated delivery times, and these have helped increase our conversion rate."
},
{
"speaker": "",
"content": "This year, we're opening our tenth and largest distribution center in Maumelle, Arkansas. The start-up of the distribution center is right on schedule as shipping will begin during June. Once again, we'll be able to capitalize on the opportunity to realign the store servicing areas across the DC network to balance transportation costs and DC capacity while improving service levels to our stores. It is great for our DC network to have this new capacity to better position our inventory and better service our stores all the while allowing us to reduce our freight cost."
},
{
"speaker": "",
"content": "Our supply chain investments over the last 4 years have provided us with material structural gross margin benefit from the reduction in stem miles."
},
{
"speaker": "",
"content": "We opened 17 new Tractor Supply stores and 4 Petsense by Tractor Supply stores in the quarter. As I shared last quarter, 2024 will be the year of the Garden Center. We're leveraging the change of seasons across the store front as the year shifts to spring. The team has come out of the gate strong to ensure we have a differentiated assortment and availability in time for the planting season. We now have nearly 500 Garden Centers across the chain. Based on our early read of spring, our expectation is that with more variety than ever and a grower network to support our Garden Centers, we should see the customer respond positively this multiyear growth driver."
},
{
"speaker": "",
"content": "At Tractor Supply, we're grounded in our purpose as a company to serve life out here and our deep-rooted commitment to our mission and values. We believe in finding meaningful ways to support our core mission. Earlier this week, we issued our fifth annual stewards of Life Out Here Tear Sheet that highlights our Stewardship priorities and progress."
},
{
"speaker": "",
"content": "For all of us at Tractor Supply, we are highly committed to preserving life out here for future generations. We are proud to share our progress towards our ambitious goals."
},
{
"speaker": "",
"content": "In summary, we're relatively pleased with our start to the year. Customer trends are in line with our expectations. The team is executing very well. We're controlling our controllables and making progress on our Life Out Here strategy. With the majority of the year remaining, we are reiterating our guidance for fiscal 2024."
},
{
"speaker": "",
"content": "And with that, I'll turn the call over to Kurt."
},
{
"speaker": "Kurt Barton",
"content": "Thank you, Hal, and hello to everyone on the call. Let me start by building on to Hal's comments about the quarter. Our first quarter performance was right down the middle when compared to our expectations on both the top line and the bottom line. Regarding the cadence of comp sales for the quarter, we started out with a very strong January as the month features some spans of brutal cold."
},
{
"speaker": "",
"content": "While February was warmer than normal and relatively soft, the best way to view the winter season performance is to look at weather categories across January and February combined. And overall, we were pleased with our cold weather category performance. We comped positive in March in spite of a limited arrival of spring across our markets. Where this season had turned to spring, we were very pleased with how the business performed."
},
{
"speaker": "",
"content": "All geographic regions performed in a tight band for the quarter. Average unit retail was impacted by modest product deflation of about 1% in line with our expectations. We're encouraged by the trends we are seeing in unit growth and the underlying share gains in categories where deflation has had an outsized impact to AUR. Our gross margin rate of 36% increased 50 basis points to last year. We were very pleased with these results, which were driven primarily by ongoing lower transportation costs, disciplined product cost management and the continued execution of our everyday low price strategy."
},
{
"speaker": "",
"content": "We were able to strategically provide great value for our customers while maintaining our gross margin. We remain committed to being the everyday low-price leader in our markets."
},
{
"speaker": "",
"content": "Our first quarter SG&A expense rate, including depreciation and amortization, increased 16 basis points to 28.2%. This increase in SG&A as a percent of net sales was primarily attributable to our planned growth investments, which included higher depreciation and amortization as well as the modest deleverage of our fixed cost given the level of comparable store sales growth. The leverage from our distribution center productivity gains did partially offset the loss of fixed cost leverage. Excluding depreciation and amortization, SG&A was essentially flat as a percent of sales. This was better performance than we anticipated entering the year as there were approximately $5 million of expenses that we had planned to occur in the first quarter that we now anticipate incurring in the second quarter. From my perspective, the team did a great job controlling the controllables."
},
{
"speaker": "",
"content": "Altogether, operating income increased 7%, with operating margin expansion of 34 basis points. Net income increased 8.2% and diluted EPS increased 10.9% to $1.83. During the quarter, we repurchased approximately 0.5 million shares and paid quarterly cash dividends totaling $118.8 million, returning $236.2 million of capital to shareholders. We also increased our dividend by 7%, marking our 15th consecutive year of growing our dividend."
},
{
"speaker": "",
"content": "Turning now to our balance sheet. Merchandise inventories were $3.0 billion at the end of the first quarter, representing a modest decrease of about 4% in average inventory per store. Lower freight costs was a contributor to the decrease in inventory dollars. Excluding freight in Orscheln, our comp inventory was up modestly in dollar value and units. We are pleased with how we exited the winter season and the quality of our inventory as of the end of the first quarter. In our commitment to be the dependable supplier for our customers' lifestyle, we are at the highest in-stock levels since pre-COVID. With strong annualized cash flows and improved working capital, we continue to maintain a healthy balance sheet with a leverage ratio of around 2x."
},
{
"speaker": "",
"content": "As Hal mentioned, we are reiterating our guidance for 2024. We anticipate this year to be a continued story of ongoing share gains offset by macro headwinds. We continue to expect full year sales of $14.7 billion to $15.1 billion and project comparable store sales to be in the range of down 1% to a positive 1.5%. As we manage through the first half of the year, we expect to see second quarter comp sales in line with our full year outlook. Given the trends in our comp sales, our outlook assumes that strength in big ticket and seasonal will continue. We are planning for a modest AUR pressure on CUE with positive unit trends."
},
{
"speaker": "",
"content": "Our expectation is that select discretionary categories will remain under pressure. For the second quarter, we expect gross margin expansion in line with the first quarter from continued supply chain efficiencies and benefits from effective cost management, partially offset by the mix impact of growth in big ticket, which runs below the chain average."
},
{
"speaker": "",
"content": "We anticipate the gross margin expansion to be offset by SG&A deleverage from our planned investments, including the incremental cost for the opening of our new distribution center."
},
{
"speaker": "",
"content": "As I mentioned earlier, there's approximately $5 million of shifting to the second quarter that we had initially anticipated in the first quarter, including staffing and training costs associated with the opening of the DC. As a result, we expect second quarter operating profit margin to be down slightly compared to prior year."
},
{
"speaker": "",
"content": "As I shared when we initially provided guidance in February, there are a few factors that will impact operating margin in certain quarters. We anticipate the tailwinds of lower transportation costs to continue to benefit our results in the second quarter and begin to flatten year-over-year starting in Q3."
},
{
"speaker": "",
"content": "In regards to SG&A, the second and third quarters will be pressured from the start-up costs for the new distribution center, while the supply chain benefits will not begin to be realized in gross margin until late in the third quarter."
},
{
"speaker": "",
"content": "To sum it up, for the full year, we continue to guide toward net income of $1.06 billion to $1.13 billion and diluted earnings per share of $9.85 to $10.50. With the majority of the year still ahead of us, we believe these expectations are still appropriate. We continue to believe that the best way to look at our business is not by the quarters, but by the halves of the year."
},
{
"speaker": "",
"content": "In this environment, what sets Tractor Supply apart is our ability to effectively manage the top line and bottom line while investing in our Life Out Here strategic growth drivers. And with that, I will turn the call back to Hal for some final remarks."
},
{
"speaker": "Harry Lawton",
"content": "Thanks, Kurt. Tractor Supply has a proven business model that has been resilient over many business cycles. As a company, we have numerous levers to continue to gain market share and numerous levers to effectively control expenses. Our Life Out Here strategic priorities are on track and delivering on our expectations. We continue to see fantastic opportunities for growth ahead. In store and online, we're ready for the spring and summer season. Customers are responding positively to our new product assortments from Weber, Toro, YETI and more. We have several product test and learn initiatives in store and online, like Martha Stewart and Eddie Bauer."
},
{
"speaker": "",
"content": "Across companion animal, we're adding to our assortment with new brands like ACANA, Real Mesa and Native Pet and expanding our offerings across brands like Purina Pro Plan, SPORTMiX and Hill's Science Diet. Our Garden Centers are set to help our customers prepare for their hobbies of gardening, especially with a focus on vegetables and fruit trees and just simply enjoying their property."
},
{
"speaker": "",
"content": "Across the seasons, we have new product offerings specific to the Garden Center. We're currently showcasing our roses, Plant of the Month, and are prepared with hanging baskets for Mother's Day. As we move into the second half of the year, we will shift to Fall Harvest and Halloween and then to Christmas with live goods and decor. Overall, this is a great way for us to track new customers and soften the front of our store."
},
{
"speaker": "",
"content": "Across the store, we have a tremendous amount of newness for our customers' passions and lifestyles. We also continue to invest in customer service at our stores. In addition to our Hey GURA app, to turbocharge service our store team members provide to our customers, we are leveraging AI in our stores and Garden Centers through our Tractor Vision, which uses cameras and computer vision technology to provide data to deploy alerts that help our team members efficiently and effectively staff the store."
},
{
"speaker": "",
"content": "One scenario where this is incredibly beneficial is when customer traffic is building up at our registers, Tractor Vision will alert team members through their ERP that another team member needs to come up to open another register. We're also leveraging Tractor Vision to monitor our front apron of the store for dwell time. This allows for a team member to better serve our customers particularly in categories like outdoor riding lawn mowers. These are the types of investments and capabilities that separate us from our farm and ranch competition and really make us a leader in retail."
},
{
"speaker": "",
"content": "It's an exciting time at Tractor Supply. My thanks and appreciation goes out to the team for their dedication to delivering our mission and values every day. And now we'd like to open up the call for questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] The first question comes from the line of Seth Sigman with Barclays."
},
{
"speaker": "Seth Sigman",
"content": "I wanted to talk about the big ticket improvement. Obviously, that's a nice change from what we've seen. If I recall, when you talk about big ticket, you're looking at transactions over a certain size. Can you try to separate for us the difference between sales from high price point products, so you mentioned riding lawn mowers. Have you actually seen comps in those specific high-ticket categories go positive? Or is it more basket building, you're seeing the benefit from more units per transaction as part of the spring activity?"
},
{
"speaker": "Harry Lawton",
"content": "Seth, thanks for the question. We were very pleased with our big ticket performance in Q1. I'll highlight 2 trends and then provide some examples in the context of each of those. The first one I'll highlight was in January, where we had the nice cold weather come through the country. And as a consequence of that, had some nice big ticket sales that go along with that as we often do, whether that's things like snow throwers or log splitters. And to your point, the cutoff that we use for big ticket is $350 price point. ."
},
{
"speaker": "",
"content": "But then the other comment I'll make is in the month of March, particularly the last couple of weeks where we start to see that spring ramp occur, we saw a nice lift in big ticket over those weeks. And we did highlight in the prepared remarks in categories like riding lawn mowers, outdoor power, we saw strong positive comps in those categories in those weeks. As we highlighted in the prepared remarks, we saw an over penetration in those purchases of higher income consumers versus lower income consumers. As we talked about, just kind of buying a bit more towards need for the lower income consumers."
},
{
"speaker": "",
"content": "The last thing I'll add is that the trend on big ticket that we saw in March for spring sales has continued into Q2."
},
{
"speaker": "Operator",
"content": "The next question comes from the line of Simeon Gutman with Morgan Stanley."
},
{
"speaker": "Simeon Gutman",
"content": "My question is also on big ticket, and Hal maybe I can put it in this way, if you look at it relative to 2019, and I think we're trying to assess whether there's like a bottoming and a turn that's happening versus seasonal. I think your comments around the March volume sounds like there may be a turn. But if we compare it to 2019 or 2020, granted it's hard to understand what baseline is normal versus not, but looking at it that perspective, and then -- and if there's anything about these big ticket trends that informs you about the cadence of the year. It doesn't sound like it, and it sounds like the cadence has always been pretty static across the quarters, but anything that you think about maybe big ticket strength continuing into the second half that maybe you didn't plan for?"
},
{
"speaker": "Harry Lawton",
"content": "Simeon. I'll reiterate a couple of the comments that I have on the previous question, just to tee up the discussion. So on big ticket, as it relates to spring, we saw nice big ticket ramp in absolute dollars and comps as we exited Q1 and those trends have continued into Q2, and we're very pleased with our big ticket spring sales. As we look at a multiyear history on that, if you recall, last year, we commented that our big ticket categories were back to 2019 levels. So I would articulate the growth that we're seeing now is kind of consistent and growth that would be on top of a normal -- go back to 2019 trend. So we feel like it's a healthy growth, compounding growth and very much in the kind of stable on top of 2019 levels."
},
{
"speaker": "",
"content": "The final thing I'll add is we called out numerous times, the drought conditions and the heat conditions that occurred in a number of our key markets the last 2 years, whether that's the Midwest or Texas, given the cooler weather that we've had and the nice precipitation we've had, grass is green across the country right now. And we all just returned from our executive walks across the whole country last week, and we all came back and kind of talked about the same thing. You've got really green grass, and it's growing well and the temperatures are staying cool. So the conditions are right for big ticket sales as well for us. But we're very pleased with the big ticket activity, strong exit in Q1 and continuing that pace into Q2, healthy on top of 2019 and the conditions are favorable for it as well this year."
},
{
"speaker": "Operator",
"content": "The next question comes from the line of Seth Basham with Wedbush."
},
{
"speaker": "Seth Basham",
"content": "I'm just trying to understand your inflation and deflation outlook a little bit more as we see a rise in oil prices here, do you think that could lead to any material inflation as we move through the year?"
},
{
"speaker": "Harry Lawton",
"content": "Seth, good morning. As it relates to inflation, the -- probably the most important point to take away from us is that we've lapped our 2 most difficult quarters as it relates to comping on top of inflation. As we remarked at the end of our Q4 call, we were lapping 11% inflation from Q3 of 2022. And then we're lapping substantial inflation from last year in Q1 of 2023. So as we look ahead, we have significantly less lapping issues."
},
{
"speaker": "",
"content": "And, in particular, as it relates to things like animal feed, as we get towards the end of Q2, we really start to get back to a more normalized environment. And by the way, by the time we get to mid-Q3, we're in -- we basically lapped it all. So I feel really good as we look forward that we're kind of getting close to hitting the bottom on disinflation and starting to be back as we get towards the end of the year towards a more normal outlook."
},
{
"speaker": "",
"content": "We're not seeing anything different in our margin expectations, pricing expectations, cost to good expectations that we saw at the beginning of the year. As we've mentioned, we worked closely with our vendor partners middle of last year to pull back on a lot of the cost increases we've seen. That's been successful. You see that in our gross margin rate results."
},
{
"speaker": "",
"content": "At the same time, we're appropriately moderated on prices. Our pricing has never been sharper in the industry. We monitor that very closely, and we've got multi, multiyear trends on that, never been sharper than we had in Q1 and coming into Q2. And we don't see anything on the horizon that would change kind of our retail price, cost of goods outlook. We did just complete all of our container, kind of shipping negotiations. Those are basically coming in kind of flat to last year. So there's not -- we don't see headwind in the future there."
},
{
"speaker": "",
"content": "And I don't think that there's been a significant amount of oil, fuel kind of cost type increases to impact certainly -- first cost type at this point at all. And the freight market, given the status of the freight market and the overcapacity that there is, you had to start to see prices come up to reflect fuel in that area as well. So pretty stable, no real change to our outlook, either on this call or versus our last call."
},
{
"speaker": "Kurt Barton",
"content": "Yes. And Seth, this is Kurt. Just to tie that back to our guidance. As we entered 2024, I have said that we could see and are planning for 2024 from an inflation, deflation, relatively neutral, plus or minus a point. And we expect as we're starting to lap some of those inflation quarters last year, Q2 may have a similar impact as we saw in Q1. But then if you were to play out the current environment today, it would really put us in an expectation for the year sort of that neutral standpoint. And we'll know more on how the back half looks after Q2, but still pretty much playing right in line with our guidance."
},
{
"speaker": "Operator",
"content": "The next question comes from the line of Chris Horvers with JPMorgan."
},
{
"speaker": "Christopher Horvers",
"content": "I wanted to expand on the big ticket commentary and focus on what's happening with spring. Can you contrast what you saw in March in markets where spring broke? Where did it break? Where it hasn't yet broken? And how you're thinking about what's April telling you about the business so far in the quarter?"
},
{
"speaker": "Harry Lawton",
"content": "Yes. Chris, we think where the sun has been out and conditions have been right, we've been very pleased with spring. Our big ticket sales are strong, our Live Goods are selling well. Our Garden Centers are performing, categories like grilling, other categories like fertilizer and grass seed, we're seeing real strength across the board when the sun is -- where the sun is out and conditions are right. Interestingly, in the first half -- in the first quarter, conditions were stronger, really more in the Northeast and the Midwest, as there was a decent bit of cloudiness and precipitation through the Southeast and over into Texas throughout the back of the last couple of weeks of the quarter. And that's, interestingly, kind of continue to bid into the second quarter."
},
{
"speaker": "",
"content": "But we feel very optimistic about the southern markets. They always turn in spring. And, you know, it's beautiful in Nashville today. But very pleased with our spring performance as we've headed into Q2 here. And we see Q2 really very similar to Q1, just right down the middle of a fair way. We expect Q2 to be very similar to Q1. And with the one notable call-up that Kurt had around, we think it's the bottom quarter for us on disinflation as it relates to CUE. But otherwise, it's kind of a streak down the middle, very similar quarter to Q1. And as I said, we're very optimistic and pleased with our spring start."
},
{
"speaker": "Operator",
"content": "The next question comes from the line of Steven Forbes with Guggenheim Partners."
},
{
"speaker": "Steven Forbes",
"content": "I think you noted 34 million members in the program, which is surprised to the upside here a little bit, at least as per our expectations. So I was wondering if you could maybe expand on the changes you made to the program. Is there anything sort of notable in terms of acquisition, maybe converting those non-Neighbor's Club members into members or repeat or retention trends that changed how you're thinking about that program membership evolving over time? And in any way to sort of size up what the true opportunity is for the 20% of sales that are coming from non-members today?"
},
{
"speaker": "Harry Lawton",
"content": "We're very pleased with the continued progress we're making in our Neighbor's Club platform. And clearly, our customers are engaging in it and using it, finding value in it and it's a key retention driver and behavior driver for our business. And it's certainly become an integral part of how we go to market and a key area of competitive advantage for us."
},
{
"speaker": "",
"content": "This quarter, we were pleased with the number of customers that we added to the Neighbor's Club platform. I called out that we had new customer growth in the quarter. And that was, new customers are a key driver to Neighbor's Club program growth. We're very pleased to have a positive new customer counts in the quarter."
},
{
"speaker": "",
"content": "The second thing I'll call out as to your point, we made adjustments to our membership program to allow for a lower dollar increments to be redeemed in terms of points, both $2 and $5. We also modified our tier structure a bit to allow people to earn more dollars sooner. And the entire goal of that was to drive that opening tier and that behavior to get them more engaged as we talked about on these calls over the last 2 or 3 years, the best performance we've seen has been in our Preferred Plus tier. Second best performance had been in our Preferred tier. And our basic Neighbor's Club tier was really where we wanted to regalvanize that group, reenergize that group. And the changes we made, we saw a significant response to, and we're very pleased. And we've got a number of things on the horizon that will continue to help us grow that program."
},
{
"speaker": "",
"content": "As we called out at the beginning of the year, we've got a Heroes program that we'll be rolling out towards the end of the second quarter or beginning of the third quarter, right around July 4 time frame. We'll share more about those details on our next call, but that's a lot -- that's going to allow us to embrace another set of customers that we have, provide them incremental value, and we're excited about that. We've gotten great feedback from the customers that we've tested that with."
},
{
"speaker": "",
"content": "And we're also in the process of implementing a customer data platform that's going to allow us to significantly improve our personalization and that's time for implementation in the back end -- back half of the year. And that's going to allow us to just take our personalization, capabilities and our targeting capabilities to the next level, in which we already do an excellent job. I'd say market-leading job on that, but this just keeps the improvement there."
},
{
"speaker": "",
"content": "So great performance in Neighbor's Club in the quarter, new features being launched already that are going to keep driving that. And then we've got a number of new things on the horizon. And as I said, this is a distinct part of Tractor Supply and an area of competitive advantage for us."
},
{
"speaker": "Operator",
"content": "The next question comes from the line of Steven Zaccone with Citigroup."
},
{
"speaker": "Steven Zaccone",
"content": "I wanted to ask on gross margin. So given the guidance for the second quarter that it should be similar in terms of expansion. Can you just talk through the back half of the year because you start to face some tougher comparisons. Just talk through some of the expectations in the back half?"
},
{
"speaker": "Kurt Barton",
"content": "Yes, Steven, this is Kurt. The gross margin drivers are very similar throughout the year, but yet, as I mentioned in some of my remarks, it has a bit of a difference in impact by quarter. So our biggest opportunity and biggest growth driver in gross margin will be, throughout the year, our transportation and freight. And in transportation and freight, it's both transitory or rate-related, where we are coming off of those higher costs, particularly in the ocean freight, but also the more sustainable is the structural where the new improvements in the supply chain, the distribution centers are driving down our stem miles. And even as we open up our tenth distribution center, we'll reoptimize the lanes and reduce stem miles, be able to optimize by finding the lowest better rates, and that happened with our Navarre, Ohio DC last year."
},
{
"speaker": "",
"content": "So those -- that will be the biggest driver. We'll start to lap in Q3, and heavily in Q4, some of the rate-related benefits. So it will begin to moderate on that aspect. But then on the other aspect of that is our cost management on our products. And there's really been a very disciplined strategic approach towards that, that began last year, but really, we started to see the benefit modestly in Q4. And our merchants and our vendors really partner together to drive down some of that cost."
},
{
"speaker": "",
"content": "And we're actually even creating some of that AUR deflation so that in our CUE categories, our key drivers, we're able to offer the best value and even better gross margin rate. And that's some of what the pressure that I mentioned on AUR is that we feel very confident that we're bringing the best prices in our categories, regardless of competition, and that's what's helping to really gain the market share. So for the back half of the year, transportation, cost management and lower cost drivers will contribute."
},
{
"speaker": "",
"content": "And then in the second half, the third item that will begin will be the supply chain benefits from the new distribution center. As the transportation costs are the highest one, that's why we've said the second half may be a slightly lower gross margin growth in the first half as we start to cycle it. But it's really been the main 3 things that will benefit throughout the year, but just beginning to less of a benefit on the transportation side in the second half."
},
{
"speaker": "Operator",
"content": "The next question comes from the line of Michael Lasser with UBS."
},
{
"speaker": "Michael Lasser",
"content": "Can you give us a sense for how the pet food category has been performing as of late? Have you been surprised that there's been general softness in these trends? And how has Tractor Supply's market share compared this quarter to the last couple of quarters, especially as it seems like the company has been taking more aggressive steps whether it's price investments, kinks to the loyalty program."
},
{
"speaker": "",
"content": "And then finally, there's been a lot of parsing of your words on quarter-to-date trends. Can you give us an explicit indication of what's been happening quarter-to-date, so we can understand if you have to see an acceleration from here in order to get to that down the fairway commentary about the second quarter?"
},
{
"speaker": "Harry Lawton",
"content": "Michael, I'll comment first on pet. First off, I'll just step back on pet and say it's an incredibly attractive market. It's one that outperformed kind of the broader retail market for decades. It's been a long-term source of growth for us. And I think that the slowdown in that industry this year has been well documented, with that slowdown being driven really by 2 macro drivers. The first is moderation in pet ownership. And the second is stagnant pricing, right? That's an industry that's historically been able to claw 2 or 3 points of price increase every year, given the substantial price increases that have occurred in that category over the last 2 years, basically, that category is flat in pricing for the year."
},
{
"speaker": "",
"content": "So you've got some moderation in the category just for this year. We have an incredibly distinct value proposition in that category. Our value proposition includes, I think, importantly, the co-mingling of purchases with animal feed. 88% of our customers have animals and pets. The vast majority has both. So they appreciate being able to shop for both their animal and pet food at the same time. We complement that key kind of portfolio advantage obviously, with customer service, with a pet-friendly environment now having over 900 pet washes, which by the way, we see nearly 50,000 pets a week in our stores, with pet washes, pet clinics, et cetera. And that's true, just animals in our store."
},
{
"speaker": "",
"content": "So we have a very distinct value proposition. We had all -- kind of publicly available brands, the international brands, but we also have 2 very leading private label brands. We cover the range of assortments. So incredible value proposition there, one that's distinct and I think in particular one that really holds up well in this market, given the various competitive dynamics that are going on, and as I said, but I want to reinforce, we are absolutely still taking share in that category, albeit at a lower growth rate because of the moderation in the category, but we are absolutely still taking share in that category, and we're only doing things to reinvest and lean in further to continue to capture that share. And as we look forward, we fully expect that pet will continue to be a long-term growth category for us and a driver of our overall growth."
},
{
"speaker": "",
"content": "As it relates to Q2, as I said, we expect it to be another just straight down the fairway quarter for us. We don't need meaningful acceleration to use your words to deliver that performance for the quarter. One of the things I already highlighted is that the last quarter of real material disinflation, particularly in animal feeds. So it would be great to have that behind us and our outlook takes that into consideration. And if anything, I think there could be some modest upside as we look ahead, if you look at our quarterly comps last year, we had mid-single-digit comps in the month of April and May and then basically dropped off to a flat comp in the month of June."
},
{
"speaker": "",
"content": "We can all recall June last year, it went immediately hot and you had the Canadian forest fires. Our outlook does not count on that performance improvement, but it's an opportunity should we get the right conditions for that month."
},
{
"speaker": "Operator",
"content": "The next question comes from the line of Scot Ciccarelli with Truist."
},
{
"speaker": "Scot Ciccarelli",
"content": "I know it's still a, somewhat, limited data set, but you talked about seeing good results from your Garden Centers where spring has broken. I know you guys have previously provided a framework for what you expect to happen. But can you provide any kind of real-time updates in terms of what you're seeing on actual results?"
},
{
"speaker": "Harry Lawton",
"content": "Two things on that. So we've gotten so much better at sorting our Garden Centers, staffing our Garden Centers, putting technology at play to drive our Garden Centers would encourage everyone on the call, if you hadn't had a chance to go visit one of our Garden Centers in the spring to do so. We've got things this year like our Plant of the Month, as I mentioned on the call, which are Knockout Roses right now. We're deploying our Tractor Vision software into all the Garden Center stores to optimize and improve customer service. Our grower network now that we're in year 3 in many of these stores are now really lined up to produce tailored product for us. And we're seeing those results in our live goods sales broadly across our -- the country [ for us ], even in areas where conditions have been ideal, we're seeing good results there. ."
},
{
"speaker": "",
"content": "The team is doing things like, for Easter this year, for the first time, we brought any kind of in and out. We bought over 100,000 bulbs for Easter with a real nice packaging around and blew those things down. It just gives us even more confidence that we can execute in those sorts of ways. And so very pleased with our live goods and our Garden Center performance."
},
{
"speaker": "",
"content": "In addition to the live goods piece, which was about half of the lift that we're looking for. We also, this year, have gotten much better at what goes outside in our, like, Garden Centers versus what goes inside, you'll see all of our pots assortment out there this year. You'll see organic soils closely, cross-merchandise besides our fruit and vegetables this year. You'll see soil and mulches lined up in our side lots to be able to facilitate drive-through and load up there."
},
{
"speaker": "",
"content": "So we really got those things prime this year. And then as we look towards the back half, this year, you'll see us have much more expansive programs and things like harvest, and that's really blowing that out this year with mums pumpkin, a harvest product, Halloween product building a real kind of harvest destination in our Garden Centers."
},
{
"speaker": "",
"content": "And then similarly, you'll see Winter Wonderland really brought to life this year like we've not yet done for Christmas. So really excited about our Garden Center performance in the current spring period, but also as we look forward to the plans that we have, the team is doing an excellent job across all functions, really lining us up like -- as an example, on that Easter program, we shipped that to our DCs. It was the first time we ran plants through our DC. So a lot of learnings and a lot of continued execution there."
},
{
"speaker": "Scot Ciccarelli",
"content": "Is there a way to quantify the comp lift, though, Hal?"
},
{
"speaker": "Harry Lawton",
"content": "Yes. So as we exit Q2, we'll have a much better sense of that, as you all will certainly recall, our -- over the last year, we said our Garden Centers were not performing at our expectations, because of the suboptimal spring conditions that we operated in last year, but that we had high expectations for this year, noted it is the year of the Garden Center, we're performing at those expectations. But again, 6, 7 weeks into spring with another 6, 7, 8 strong weeks to go. So more to come on that. But I think the short answer, I would say is they're performing at our expectations kind of season-to-date."
},
{
"speaker": "Operator",
"content": "The next question comes from the line of Peter Benedict with Baird."
},
{
"speaker": "Peter Benedict",
"content": "Just curious, I believe the Orscheln stores are earning the comp base in the second quarter. Just curious how we should think about that? Anything that those stores are cycling from a year ago standpoint that we need to think about? And kind of related to that or maybe a little unrelated, I was curious if Seth would talk a little more about some of the merchandising, innovation, newness that's in the store and maybe what he's most excited about as we look out over the balance of the year?"
},
{
"speaker": "Kurt Barton",
"content": "Yes, Peter, this is Kurt. I'll start with your first part of your question and then hand it over to Seth to address the back end part of it. Orscheln is running right in line with our expectation. The first quarter, for instance, is still lapping a lot of the liquidation in Orscheln. And then in second quarter, as we transition, you begin to get outside of a lot of that liquidation. So as we converted into our point of sale, it's somewhat in line with the time frame of having all of the Tractor Supply inventory in the Tractor Supply system. So we begin to lap a more normal time frame, particularly in the back half of the year."
},
{
"speaker": "",
"content": "The Orscheln stores are running in line with a lot of our Midwest performance. We're pleased with Orscheln. Again, as we said when we made the acquisition, such a great value proposition opportunity for us, and it's playing out well in that. Some of the things that we've done, we've got 81 stores that were sized very differently. We've been able to rightsize and put many of the stores right in line with the Tractor Supply, 15.5 square foot. We've got some larger ones that allow us to do some test in those. But for the bulk over the period of the last 12 months, we've been [indiscernible] go in rebrand, put the fusion in there and make sure that it fits the best Tractor Supply streamlined, efficient shopping experience there. The team is engaging and learning a lot of the Tractor, the optimized Tractor process."
},
{
"speaker": "",
"content": "So across the board, very pleased with that. And Seth can be able to talk a little bit about some of the other aspects on the merchandising side with Orscheln."
},
{
"speaker": "Seth Estep",
"content": "Thanks, Peter, for the question. So I would just say, if we look out to the back half, I'd speak a little bit more broadly even outside of Orscheln, and even go back to kind of last quarter's call and how really talked about this being the most innovation that we've seen in our stores since the start of the pandemic with all the reset activity, newness, partnership with our supplier base, how their supply chains are kind of back to normal levels."
},
{
"speaker": "",
"content": "A couple of things that I would highlight that we're really excited about. First, I would just say, we talked about the strength in big ticket right now and Hal talked a minute ago about Tractor and riders. I will tell you that exclusive lineup that we have, like in the Toro, Havoc is performing very well. We see that innovation really responding, again, a product built for our life out here. Some things that we don't speak much about when we think about garden itself. Like we just launched a comprehensive assortment of Groundwork soils and our exclusive brands that have been very strong. We just launched Weber. Very pleased with that start and how that's going."
},
{
"speaker": "",
"content": "And then if you go to the back half, I would just say, we mentioned in the prepared remarks, some of the newness coming in pet, but even things like [ Iconic Classics ] where we'll be the first brick-and-mortar here in the U.S. launching [ Iconic Classics ]. Real Mesa, which has been a strong new digital brand, will be the first brick-and-mortar launching Real Mesa in pet food, but it's really targeted to kind of our consumer in that approach. And then just the Garden Centers themselves and all the new activity that we have going throughout the course of the year and just lean into those activities and then [indiscernible]. We think about Orscheln Farm & Home, like some of the learnings that we're getting out of outdoor [indiscernible], you'll see us launch new programs there midyear, getting really towards that kind of hunting customer, and we believe that those will be some categories that we can take across the Tractor Supply stores from a regional perspective and some localization perspective to really drive some business."
},
{
"speaker": "",
"content": "So again, just reiterate this kind of from 2024, lot of new innovation, a lot of newness and some most newness we've had over the past few years."
},
{
"speaker": "Mary Pilkington",
"content": "We've have maybe one more question just so that we're sure we end at the top of the [ board ] hour."
},
{
"speaker": "Operator",
"content": "Final question comes from the line of Peter Keith with Piper Sandler."
},
{
"speaker": "Peter Keith",
"content": "Nice results, by the way. So I wanted to kind of just ask around the broader economy. Housing remains quite sluggish. So how do you see the economic backdrop in general for the rural economies where you guys operate versus maybe the broader U.S. economy. We've been housing into that discussion would be helpful as well. I guess is rural outperforming? Or do you think performing more in line with the broader U.S.?"
},
{
"speaker": "Harry Lawton",
"content": "Peter, thanks for the question. To start by the highest level, rural is very -- I think rural America is doing very well right now. We see our highest performance across our store base in rural America right now. If you look at the national statistics, you see net urban migration out -- kind of more migration coming out of cities than in. And you see that migration going to rural America. I think there's a variety of drivers for that, but that trend benefits us."
},
{
"speaker": "",
"content": "Stepping back, as we acknowledged on our earnings call last quarter, we acknowledge 2024 would be a non-algo for us and that we look forward to getting back to our long-term algorithm as kind of economic conditions became more neutral for us. Most importantly, the two economic conditions that were most impacting us with the transition from goods to services in the context of PCE spend and the notion -- and kind of disinflation. Those two trends are playing out as we expected at the beginning of the year."
},
{
"speaker": "",
"content": "As I commented, we're 100 basis points away from goods to services being at its pre-COVID levels. We've already traveled almost 400 basis points on that journey. So unclear where it will obviously stop, but you would say we're the vast majority of the way along on that journey. Disinflation, we've called out that. Q2 will be our bottom on that. And so we feel really good about that as well and that that's near behind us. And so the two major conditions that are affecting our business, you can see light at the end of the tunnel."
},
{
"speaker": "",
"content": "As it relates to housing more broadly, as we called out, last quarter, we really don't see housing as a primary driver of our business. And I know there's been some conversation around [ hire ] for longer [ run rate ], and the impact that might have on the housing market and then any delay in how 2025 results may occur. And obviously, talking about 2025 results right now is very premature for us. But we don't see the [ hire ] for longer kind of notion impacting our business anywhere near to the degree that it impacts those that are very housing sensitive. Thanks, Peter, for the question."
},
{
"speaker": "Mary Pilkington",
"content": "All right, everyone, that will wrap up our call today. I'm around and we're available for calls. And if you need anything, please don't hesitate to reach out, and we look forward to talking to you at the end of our second quarter. So thank you."
},
{
"speaker": "Operator",
"content": "This concludes today's conference call. Thank you for your participation. You may now disconnect your lines."
}
] |
tsla | 2,024 | 4 | [
{
"speaker": "Operator",
"content": "Good afternoon, everyone and welcome to Tesla's Fourth Quarter 2024 Q&A Webcast. My name is Travis Axelrod, the Head of Investor Relations here at Tesla, and I am joined today by Elon Musk and Vaibhav Taneja and a number of other executives. Our Q4 results were announced at about 3.00 p.m. Central Time in the update deck we published at the same link as this webcast. During this call, we will discuss our business outlook and make forward-looking statements. These comments are based on our predictions and expectations as of today. Actual events or results could differ materially due to a number of risks and uncertainties, including those mentioned in our most recent filings with the SEC. During the question-and-answer portion of today's call, please limit yourself to one question and one follow-up. Please use the raise hand button to join the question queue. Before we jump into Q&A, Elon has some opening remarks. Elon?"
},
{
"speaker": "Elon Musk",
"content": "Thank you. So, in summary, in Q4, we set a record and delivered vehicles at an annualized rate of nearly 2 million a year. So, congratulations to the Tesla team on excellent work, achieving record production and deliveries. Model Y was the best-selling vehicle of any kind for 2024. That's worth noting. Not just the best electric vehicle, the best vehicle of any kind on earth, number one was Model Y. We're staying focused on maximizing volumes and obviously doubling down for, I don't know what, it really, I was going to say doubling down on autonomy, but really it's like autonomy is like 10x-ing. Frankly, doubling is not even enough. We made many critical investments in 2024 in manufacturing AI and robotics that will bear immense fruit in the future, immense. Like it's, in fact, to such a scale that it is difficult to comprehend. And I've said this before, and I'll stand by it. I see a path, I'm not saying it's an easy path, but I see a path for Tesla being the most valuable company in the world by far, not even close. Like, maybe several times more than, I mean, there is a path where Tesla is worth more than the next top five companies combined. There's a path to that. I mean, I think it's like an incredibly, just like a difficult path, but it is an achievable path. So -- and that is overwhelmingly due to autonomous vehicles and autonomous humanoid robots. So, our focus is actually building towards that. And that's where we're laying the ground. We laid the ground work for that in 2024. We'll continue to lay the ground work for that in 2025. In fact, more than laid the groundwork actually, so it would be building the structure, it’d be we're building the manufacturing lines and like -- like, setting up for what I think will be an epic 2026 and a ridiculous ‘27 and ‘28. Ridiculously good. That is my prediction. As yet, very few people understand the value of Full Self Driving and our ability to monetize the fleet. I've -- some of these things I've said for quite a long time and I know people said, well, Elon is the boy who cried wolf like several times but I'm telling you there's a damn wolf this time and you can drive it. In fact, it can drive you. It's a self-driving wolf. For a lot of people, like their experience of Tesla autonomy is like, if it's even a year old, if it's even two years old, it's like meeting someone when they're like a toddler and thinking that they're going to be a toddler forever. But obviously they're not going to be a toddler forever if they grow up. But if their last experience was like, FSD was a toddler, it's like, well, it's grown up now. Have you seen it? It's like walks and talks. And that's really what we've got. And it's difficult for people to understand this because human intuition is linear as opposed to what we're seeing is exponential progress. So, that's why my number one recommendation for anyone who doubts is simply try it. Have you tried it? When's the last time you tried it? And the only people who are skeptical, the only people who are skeptical are those who have not tried it. So, a car goes -- a passenger car typically has only about 10 hours of utility per week out of 168. A very small percentage. Once that car is autonomous, my rough estimate is that it is in use for at least a third of the hours of the week. So, call it 50, maybe 55 hours of the week. And it can be useful both for cargo delivery and people delivery. So, even let's say people are asleep, but you can deliver packages in the middle of the night or resupply restaurants or whatever the case may be, whatever people need at all hours of the day or night. That same asset, the thing that these things that already exist with no incremental cost change, just a software update, now have five times or more the utility than they currently have. I think this will be the largest asset value increase in human history. Maybe there's something bigger, but I just don't know what it is. And so people who look in the rearview mirror are looking for past precedent, except I don't think there is one. So -- but the reality of autonomy is upon us. And I repeat my advice, try driving the car or let it drive you. So, now it works very well in the US, but of course it will over time work just as well everywhere else. So, we're working hard to grow our annual volumes. Our constraint this year -- our current constraint is battery packs this year, but we're working on addressing that constraint. And I think we will make progress on addressing that constraint. And then things are really going to go ballistic next year, and really ballistic in ‘27 and ‘28. So, yeah. So, a bit more on Full Self Driving. Our Q4 Vehicle Safety Report shows continued year-over-year improvement in safety for vehicles so that the safety numbers, if somebody has supervised Full Self Driving turned on or not, the safety differences are gigantic. So, and people have seen the immense improvement with Version 13 and with incremental versions in Version 13 and then Version 14 is going to be yet another step beyond that that is very significant. We launched the Cortex training cluster at Gigafactory Austin, which was a significant contributor to FSD advancement, and we continue to invest in training infrastructure out of Texas headquarters. So, the training needs for Optimus or Optimus humanoid robot are probably at least ultimately 10x of what's needed for the car, at least to get to the full range of useful roles. You can say, how many different roles are there for a humanoid robot versus a car? Humanoid robot has probably, well, 1000 times more uses and more complex things than in a car. That doesn't mean the training scales by a 1000, but it's probably 10x. Now you can do this progressively. So it doesn't mean like, or Tesla is going to spend like $500 billion in training compute. Because we obviously train Optimus to do enough tasks to match the output of Optimus robots. And obviously, the cost of training is dropping dramatically with time. So, it is one of those things where I think long-term, Optimus will be -- Optimus has the potential to be north of $10 trillion in revenue. Like, it's really bananas. So that you can obviously afford a lot of training compute in that situation. In fact, even $500 billion training compute in that situation would be quite a good deal. Yeah. The future's going to be incredibly different from the past, that's for sure. We live at this unbelievable inflection point in human history. So, yeah. So, the proof is in the pudding. So, we're going to be launching unsupervised Full Self Driving as a paid service in Austin in June. So -- and I've talked with the team. We feel confident in being able to do an initial launch of unsupervised, no one in the car, Full Self Driving in Austin in June. We already have Tesla's operating autonomously unsupervised Full Self Driving at our factory in Fremont and we’ll soon be doing that at our factory in Texas. So, thousands of cars every day are driving with no one in them at our Fremont factory in California. They will soon be doing that in Austin and then elsewhere in the world for the rest of our factories which is pretty cool. And the cars aren't just driving to exactly the same spot because obviously it all, [went and collide] (ph) at the same spot. The cars are actually programmed with what lane they need to park in to be picked up for delivery. So, they drive from the factory end of line to their specific - to their destination parking spot and then could be picked up for delivery to customers and then doing this reliably every day, thousands of times a day. It's pretty cool. Like I said, the Teslas will be in the wild with no one in them, in June in Austin. So, what I'm saying is this is not some far-off mythical situation. It's literally, five, six months away, five months away kind of thing. And while we're stepping into -- putting our toe in the water gently at first, just to make sure everything's cool, our solution is a generalized AI solution. It does not require high precision maps of a locality. So we just want to be cautious. It's not that it doesn't work beyond Austin. In fact, it does. We just want to be, put a toe in the water, make sure everything is okay, then put a few more toes in the water, then put a foot in the water with safety of the general public and those in the car as our top priority. With regard to Optimus, obviously I'm making these revenue predictions that sound absolutely insane. I realize that. But they are, I think, they will prove to be accurate. Yeah. Now, with Optimus, there's a lot of uncertainty on the exact timing, because it's not like a train arriving at the station for Optimus. We are designing the train and the station and in real time while also building the tracks. And so they're like, people shouldn’t say like, why didn't the train arrive exactly at 12:05? We're literally designing the train and the track and the station in real time while you're saying, how can we predict this thing with absolute precision? It's impossible. The normal internal plan calls for roughly 10,000 Optimus robots to be built this year. Will we succeed in building 10,000 exactly by the end of December this year? Probably not, but will we succeed in making several thousand? Yes, I think we will. Will those several thousand Optimus robots be doing useful things by the end of year? Yes, I'm confident they will do useful things. The Optimus in use at the Tesla factories, production design one, will inform how - what we change for production design two, which we expect to launch next year. And our goal is to ramp prompt Optimus production faster than maybe anything's ever been ramped. Meaning, like aspirationally an order of magnitude ramp per year. Now, if we aspire to an order of magnitude ramp per year, perhaps we only end up with a half order of magnitude per year. But that's the kind of growth that we're talking about. It doesn't take very many years before we're making 100 million of these things a year. If you go up by, let's say, a factor, by 5x per year, insane. Not 50%, 500%. So, these are big growth numbers. Yeah. But we do need to be -- this is an entirely new supply chain, is entirely new technology. There's nothing off the shelf to use. We try desperately with Optimus to use any existing motors, any actuators, sensors, nothing worked for our humanoid robot, at any price. We had to design everything from physics first principles to work for a humanoid robot and with the most sophisticated hand that has ever been made before, by far. And Optimus will be able to like play the piano and be able to thread a needle. I mean this is the level of precision no one has been able to achieve. And so it's really something special. So, yeah, so -- and my prediction long term is that Optimus will be overwhelmingly the value of the company. Regarding energy, back to Earth. Mr. Elon, can you come back here for a minute? Okay, back to Earth. Energy storage is a big deal and will become, it's already super important, will become incredibly important in the future. And it is something that enables far greater energy output to the grid than is currently possible. Because the grid, the grids are -- the vast majority of the grid has no energy storage capability. So, they have to design the power plants to, for very high peaks and assuming that there's no energy storage. Once you have grid energy storage and home-based energy storage, the actual total energy output per year of the grid is dramatically greater than people think. Maybe it's at least double. This will drive the demand of stationary battery packs, and especially the grid scale ones, to insane, basically as much demand as we could possibly make. So, we have our second factory, which is in Shanghai, that's starting operation and we're building a third factory. So we're trying to ramp output of the stationary battery storage as quickly as possible. Now, there is a challenge here where we have to be careful to that we're not robbing from one pocket to take to another pocket because for a given gigawatt hours per year of the cell output, we have to say, does it go into stationary applications or mobile applications? It can't go both into both. So, we have to make that trade-off. Yeah. But overall, the demand for total gigawatt hours of batteries, whether mobile or stationary, that will grow in a very, very big way over time. So, in conclusion, 2025 really is a pivotal year for Tesla. And when we look back on 2025 and the launch of unsupervised Full Self Driving, true real-world AI that actually works, I think they may regard it as the biggest year in Tesla history, maybe even bigger than our first car, the Roadster or the Model S, so the Model 3 or Model Y. In fact, I think it probably will be viewed ‘25 as maybe the most important year in Tesla's history. There is no company in the world that is as good at real-world AI as Tesla. I don't even know who’s in second place. Like, you say like who's in second place for real-world AI. I would need a very big telescope to see them. That's how far behind they are. All right."
},
{
"speaker": "Travis Axelrod",
"content": "Great. Thank you very much, Elon. And, Vaibhav has some opening remarks as well."
},
{
"speaker": "Vaibhav Taneja",
"content": "Yeah, I'll talk about things on Earth. As Elon mentioned, in Q4, we set records in vehicle deliveries and energy storage deployments in an uncertain macro environment. We were able to grow auto and energy storage volumes both sequentially and on a year-on-year basis. For this, I would like to thank the efforts of everyone at Tesla to make this a reality and our customers who helped us achieve this feat. Coming into the fourth quarter, our focus was to reduce inventory levels in the automotive business and we accomplished that by ending the quarter with the lowest finished good inventory in the last two years. This was a result of offering not only attractive financing options but also other discounts and programs which impacted ASPs. While we saw volume growth in almost all regions that we operate in, we hit a new record for deliveries in the Greater China market. This is an encouraging trend since we grew volume in a highly competitive BEV market. On the automotive margin front, we saw a quarter-over-quarter decline primarily due to lower ASPs and due to the recognition of FSD related revenue in Q3 from feature releases. Our journey on cost reduction continues, and we were able to get our overall cost per car down below $35,000, primarily by material costs. This was despite increased depreciation and other costs as we prepare for the transition to the new Model Y for which we recently started taking orders in all markets. All our factories will start producing the new Model Y next month while we feel confident in our team’s abilities to ramp production quickly, know that it is an unprecedented change and we are not aware of anybody else taking the best-selling car on the planet and updating all factories at the same time. This changeover will result in several weeks of lost production in the quarter. As a result, margins will be impacted due to idle capacity and other ramp related costs, as is common in any launch, but will be overcome as production is ramped. We will be introducing several new products throughout 2025. We are still on track to launch a more affordable model in the first half of 2025 and will continue to expand our lineup from there. From a dollar-for-dollar basis, we believe we have the most compelling lineup today compared to the industry, and it will continue to get better from here. As always, all our products come with the best software in the industry, autonomy features and capable of full autonomy in the future. And despite the premium experience, the total cost of ownership is close to mass market, less premium competitors. Energy storage deployments reached an all-time high in Q4, and this -- and resulted in -- but declined sequentially. This was a result of higher -- sorry, growth came from Megapack and Powerwall. Both businesses continue to be supply constrained, and like Elon mentioned, we're trying to ramp up production with Megafactory Shanghai coming online this quarter onwards. While quarterly deployments will likely continue to fluctuate sequentially, we expect at least 50% growth in deployments year-over-year in 2025. Gross profit and margins in the service and other business was up year-over-year but declined sequentially. This was the result of higher service center costs and lower profit from used car business. The businesses within service and other primarily support our new car business, especially through their impact on total cost of ownership. Therefore, while we manage them to be positive on a GAAP basis, we do not expect similar margins as the rest of the business. There's a lot of uncertainty around tariffs. Over the years, we've tried to localize our supply chain in every market, but we are still very reliant on parts from across the world for all our businesses. Therefore, the imposition of tariffs, which is very likely, and any [Indiscernible] will have an impact on our business and profitability. Our operating expenses grew both year-over-year and sequentially. The biggest driver of the increase was R&D as we continue to invest in AI-related initiatives. The remaining increase came from growth in our sales capabilities and marketing efforts from referral program. For 2025, we expect operating expenses to increase to support our growth initiatives. It is important to point out that the net income in Q4 was impacted by a $600 million mark-to-market benefit from Bitcoin due to the adoption of a new accounting standard for digital assets, whereby we will change -- we will take mark-to-market adjustments through other income every reporting period going forward. Our free cash flow for the quarter was $2 billion, and despite CapEx increase of over $2.4 billion in 2024, we were able to generate free cash flow of $3.6 billion for the year. CapEx efficiency is something we are extremely focused on. While we have invested in AI-related initiatives, we have done so in a very targeted manner to utilize the spend to get immediate benefits. The build-out of Cortex was accelerated because of the role -- actually to accelerate the rollout of FSD Version 13. Accumulative AI-related CapEx, including infrastructure, so far has been approximately $5 billion. And for 2025, we expect our CapEx to be flat on a year-over-year basis. In conclusion, like Elon said, 2025 is going to be a pivotal year for Tesla. There are a lot of investments which we have made and will continue to make in this coming year, which will set the pace for the next phase of growth. And it is something which now I'm getting out of earth, it is going to be out of this world. And we just are putting the right foundation. And that's all I have."
},
{
"speaker": "Travis Axelrod",
"content": "Great. Thank you very much, Vaibhav. Now, we will move over to investor questions and we'll start with say.com. The first question is, is unsupervised FSD still planned to be released in Texas and California this year? What hurdles still exist to make that happen? You addressed the Texas piece, I think, already, so..."
},
{
"speaker": "Elon Musk",
"content": "Yeah, I'm confident that we'll release unsupervised FSD in California this year as well. Yeah, in fact, I think we will most likely release unsupervised FSD in many regions of the country of the US by the end of this year. Like I said, we're just putting our toe in the water, then a few toes, then a foot, then leg, then make sure everything is cool. And we're looking for a safety level that is significantly above the average human driver. So, it's not anywhere like much safer, not like a little bit safer than human, way safer than human. So the standard has to be very high because the moment there's any kind of accident with an autonomous car, this immediately gets worldwide headlines, even though about 40,000 people die every year in car accidents in the US, and most of them don't even get a mention anywhere. But if somebody scrapes a shin with an autonomous car, it's headline news."
},
{
"speaker": "Vaibhav Taneja",
"content": "We want to avoid that."
},
{
"speaker": "Elon Musk",
"content": "Yeah. So it's really from an -- the only thing holding us back is an excess of caution. But people can certainly get a feel for how well the car would perform as unsupervised FSD by simply having a car, allowing the car to drive you around your city and see how many times did you have to intervene. Not where you wanted to intervene or were a little concerned. But how many times did you have to intervene for, for definite safety reasons. And you will find that that is currently very rare, and over time, almost never."
},
{
"speaker": "Travis Axelrod",
"content": "Great. Thank you very much. The next question is, are there any discussions with other auto companies about licensing FSD?"
},
{
"speaker": "Elon Musk",
"content": "Yes. What we're seeing is, at this point, significant interest from a number of major car companies about licensing for Tesla Full Soft Driving technology. What we've generally said is the best way to know what to do is take one of our cars apart, and then you can see where the placement of the cameras are, what the thermal needs are of the Tesla AI inference computer. That's better than us sending some CAD drawings. And then we're only going to entertain situations where the volume would be very high, otherwise it's not worth the complexity. And we will not burden our engineering team with laborious discussions with other engineering teams until we obviously have unsupervised Full Self Driving working throughout the United States. I think the interest level from other manufacturers to license an FSD will be extremely high once it is obvious that unless you have FSD, you're dead."
},
{
"speaker": "Travis Axelrod",
"content": "Great. Thank you very much. The next question is, is Optimus now mostly design locked for 2025 production?"
},
{
"speaker": "Elon Musk",
"content": "Optimus is not design locked. So, when I say like we're designing the train as it's going to -- we're redesigning the train as it’s going down the tracks while redesigning the tracks and the train stations."
},
{
"speaker": "Vaibhav Taneja",
"content": "Every [indiscernible]."
},
{
"speaker": "Elon Musk",
"content": "Yeah, it's rapidly evolving. It's rapidly evolving in a good direction. It's pretty damn amazing actually. Team’s doing a fantastic job. We really have, by far, I think by far the best team of humanoid robotics engineers in the world. And we also have all the other ingredients necessary, because you need a great battery pack, you need great power electronics, you need great charging capability, you need great communications, great Wi-Fi and cellular connectivity. And of course, you need real-world AI. And then the ability to scale that production to huge levels. So you have to design for manufacturing. The things that, really what other companies are missing is they're missing the real-world AI and they're missing the ability to scale manufacturing to millions of units a year."
},
{
"speaker": "Vaibhav Taneja",
"content": "I think that is an underappreciated thing that industrialization of design is a whole different thing than making a design."
},
{
"speaker": "Elon Musk",
"content": "Yeah, prototypes are trivial basically. Prototypes are easy, production is hard. I've said that for many years. The problem is that there's like, those who have never been involved in production or manufacturing somehow think that once you come up with some eureka design that you magically can make a million units a year. And this is totally false. There needs to be some Hollywood story where they show actually the problem is manufacturing. I've never even heard of one. It just doesn't fit the narrative. The Hollywood thing is like it's like some lone inventor in a garage goes Eureka and suddenly it files a patent and suddenly there's millions of units. I, like, I'm listening to guys who were missing most really 99% of the story. 1% is another old saying of one person -- like a product is 1% inspiration 99% perspiration. The Hollywood shows you 1% inspiration and minus, but forgets about the 99% perspiration of actually figuring out how to make that initial prototype manufacturable and then manufactured at high volume such that the product is reliable, low cost, consistent, doesn't break down all the time, and that is 100 times harder, at least, than the prototype."
},
{
"speaker": "Vaibhav Taneja",
"content": "Then you have to get it there, deliver it, I think, yeah."
},
{
"speaker": "Elon Musk",
"content": "Yeah, you have to meet all these regulations, and there's a million regulators around the world, it's pretty difficult."
},
{
"speaker": "Travis Axelrod",
"content": "Great, thank you. The next question is also Optimus related. When will Tesla start selling Optimus, and what will the price be?"
},
{
"speaker": "Elon Musk",
"content": "Well, the -- it may -- for this year we expect to just close the loop with Optimus being used internally at Tesla, because we obviously can easily use several thousand humanoid robots at Tesla for the most boring, annoying tasks in the factory, like the tasks nobody wants to do, where we have to like beg people to do this task. And then they -- then it's like the robot's totally happy to do the boring, dangerous, repetitive task that no humans want to do. And that's also actually some of the easiest use cases for us to have Optimus do things like load the hopper, like, say you're loading the body line if you're transporting pieces of sheet metal to the robot, which is already robot, the robot welding line for the body, and you just have to nonstop take things out of a, from one fixture to another fixture. And it's a very boring job That's the kind of thing what the Optimus could do."
},
{
"speaker": "Vaibhav Taneja",
"content": "The guy who runs around all the wall studs and the pins."
},
{
"speaker": "Elon Musk",
"content": "Yeah, there's a ton of boring jobs, tedious jobs, dangerous, slightly dangerous jobs that are perfect for Optimus. So we expect to use Optimus for those tasks at our factories and that'll help us close loop for improvement this year. It really was the production Version 2 which I think launches sometime next year. I'd like it to be the beginning of next year but maybe it's more like the middle of next year. And then we have to -- with a production line that is designed for -- on the order of 10,000 units a month versus 1,000 units a month. So, when you're designing a production line for 1,000 units a month, it takes you a while to actually reach anywhere close to 1,000 units a month. For any given production output, it takes a while to actually reach its potential. The current line that we're designing is for roughly 1,000 units a month of Optimus robots. The next line would be for 10,000 units a month. The line after that would be for 100,000 units a month. And I think probably with Version 2, it is a very rough guess because there's so much uncertainty here, very rough guess that we start delivering Optimus robots to companies that are outside of Tesla in maybe the second half of next year, something like that. But like I said, this is such an exponential ramp that it will go from no one's receiving humanoid robots to these things like coming out like crazy."
},
{
"speaker": "Vaibhav Taneja",
"content": "We can't build enough."
},
{
"speaker": "Elon Musk",
"content": "We're always going to be in a we can't build enough situation. Demand will not be a problem even at a high price. And then as I said, like, once we start -- once we're at a steady state of above 1 million units a year, I think the production -- I'm confident at 1 million units a year, that the production cost of Optimus will be less than $20,000. If you compare the complexity of Optimus to the complexity of a car, so just the total mass and complexity of Optimus is much less than a car. So, I would expect that at similar volumes to say the Model Y, which is over 1 million units a year, that you'd see Optimus be, I don't know, half the cost or something like that. What the price of Optimus is a different matter. The price of Optimus will be set by the market demand."
},
{
"speaker": "Travis Axelrod",
"content": "Great. Thank you very much. The next question is, what is the status on mass production of the Tesla Semi? And how will it impact revenue and scale?"
},
{
"speaker": "Lars Moravy",
"content": "I can take that one. So, we just closed out the Semi factory roof of walls last week in Reno, a schedule, which is great with the weather. In Reno, you never know what's going to happen. But we're prepping for mechanical installation of all the equipment in the coming months. The first builds of the high volume Semi design come late this year in 2025 and begin ramping early in 2026. But as we've said before, the Semi is a TCO, no-brainer. I think it's really similar to Optimus, set by how much people pay and it has the total cost of ownership, it's much, much cheaper than any other transportation you can have. So at that point, when we're at scale, it will meaningfully contribute to Tesla's revenue. I think it’s difficult to say how much. Anything you want to add Elon?"
},
{
"speaker": "Elon Musk",
"content": "No. I mean, I do think that Tesla Semi, again with autonomy, is going to be incredibly valuable. That we actually have a shortage of truck drivers in America, that's one of the limiting factors on transport. And people are human so they get tired and sometimes there's -- it's -- I have a lot of respect for truck drivers because it's a tough job. But because it's a tough job, there's not that many people that want to do it. And there's actually fewer -- I believe, if my saying is correct, there are a few people entering truck driving as a profession than are not leaving it."
},
{
"speaker": "Vaibhav Taneja",
"content": "Yes."
},
{
"speaker": "Elon Musk",
"content": "So when you think, yeah, exactly. So when you consider, okay, there's more people leaving truck driving as a profession than entering it, well, we're going to have a real logistics problem as time goes by. So autonomy will be very important to meet that need. So like, yeah, it will -- I don't know. It's a several billion a year opportunity, which I don't know in this context. Is that -- these days, does several billion a year matter? I think it does. It's not nothing. It's probably -- it might -- it’s probably like a $10 billion a year thing. That's $1 billion a month at some point probably. But it's -- all this is going to pale in comparison to Optimus. So yeah, $1 billion a month is a lot but it's not -- it's going to be like 1% of Optimus."
},
{
"speaker": "Travis Axelrod",
"content": "Great. Thank you very much. We already covered the next question in opening remarks, so moving on. Is it expected that Tesla that will need to upgrade Hardware 3 vehicles? And if so, what is the timeline and expected impact to Tesla's CapEx? I think they are referring to cost there."
},
{
"speaker": "Elon Musk",
"content": "They're really asking the tough questions, aren't they?"
},
{
"speaker": "Vaibhav Taneja",
"content": "I guess we reached -- we haven't started working on Hardware 3 yet. We are still making software releases. We released the 12.6 release recently, which was like a -- is like a baby V13, but it's a significant improvement compared to what they had previously. And people are still finding ways, there are still larger motors in the smaller models. So we don't give up on Hardware 3, we're still working on it. Just the releases will trail the Hardware 4 releases."
},
{
"speaker": "Travis Axelrod",
"content": "Great. Thanks."
},
{
"speaker": "Elon Musk",
"content": "Yeah. I mean, I think the honest answer is that we're going to have to upgrade people's Hardware 3 computer for those that have bought Full Self Driving, and that is the honest answer and that's going to be painful and difficult but we'll get it done. Now, I'm kind of glad that not that many people bought the FSD package."
},
{
"speaker": "Travis Axelrod",
"content": "Thanks, Elon. The next question. Has Tesla given up on ramping their solar roof product?"
},
{
"speaker": "Elon Musk",
"content": "No, we -- sorry, Mike, go ahead, yeah."
},
{
"speaker": "Unidentified Company Representative",
"content": "Yes, I can take it. Yeah, solar roof is a core part of the residential product portfolio and it still remains. It draws a lot of customer interest despite it being premium products. We've worked on multiple iterations of engineering to make the product easier to install and distribute by reducing SKU count. And more recently, rather than direct installation, we are focused on growth through our nationwide network of certified installers. And many of those, they've been installing solar roof for many years."
},
{
"speaker": "Elon Musk",
"content": "That's actually turned out to be a much better way for the -- like it's just let the roof -- just supply products to the roofing industry. And especially when somebody's is getting a new roof anyway or building a house from scratch, obviously, this is by far the most efficient time to put in a solar roof as opposed to putting a solar roof on a house that -- where the roof still has 20 years of life. That's not economically senseful. But if it's a new house or the roof needs to be replaced anyway, then solar roof can make a lot of sense. And it is a premium product. It's like the Model S, Model X or something, like it's a premium product. I think it looks really cool. And you -- I mean, your house generates electricity. And if you combine it with the Tesla Powerwall battery, then you can be self-sufficient. So, even if the grid turns off, even if the grid turns off for several days, your house still works, and your roof looks awesome. So, it's like, I recommend anyone who had -- who can afford it, get the Tesla solar roof and the Powerwall. Your family’s life might depend on it. And just in terms of convenience, your kids are not going to yell at you because their computers don't work because power went out and you can't charge your phone. Actually happens. Yeah. You literally can't even call anyone because your phones out of juice."
},
{
"speaker": "Travis Axelrod",
"content": "Thank you very much. The next question was covered in opening remarks, so we will skip that. And the last question from say.com. What technical breakthroughs will define V14 of FSD, given that V13 already covered photon to control?"
},
{
"speaker": "Elon Musk",
"content": "Well, we're going to help a lot -- help a lot further than [indiscernible] We've been in sort of the nothing but nets situation, nothing but neural nets from photons to controls for a while now for just improving the neural nets. I guess we could get into some of the technical details to some degree. I have to say I continue to be amazed by just how effective order aggressive transformers are at solving a wide range of problems. I mean, Ashok, is there anything you'd like to add there without giving away the sort of family secrets?"
},
{
"speaker": "Ashok Elluswamy",
"content": "I mean, except for things we put on X already. Yeah, it's continuing to scale the model size a lot. We scale a bunch in V13, but then there's still room to grow. So we're going to continue to scale the model size. We're going to increase the context length even more. The memory is sort of limited right now. We want to increase the amount of memory, also give to even minutes of context for driving. We're going to add audio and emergency vehicles better, add data of the tricky common cases that we get from the entire fleet, any interventions or any kind of user intervention. We just add that to the data, the dataset. So the scaling in basically every axis, training compute, data set size, model size, model context, and also all the reinforcement learning objectives."
},
{
"speaker": "Travis Axelrod",
"content": "Great. Alrighty. With that, we will move over to analyst questions. So just as a reminder, you will need to unmute yourself to ask your question and the first question will be coming from Daniel Roeska from Bernstein. Daniel, please go ahead and unmute yourself."
},
{
"speaker": "Daniel Roeska",
"content": "Hey, good evening, everybody. It's Daniel from Bernstein. Elon, Tesla's share price clearly already includes quite few of the anticipated benefits you talked about today, yet realizing what you call kind of difficult but achievable will take some time. What are you pushing the Tesla executive team to do differently now to accelerate the innovation in order to realize the value you described for the company."
},
{
"speaker": "Elon Musk",
"content": "Well, I mean, we're, I think, working on perfecting real-world AI and making rapid progress week over week, if not month, certainly month over month, but often week over week. I spent a lot of time with the Tesla AI team and the Tesla Optimus team. I mean, I go where the problem is essentially. Like, not -- if something's, this is, unfortunately sometimes, like, don't talk to Tesla executives, and like, hey, we don't see you very often. I'm like, that's because your stuff is working awesome. If you start working really great, unfortunately, I didn't see them very often because I go where the problem is. So, [indiscernible] what's the greatest challenge that lies ahead? So obviously there are many challenges with Optimus. It's a hard problem to solve. Many challenges with vehicle autonomy. But we're making rapid progress in both. Yeah."
},
{
"speaker": "Daniel Roeska",
"content": "Okay. I mean, it sounds like you've got a conviction that the pieces you need, right, are in place. If we kind of go 12 months down the line and we look back, and you had some of those, but maybe what are the kind of two or three KPIs that would tell you that you're on track and it's going the right way and the pieces you've put in place are the right pieces, right? That's kind of what I'm looking for or other way around, where would it be off most likely in your mind that you say, hey, I need to go back there and I need to change something to enable the team better?"
},
{
"speaker": "Elon Musk",
"content": "Well, I mean, I think my predictions that I'm making here are going to be pretty accurate. And it's worth the next -- sometimes people say, Elon's always late. Well, actually, no, the problem is that the media reports on when I'm late, but never reports when I'm early. So sure, I'm optimistic, but I'm not that optimistic. There are many cases in the past where I actually, we've been early, such as completion of the Shanghai factory or factory completion has generally have been ahead of schedule, not behind. So, yeah, so the -- but I like to say I'm very confident we'll have released unsupervised Full Self Driving fully autonomous Teslas in Austin and several other cities in America by the end of this year. That's probably everywhere in America next year, and everywhere in North America at least. I think in terms of next year our constraints, I think it's likely to be just regulatory. Like Europe really has, for example, Europe is a layer cake of regulations and bureaucracy, which really needs to be addressed. There's this joke like America innovates, Europe regulates. It's like, guys, there's too many refs on the field. I mean, for example, for us to just to release supervised Full Self Driving in Europe, even though it works really well, we have to go through a mountain of paperwork with the Netherlands, which is our primary regulatory authority. Then the Netherlands presents this to the EU and I think May. And there's like this big EU country committee. We expect it to be approved at that time, but there's nothing we can do to make that may happen sooner. In fact, nobody seems to do it. But I guess all the countries would have to somehow vote in some way to have it happen sooner than May. Otherwise, it won't happen sooner than May. So then when is unsupervised FSD allowed in Europe? I’m like, May next year maybe? I don't know. I have to find out when the EU is meeting again. Sometimes it's a 12-month cadence, sometimes a six-month cadence. Then in China, which is a gigantic market, we do have some challenges because they weren't, currently allow us to transfer training video outside of China. And then the US government wouldn't let us do training in China. So we're in a bit of a bind there. So like, bit of a quandary. So we are already solving then is by literally looking at videos of streets in China that are available on the Internet to understand and then feeding that into our video training so that publicly available video of street signs and traffic rules in China can be used for training and then also putting it in a very accurate simulator. And so it will train using SIM for bus lanes in China. Like bus lanes in China, by the way, were about the biggest challenges in making FSD work in China is the bus lanes are very complicated. And there's like literally like hours of the day that you're allowed to be there and not be there. And then if you accidentally go in that bus lane at the wrong time, you get an automatic ticket instantly. So, it's kind of a big deal, bus lanes in China. So we're going to put that into our simulator, train on that. The car has to know what time of day it is, read the sign. Anyway, we'll get this solved. But I think we'll have unsupervised FSD in almost every market this year limited simply by regulatory issues, not technical capability. And then unsupervised FSD in the US this year, in many cities, but nationwide next year. And hopefully we have unsupervised FSD in most countries by the end of next year. That's my prediction with the best data that I have right now."
},
{
"speaker": "Travis Axelrod",
"content": "Great. Thank you very much. The next question will come from Adam Jonas at Morgan Stanley. Adam, please feel free to unmute yourself."
},
{
"speaker": "Adam Jonas",
"content": "Thanks everybody. So, Elon, you've said in the past about LiDAR, for AVs at least, that LiDAR is a crutch, a fool's errand. I think you even told me once, even if it was free, you'd say you wouldn't use it. Do you still feel that way?"
},
{
"speaker": "Elon Musk",
"content": "Yes."
},
{
"speaker": "Adam Jonas",
"content": "Care to elaborate or just, I have another question."
},
{
"speaker": "Elon Musk",
"content": "Look, we even have a radar in the car and we turned it off."
},
{
"speaker": "Adam Jonas",
"content": "I got it. All right. So you're still -- people think you're crazy for not looking to LiDAR."
},
{
"speaker": "Elon Musk",
"content": "Obviously humans drive without shooting lasers out of their eyes. Unless you're Superman. But like humans drive just with passive visual, humans drive with eyes and a neural net and a brain neural net. So the digital equivalent of eyes and a brain are cameras and digital neural nets or AI. So that's the entire road system was designed for passive optical neural nets. That's how the whole road system was not designed and what everyone's expecting, that's how we expect other cars to behave. So therefore that is very obviously the solution for Full Self Driving in it as a generalized, but the generalized solution for Full Self Driving as opposed to the very specific, neighborhood by neighborhood solution, which is very difficult to maintain, which is what our competitors are doing."
},
{
"speaker": "Adam Jonas",
"content": "I got it."
},
{
"speaker": "Elon Musk",
"content": "Yeah. I mean, LiDAR doesn't work in the fall, guys. LiDAR has a lot of issues. I don't have to like, the SpaceX Dragon docks with the space station using LiDAR that a program that I've personally spearheaded. I don't have some fundamental bizarre dislike of LiDAR. It's simply the wrong solution for driving cars on roads."
},
{
"speaker": "Adam Jonas",
"content": "Right. You understand how light are works. I get it."
},
{
"speaker": "Elon Musk",
"content": "Literally designed and built our own red LiDAR. I oversaw the project, the engineering thing. It was my decision to use LiDAR on Dragon and I oversaw the engineering project directly. So I'm like we literally designed and made a radar, a LiDAR to dock with the space station. But if I thought it was the right solution for cars, I would do that, but it isn't."
},
{
"speaker": "Adam Jonas",
"content": "Yeah. All right. Just as a follow up. At CES, you said, I'm paraphrasing, that any AI will be able to do any cognitive task not involving atoms within the next three or four years. And that would imply, Elon, that before the end of President Trump's term in office, that AI would be moving pretty damn quickly into the physical world, into the world of photons and atoms. And I'm thinking, given your work with the administration, how confident are you that the US will have the manufacturing and the supply base to make good on your excitement about physical AI by the end of -- by latter this decade. We seem pretty vulnerable right now. I've seen you tweeting about, or sorry, X-ing, excuse me, Elon, about China, Freudian slip, about China having like making more drones in a day than the US makes in a year and all the entanglement of the supply. So, what has to happen in the US to make that possible? What's your message and what can what can you do about it and what's relevant for Tesla shareholders? Thanks, Elon."
},
{
"speaker": "Elon Musk",
"content": "Well, at Tesla, obviously, we think manufacturing is cool. SpaceX, we think manufacturing is cool. But in general, for talented Americans, they need to be beyond, beyond my companies, beyond me and my teams here, in general, we need to make manufacturing cool again in America. And, like, I honestly think people should move from like law and finance into manufacturing. That's my honest opinion. We have too much, this is both a compliment and a criticism. We have too much talent in law and finance in America. And there should be more of that talent in manufacturing. So, yeah. The potential for the future. I mean, it tells that we're making sure that we can continue to manufacture our stuff. Even in the event of geopolitical tensions rising to very high levels."
},
{
"speaker": "Adam Jonas",
"content": "Great. Thank you very much. The next question will come from Pierre Ferragu at New Street. Pierre, please feel free to unmute yourself."
},
{
"speaker": "Pierre Ferragu",
"content": "Hey, thanks guys for taking the question. So, I have a question on deploying like robotaxis in June in Austin. So that's great news. And I was wondering if it means I can drive down to Austin in June and try unsupervised by myself with my car, or it's going to be more like your fleet testing it?"
},
{
"speaker": "Elon Musk",
"content": "It'll be our fleet testing it. That's our sort of toe in the water. We'll be scrutinizing it very carefully, make sure it's not something we missed. But it will be, autonomous ride-hailing for money in Austin in June. And then as shortly as possible other cities in America. And I expect us to be operating, doing unsupervised activity with our internal fleet in several cities by the end of the year. Then it's probably next year when people are able to add or subtract their car from the fleet. So, kind of like Airbnb where you can sort of add or subtract your house or your guest room, you can say like add it to the Airbnb inventory or don't add it to the Airbnb inventory. If you're traveling for a month, or whatever, in case maybe you can, that other people use your house. Anyway, that's probably next year because we want to just make sure we've ironed out any kinks. And a lot of it is, it's not like we're not splitting the atom here. It's just a bunch of work that needs to be done to make sure the whole thing works efficiently, that people can order the car. It comes, it's the right spot, does exactly the right thing. All the payment systems work. The billing works."
},
{
"speaker": "Pierre Ferragu",
"content": "Yeah. Okay. But then, like, so my follow-up question would be, I have a Tesla, I have a FSD, and I have to keep my eyes on the road all the time. It's super boring because I don't really need to intervene anymore. And the really annoying thing is that I can't just check my emails. And so are you working also on introducing, like a kind of like free and supervised where I could be eyes off and I would be able to check my email and we just need to, with a five second notice, have to go back and keep an eye on what's happening or is that something you're working on as well? Because it feels so close with this certain that I wonder if it's something you'd expect for this year. It's a very sensitive question. I asked for myself to be honest."
},
{
"speaker": "Elon Musk",
"content": "Yes, we just need -- we need to be very confident that the probability of injury is low before we allow people to check with their email and text messages. In fact, right now we're in this perverse situation, which you may have encountered yourself where people will actually go to manual driving to check their text messages so the computer doesn't yell at them and then go then put it back on autonomous mode once they have checked the text messages, which is obviously less safe, significantly less safe, significantly less safe than just letting people check their text once in a while without the computer yelling at them. But we just want to be cautious about the advent that we're in this sort of, neither here nor there, but just for, I mean, I think it's not for many months longer. But yeah, we're in this perverse situation where people will turn the car off autopilot so the computer doesn't yell at them, check the text messages while steering the car with their knee and not looking out the window."
},
{
"speaker": "Ashok Elluswamy",
"content": "And like Elon said, if you have any problems with the system and when people are not looking, that is a dangerous thing. And that's what we're trying to avoid. The capability is getting there, but it's not fully there. That's why he was using the term of tipping a toe in the water, then getting comfortable, then keeping going."
},
{
"speaker": "Elon Musk",
"content": "Yeah. Anyway, it's not far off. But we would not want to prove to ourselves and also prove to regulators that the car is unequivocally safer in autonomous mode than not. And that's, we're not far off. So, this is like low single-digit months."
},
{
"speaker": "Ashok Elluswamy",
"content": "To the safety aspect, we did publish our Vehicle Safety Report today. And then Q4 is one crash for every 5.9 million miles driven compared to a crash every 700,000 miles without…"
},
{
"speaker": "Elon Musk",
"content": "We're getting to the point where it's an order of magnitude."
},
{
"speaker": "Ashok Elluswamy",
"content": "Yeah, it's like 8.5 times safer. So it's just about there. It's amazing."
},
{
"speaker": "Travis Axelrod",
"content": "Great. Alrighty. And our last question will be coming from Dan Levy at Barclays. Dan, feel free to unmute yourself."
},
{
"speaker": "Dan Levy",
"content": "Great. Good evening. Thank you for taking other questions. Elon, you've talked about the need for proliferation of sustainable transport in the past as part of sort of broader push to sustainable energy. Look, I know we've heard a lot about President Trump's plans to reverse the EV Mandate and I think there's a view that given regulation is a driver of EV uptake, this could slow EV uptake in the US. So, what would be your view on the right policy in the US, given your comments in the past of the need to push for sustainable transport?"
},
{
"speaker": "Elon Musk",
"content": "At this point, I think that sustainable transport is inevitable. I'm highly confident that all transport will be autonomous electric, including aircraft, and that it simply, it can't be stopped any more than one could have stopped the advent of the external combustion engine, steam engine, or one could have stopped the advent of the internal combustion engine. Like, even if you've been the biggest [indiscerinble] advocate on earth, like courses of the way, not these newfangled car automobiles, you can't stop the advent of automobile. It's going to happen. And you can't stop the advent of electric cars. It's going to happen. The only thing holding back electric cars was range, and that is the sole problem."
},
{
"speaker": "Dan Levy",
"content": "Great. And then as a follow up, in the past, Elon, you had made a comment that, you'd be willing to sell cars at effectively no margin to get the cars out there. And there's a comment in the release today of the rate of acceleration of autonomy efforts does impact volume growth. So perhaps you could just talk about, with your efforts on FSD, how we should think about your desire to put more vehicles out in the market to take advantage of your tech advances."
},
{
"speaker": "Elon Musk",
"content": "So, I'm not sure I understand the question. We have a lot of cars. I mean, we've got millions of cars out there."
},
{
"speaker": "Vaibhav Taneja",
"content": "So, is your question, Dan, that how do we marry our future growth aspects with FSD?"
},
{
"speaker": "Travis Axelrod",
"content": "Go ahead and unmute yourself, Dan."
},
{
"speaker": "Dan Levy",
"content": "Yeah. More so just how much more aggressively you would be willing to sell your cars versus in light of your improvements on FSD."
},
{
"speaker": "Elon Musk",
"content": "Well, right now, the constraint we're trying to solve is battery production as opposed to demand. So, there are -- now Q1, we've got this massive factory retooling for the new Model Y, for example. That obviously has a short-term impact on output. But the problem we are seeing with, in fact, we're talking that the executive team and I were talking about just before this call was we've got to figure out how to increase total gigawatt hours of battery production this year one way or another. That's the constraint on our output."
},
{
"speaker": "Travis Axelrod",
"content": "Great. Alrighty. And with that, I think we are all done for today. So, thanks, everyone, so much for all your questions. We look forward to talking to you next quarter. Thank you very much, and goodbye."
}
] |
tsla | 2,024 | 3 | [
{
"speaker": "Travis Axelrod",
"content": "Good afternoon, everyone, and welcome to Tesla's Third Quarter 2024 Q&A webcast. My name is Travis Axelrod, Head of Investor Relations, and I am joined today by Elon Musk, Vaibhav Taneja and a number of other executives. Our Q3 results were announced at about 3 P.M. Central Time in the update deck we published at the same link as this webcast. During this call, we will discuss our business outlook and make forward-looking statements. These comments are based on our predictions and expectations as of today. Actual events or results could differ materially due to a number of risks and uncertainties, including those mentioned in our most recent filings with the SEC. During the question-and-answer portion of today's call, please limit yourself to one question and one follow-up. Please use the raise hand button to join the question queue. Before we jump into Q&A, Elon has some opening remarks. Elon?"
},
{
"speaker": "Elon Musk",
"content": "Thank you. So to recap, something that [Indiscernible] the industry I've seen year-over-year declines in order volumes in Q3. Tesla at the same time has achieved record deliveries. In fact, I think if you look at EV companies worldwide to the best of my knowledge, no EV company is even profitable. And I'm not - to the best of my knowledge, there was no EV division of any company, of any existing auto company that is profitable. So it is notable that Tesla is profitable despite a very challenging automotive environment. And this quarter actually is a record Q3 for us. So we produced our 7-millionth vehicle actually just yesterday. So congratulations to the teams that made it happen in Tesla. That's staggeringly immense amount of work to make 7million cars. So, let's see. And we also have the energy storage business is growing like wildfire, with strong demand for both Megapack and Powerwall. And as people know, on October 10th, we laid out a vision for an autonomous future that I think is very compelling. So, the Tesla team did a phenomenal job there with actually giving people an opportunity to experience the future, where you have humanoid robots walking among the crowd, not with a canned video presentation or anything, but literally walking among the crowd, serving drinks and whatnot. And we had 50 autonomous vehicles. There were 20 Cybercabs, but there were an additional 30 Model Ys operating fully autonomously the entire night, carrying thousands of peoples [Indiscernible] with no incidents, the entire night. So -- and for those who went there that -- it's worth emphasizing that these the Cybercab had no steering wheel or brake or accelerator pedals. Meaning, there was no -- there's no -- there was no way for anyone to intervene manually even if they wanted to. And the whole night went very smoothly. So, regarding the vehicle business, we are still on-track to deliver more affordable models starting in the first half of 2025. This is I think probably people are wondering what should they assume for vehicle sales growth next year. And at the risk of - to take a bit of risk here, I do want to give some rough estimate, which is I think it's 20% to 30% vehicle growth next year. Notwithstanding negative external events, like if there's some force majeure events, like some big war breaks out or interest rates go sky high or something like that, then we can't overcome massive force majeure events. But I think with our lower cost vehicles with the advent of autonomy something like a 20% to 30% growth next year is my best guess. And then Cybercab reaching volume production in ’26. I do feel confident of Cybercab reaching volume production in ‘26. So just starting production, reaching volume production in ‘26. And that's -- that should be substantial. And we're aiming for at least 2 million units a year of Cybercab. That'll be in more than one factory, but I think it's at least 2 million units a year, maybe 4 million ultimately. So, yeah, these are just my best guesses, but if you ask me my best guesses, that those are my best guesses. The cell 4680 lines, the team is actually doing great work there. The 4680 is rapidly approaching the point where it is the most competitive set. So when you consider the fully landed - the cost of a battery pack, fully landed in the U.S. net of incentives and duties, the 4680 is tracking to be the most competitive. Meaning lower cost [Indiscernible] considered than any other alternative. We're not quite there yet, but we're close to being there, which I think is, extremely exciting. And we've got several - a lot of ideas to go well beyond that. So if I think there's -- if we execute well, the 4680 will have the -- Tesla internally produced cell will be the most cost competitive cell in North America, a testament to a tremendous amount of hard work there by the team. So that's - we'll continue to buy a lot of cells from our competitors. Our intent is not to make to provide to make cells just internally. So I don't want to set off any alarm bells here. We're also increasing substantially our vehicle output and our stationary storage output. So we need a lot of cells. And most of them will still come from suppliers, but I think it is some good news that the Tesla internal cell is likely - is tracking to be the most competitive in the U.S. So with respect to autonomy, as people are experiencing in the cars, really from week-to-week, there are significant improvements in the miles between interventions. So with the new version 12.5, release of full self-driving in Cybertruck, combining the code into a single stack so that the, city driving and the entering the highway driving are one stack, which is a bigger burden for the highway driving. So it's just all neural nets. And the release of Actually Smart Summon. We're trying to have a sense of humor here. And we're also -- so that that's 12.5. Version 13 of FSD is going out soon. Ashok will elaborate more on that later in the call. We expect to see some roughly a 5 or 6 fold improvement in miles between interventions compared to 12.5. And looking at the year as a whole, the improvement in miles between interventions, we think will be at least three orders of magnitude. So that's a very dramatic improvement in the course of the year. And we expect that trend to continue next year. So, the current internal expectation for the Tesla FSD having longer miles between intervention than human is the second quarter of next year, which means it may end up being the third quarter, but it's next - it seems extremely likely to be next year. Ashok. Do you want to add anything?"
},
{
"speaker": "Ashok Elluswamy",
"content": "Yeah. miles between critical interventions, yep, like you mentioned, Elon, we already made a 100x improvement with 12.5 from starting of this year. And then with v13 release, we expect to be a 1000x from the beginning - from January of this year on production [Indiscernible] software. And this came in because technology improvements going to end-to-end, having higher frame rate, partly also helped by hardware force, more capabilities, so on. And we hope that we continue to scale the neural network, the data, the training compute, et cetera. By Q2 next year, we should cross over the average human miles per critical intervention, call it collision in that case."
},
{
"speaker": "Elon Musk",
"content": "I mean, that that's just unvarnishing our internal estimate."
},
{
"speaker": "Ashok Elluswamy",
"content": "Yes. Yeah."
},
{
"speaker": "Elon Musk",
"content": "So, that's not sandbagging or anything else. Our internal estimate is Q2 of next year to be safer than human and then to continue with rapid improvements, thereafter. So, a vast majority of humanity has no idea that Teslas drive themselves. So especially for something like a Model 3 or Model Y, it looks like a normal car. So you don't expect normal car to be able to be intelligent enough to drive itself. The Cybercab looks different. Cybertruck looks different. But Model Y and Model 3 look, they're good looking cars, but look, I think, look fairly normal. You don't expect a fairly normal looking car to have the intelligence enough AI to be able to drive itself, but it does. So we do want to expose that to more people. And so we're doing every time we have, a significant improvement in the software, we'll roll out another sort of 30 day trial. So to encourage people to try it again. And we are seeing a significant improvement in adoption. So the take rate for FSD has improved substantially especially after the 10/10 event. So there's no need to wait for a robo-taxi or Cybercab to experience full autonomy. We expect to achieve that next year with the -- with our existing vehicle line."
},
{
"speaker": "Ashok Elluswamy",
"content": "One point Actually Smart Summon gives a small taste of what it's going to look like, the car able to drive itself to the user within private parking lots. Currently, it's speed limited, but then it's going to quickly be increased. And we already had more than 1 million usage [Indiscernible] of Smart Summon."
},
{
"speaker": "Elon Musk",
"content": "Yep. So, and we actually we have, for Tesla employees in the Bay Area, we already are offering a ride-hailing capability. So you can actually with the development app, you can request a ride, and it'll take you anywhere in the Bay Area. We do have a safety driver for now, but the software required to do that, we've developed and I mean, David, do you want to elaborate on that?"
},
{
"speaker": "Unidentified Company Representative",
"content": "Yeah. Sure. David, we showed some screenshots of this in the Q1 shareholder deck. And, yeah, this is real. We've been testing it for the better part of the year and, the building blocks that we needed in order to build this functionality and deliver it to production, we've been thinking about working on for years. It just so happens that we've used those building blocks to deliver great features for our customers in the meantime, such as sharing your profile, synchronizing it across cars, so that every single car that you jump into, whether it's another car that you own or a car that somebody's loaned to you or a rental car that you jump into, it looks exactly like yours. Everything's synchronized, seat mirror positions, media navigation, everything is the same. Just what you would expect from, one of our robotaxis. But we gave that functionality to our customers right now because we built it intending for it to be used in the future. We’re releasing that functionality now. All the -- and then cybersecurity that we knew we were going to need to deliver that functionality, sending a navigation to destination from your phone to the vehicle, and so we’re doing that now with the ride-hailing app, but it's something that we've made available to customers for years. Seeing the progress on route in the mobile app, that's something you'll need for the ride-hailing app. But again, we released it in the meantime. So it's not like we're just starting to think about this stuff right now while we're building out the early stages of our ride-hailing network. We've been thinking about this for quite a long time, and we're excited to get the functionality out there."
},
{
"speaker": "Elon Musk",
"content": "Yeah. And we do expect to roll out ride-hailing in California, Texas next year to the public. But not the California is somewhat there's quite a long regulatory approval process. I think we should get approval next year, but it's contingent upon regulatory approval. Texas is a lot faster. So it's, I'd say, like, we're -- we'll definitely have available at Texas, and probably have it available in California subject to regulatory approval. And then -- and maybe some other states actually, next year as well, but at least California and Texas. So that'd be very exciting. There's really a profound change. Tesla becomes more than a sort of vehicle and battery manufacturing company, at that point. So we published our Q3 vehicle safety report, which shows one impact for every 7 million miles of autopilot, that compares to the U.S. average of one crash roughly every 700,000 miles. So it's currently showing a 10x safety improvement relative to the U.S. average. And we continue to expand our AI training capacity to accommodate the needs of both FSD and Optimus. We're currently not a training compute constraint. That's probably the biggest factors that the FSD is actually getting so good that it takes us a while to actually find mistakes. And when you start getting to where it could take 10,000 miles to find a mistake, it takes a while to actually figure out which it is -- is this soccer ball better than -- is soccer ball A better than soccer ball B? It actually takes a while to figure it out because neither one of them are making mistakes, or takes take a long time to make mistakes. So that's actually the single [Indiscernible] based on many factors. How long does it take us to figure out which version is better? So that’s sort of high class problem. Obviously, having a giant fleet is very helpful for breaking this out. And then with Optimus, we show a massive improvement in Optimus's dexterity movement on October 10. And our next-gen, hand and forearm, which has 22 degrees of freedom double - which is double the prior hand and forearm, it's extremely human like. And also it's much better tactile sensing. It's really - I feel confident in saying that we have most advanced humanoid robot by long shot. And we're moreover the only company that really has all of the ingredients necessary to scale humanoid robots. Because the things that what other companies are missing is that they're missing the AI brain, and they're missing the ability to really scale to very high volume production. So some have seen some impressive video demos, but what but they’re [lacking is] (ph) localized AI and the [going] (ph) to scale volume to very high numbers. As I've said on a few occasions before, I think Optimus will ultimately be the most valuable product. So I think it has a good chance of being the most valuable product ever made. For the energy business, that's doing extremely well. And there's the opportunity ahead is gigantic. The Lathrop Megapack factory, reached 200 Megapacks a week, which is now a 40 gigawatt hour a year run rate. And, we have a second factory in Shanghai that will begin with a 20 gigawatt hour a year run rate in Q1 next year, so next quarter. And, that will also scale up. It won't be long before, we're shipping a 100 gigawatt hours a year, stationary storage at Tesla. And that'll ultimately grow I think to multiple terawatt hours per year. It has to actually in order to have a sustainable energy future. If you're not at the terawatt scale, you're not really moving the needle. So if you look at our admittedly very complicated last master plan, which I think actually is too much detail. I'll -- maybe I'll ask [Vaibhav] (ph) to analyze it."
},
{
"speaker": "Unidentified Company Representative",
"content": "Sure Elon."
},
{
"speaker": "Elon Musk",
"content": "Can give us the TLDR on the last master plan. But we showed in that last plan that it is possible to take all of us to a fully sustainable energy situation, using sustainable energy power generation and batteries and electric transport. And there are no fundamental material limitations. Like, there's not some very rare material that we don't have enough of on earth. We actually have enough of raw materials to, yeah, take all of human civilization make it fully sustainable. And even if civilization dramatically increased its electricity usage, it would still be fully sustainable. One way to think of the progress of a civilization, it's based out a little esoteric, but is percentage completion of Kardashev scale. So Kardashev Scale 1 would be you're using all the power of a planet. We were we're currently less than 1% on Kardashev Level 1. Level 2 would be using all the power of the sun. And level 3, all the power of the galaxy. So we have a long way to go. Long way to go. When you think in Kardashev terms, it becomes obvious that by far the biggest source of energy is the sun. Everything else is in the noise. So in conclusion, Tesla is focused on building the future of energy, transport, robotics, and AI. And this is a time when others are just focused on managing around near term trends. We think what we're doing is the right approach. And, if we execute on our objectives, then I think we will. Tesla my prediction is Tesla will become the most valuable company in the world and probably by a long by a long shot. I want to thank the Tesla team once again for strong execution in a tough operating environment, and we're looking forward to building, an incredibly exciting future. Thank you."
},
{
"speaker": "Travis Axelrod",
"content": "Great. Thank you very much, Elon. And I'll let Vaibhav pass some more big remarks as well."
},
{
"speaker": "Vaibhav Taneja",
"content": "Yeah. Thanks. Our Q3 results were positive and once again, demonstrate the scale to which businesses evolved. What they use with the generation of record operating cash flows of $6.3 billion. Our automotive revenues grew both quarter-on-quarter, year-on-year. While we had unit volume growth, we did experience reduction in ASPs, primarily due to the impact of financing incentives. As a reminder, we are providing these incentives primarily using third-party banks and financial institution and recognize the cost of these incentives as an upfront reduction to them. We released FSD for Cybertruck and other features like Actually Smart Summon, like Elon talked about in North America, which contributed $326 million of revenues in the quarter. We continue to see elevated levels of regular 2 week credit sales with over $2 billion of revenues so far this year. To expand on this at an industrial level, China continues to outperform U.S. and Europe by a factor of three. And if there is something to be learned from that, this gives a signal of what is to come in other regions. As customers’ acceptance of EV growth. And we feel that is the right strategy to build affordable and more compelling leads. Our focus remains on growing unit volume, while avoiding a build-up of inventory. To support this strategy, we're continuing to offer extremely compelling vehicle financing options in every market. When you compare any vehicle in our lineup with other OEMs, believe our vehicles provide much better value, particularly when you consider the safety features, performance, and unparalleled software functionalities, like David also talked about, include also what, Ashok talked about around autonomy, music options, parental controls, and much more. While every vehicle in our lineup comes up with these capabilities, there is an awareness gap, not just with buyers, but at times, even with existing owners. We plan on making these more visible in our interactions with both existing and future customers. Automotive margins improved quarter over quarter as a result of a 50 features released discussed before. Increase in our overall production and delivery volume, albeit benefit from the marketing pricing, and more localized deliveries in region, which resulted in lower freight and duties. Sustaining these margins in Q4, however, will be challenging given the current economic environment. Note that we are focused on the cost per vehicle, and there are numerous work streams within the company to squeeze that cost without compromising on customer experience."
},
{
"speaker": "Elon Musk",
"content": "Yes. I'm assuming that's a helpful -- hopefully, a helpful macro trend is if there's a decline in in interest rates, this has a massive effect on the, automotive demand. The vast majority of people is or the demand is driven by the monthly payment. Can they put monthly payment? So, like, most likely, we'll see continue to decline interest rates, which helps with affordability vehicles."
},
{
"speaker": "Vaibhav Taneja",
"content": "Yeah. I mean, that is one trend which we observed in the industry that, because of affordability being impacted because of interest rates, People are willing to take cars longer, especially in the U.S. And that is actually having an impact on all our industry too. As we discussed, earlier, as we discussed impact orders, energy deployments fluctuate quarter over quarter due to customer readiness, location of orders being fulfilled, and not necessarily an indicator of demand or production within the quarter. While we did see a decline in Q3, we expect to grow our deployment sequentially in Q4 to end the year with more than doubled of last year. Energy margins in Q3 were a record at more than 30%. This is a function of mix of projects being deployed in the quarter. Note that there will be fluctuation in margins as we manage through deployments and our inventory. Our pipeline and backlog continue to grow quarter over quarter as we fill our 2025 production slots, and we're doing our little best to keep up with the demand. Just coming back on automotive margins, I talked about -- sorry. I talked about what is happening. One other thing which I want to also share is that we're -- that we will continue to keep whatever we can to squeeze like I said before about squeezing out the cost. But this is something which we also are very capable of. I mean, just in Q3, we reached our lowest cost per micro. And that is a trend which we will keep focus on. Then going on to service and other, we continue to show improvements in Q3. This was a result of better performance, both in our service business, which includes collision part sales and merchandise, and continued growth in supercharging. These field based revenues will continue to grow as the overall fleet size increases. Our operating expenses declined quarter over quarter in a year on year basis. This is partially due to the restructuring we undertook in Q2. Cost savings from these initiatives were partially offset by increase in costs related to our AI efforts. We've started using the GPU cluster based out of our factory house and ahead of schedule, and are on track to get 50k GPUs deployed in Texas by the end of this month. One thing which I'd like to elaborate is that we're being very judicious on our AI compute spend too and saying how best we can utilize the existing infrastructure before making further investments. On the CapEx front, we had about $3.5 billion in the quarter. This was a sequential increase largely because of investments in AI compute. We now expect our CapEx for the year to be in excess of $11 billion. We shared our vision for the future at the real world event at the beginning of the month. The Tesla team is hyper focused on delivering on that version, and all efforts are underway to make it a reality. While we've achieved significant progress this year, it will take time to get this as we find a new and incredibly complex technologies and navigate a fragmented regulatory landscape. Future is incredibly bright, and I want to thank the Tesla team once again for all their help."
},
{
"speaker": "A - Travis Axelrod",
"content": "Great. Thank you very much, Vaibhav. Now we'll go to investor questions. The first one is, is Tesla still on track to deliver the more affordable model next year as mentioned by Elon earlier? And how does it align with your AI product roadmap?"
},
{
"speaker": "Lars Moravy",
"content": "Sure. I mean, as Elon and Vaibhav both said, you are in plan, to meet that in the first half of next year. Our mission has always been to lower the cost of our vehicles to increase the adoption of sustainable energy and transport. Part of that is lowering the cost for current vehicles, which is where, all of the personally owned vehicles that we sell today come in. But the next stage in that really is it fits into AI roadmap is when we bring in robotaxis, which lowers the initial cost of getting into an EV. And those -- that's really where we see the marriage of EV road map and the AI road map."
},
{
"speaker": "Elon Musk",
"content": "Yeah. It'll be with incentive sub-30k, which is kind of a key threshold."
},
{
"speaker": "Travis Axelrod",
"content": "Great. Thank you very much. Similar, question next. When can we expect Tesla to give us the $25,000 non-robotaxi regular car model?"
},
{
"speaker": "Elon Musk",
"content": "We're not breaking it on."
},
{
"speaker": "Lars Moravy",
"content": "Yeah. All our vehicles today are road jets."
},
{
"speaker": "Elon Musk",
"content": "I think we've made very clear that, we're the future is autonomous. It I mean, I it's going to be you know, I've actually said this many years ago, but that, in my strong belief, and I believe that is panning out to be true. So and I'll be very obvious in retrospect, is that the future is autonomous electric vehicles, and, non-autonomous gasoline vehicles in the future will be like riding a horse and using a foot bone. It's not that there are no horses. Yeah. There are some horses, but they're unusual. They're niche. And so it just everything's going to be electric autonomous. I think this is like it should be frankly blindingly obvious at this point that that is the future. So a lot of automotive companies or most automotive companies have not internalized this, which is surprising, because we've been shouting this from the rooftops for such a long time, and it will accrue to their detriment in the future. But all of our vehicles in the future will be autonomous. Yes. So all the vehicles that we've really made, all the 7 million vehicles, vast majority are capable of autonomy. And, we're currently making on the order of 35,000 autonomous vehicles a week. Compare that to, say, Waymo's entire fleet is less than – they’ve have less than a 1,000 cars. We make 35,000 a week."
},
{
"speaker": "Lars Moravy",
"content": "Yeah. And our cars look normal."
},
{
"speaker": "Elon Musk",
"content": "Yeah. They mostly look normal. The Cybertruck looks abnormal. And the, Cybercab/robotaxi. We wanted to have something futuristic working. I think it does look futuristic. And it's worth noting with respect to the Cybercab. It's not it's especially not just a revolutionary vehicle design, but a revolution in vehicle manufacturing that is also coming with the Cybercab. The cycle time, like, the, the units per hour of the Cybercab line it is -- like, this is just really something special. I mean, this is probably a yeah. Half order of magnitude better than other car manufacturing lines. Like not in the same league is what I'm saying. Not in the same league. So it's -- and I said, like, several years ago that the -- maybe the most I mean, the hottest Tesla product to copy will be the factory. Just like buy a factory."
},
{
"speaker": "Lars Moravy",
"content": "Yeah. In camera versus near a factory, that's up to my --"
},
{
"speaker": "Elon Musk",
"content": "Yeah. It's like things yeah. So the and as we so we're rapidly evolving and manufacturing technology. So anyway, there's, like, basically, I think having a regular $25,000 model is pointless. Yeah. It would be silly. Like, it'll be completely at odds with what we believe."
},
{
"speaker": "Lars Moravy",
"content": "In autonomous world. But matters as well as cost per mile of efficiency of that vehicle. And that's what we've done with the robotaxi."
},
{
"speaker": "Elon Musk",
"content": "Exactly. Autonomous, it it's fully considered cost per mile, is what matters. And if you try to make a car that is, essentially, a hybrid manual automatic cars. It's not going to be as good as a dedicated autonomous car. So, yeah -- Cybercab is just not going to have steering wheels and pads. It's only designed to optimize for autonomy. But now it'll cost on the order of cost roughly $25,000. So it is a $25,000 car. And you can -- you will be able to buy one on an exclusive exclusively if you want. So just what happens to your mobile phones. You don't need it."
},
{
"speaker": "Travis Axelrod",
"content": "Great. Thank you very much. The next question is, what is Tesla doing to alleviate long wait times at service centers?"
},
{
"speaker": "Unidentified Company Representative",
"content": "So we aim on solving problems at the source, so at the factory before they can even affect our customers. We believe the best service is no service and our heads don't even have them."
},
{
"speaker": "Elon Musk",
"content": "If the car doesn't break, yeah. That's the best thing."
},
{
"speaker": "Unidentified Company Representative",
"content": "Exactly. Don't see any with the test. You either do it remote, yeah fix the issue upstream or do it remotely, do it through software, maybe being at work or at home and car can be parked. And we've addressed fixed the issue, and we've partnered the field with service to make sure we're looking at the same issues. And additionally, just in Q3 Q4 of this year alone, we have opened and will open in total at nearly 70 locations. And in North America, we've significantly expand the size of each location and have doubled the size last year compared to this year."
},
{
"speaker": "Elon Musk",
"content": "Yeah. I think it's, like, actually a lot of merit to having large service centers because you can have specialization of labor. Okay. You can start to approach. Yeah. It should be more factory like, where you can have dedicated lanes for particular types of service. And people and it's way easier for somebody to come expert in a few different types of repairs than in every repair."
},
{
"speaker": "Unidentified Company Representative",
"content": "Exactly. This has helped us with the base set, these heavy repairs clogging up the lane. They've dedicated lanes for different type of repairs. And so it's through a bit massively treating it like a factory."
},
{
"speaker": "Elon Musk",
"content": "Yes. This is where a Tesla structure, I think, a strong advantage relative to the rest of the auto industry because we make the cars and we service the cars, whereas I think there's a bit of a conflict of interest with the dealer model and the traditional OEM and dealer model where the dealerships make most of their money on service. And so they don't -- they obviously assistance to reduce the servicing cost, whereas in our case, we are incented to reduce the service and cost because we carry that servicing cost. And we've got a good feedback with our cars."
},
{
"speaker": "Unidentified Company Representative",
"content": "Exactly. If you were with the factory, with the service leaders together, and send back people from the factories that field to the factory to see it firsthand. Suggestions for manufacturing as well as for engineering on design."
},
{
"speaker": "Elon Musk",
"content": "Yeah. So I view this as a structural -- fundamental structural advantage of Tesla versus the rest of the auto industry."
},
{
"speaker": "Unidentified Company Representative",
"content": "Also do a bunch of work on the software side, not only to automate diagnostics so identifying what needs to be done to a car before it comes into service, but also automating all of the preparation work and aligning all the resources that are necessary in order for the car to be very efficiently worked on once it arrives. So the parts are there, like, the lift is scheduled, the technician's schedule, like, everything that's what I'm saying. This is what's wrong with me, and tells us tell the service center."
},
{
"speaker": "Unidentified Company Representative",
"content": "The car everything ready in the van."
},
{
"speaker": "Elon Musk",
"content": "Yeah. Please fix me and this is what's wrong."
},
{
"speaker": "Unidentified Company Representative",
"content": "This is what I'm trying to do now. This is what I'm trying to do. Yeah."
},
{
"speaker": "Unidentified Company Representative",
"content": "Instead of customer trying to translate the car, it's telling us directly and we're pulling that. Yeah."
},
{
"speaker": "Elon Musk",
"content": "Yeah. You don't need most of the time, you don't need to diagnose the car when it arrives. The car yeah -- this is like, again, a fundamental technology advantage and structural advantage compared to the rest of the auto industry."
},
{
"speaker": "Vaibhav Taneja",
"content": "I think it's underappreciated as to what all we are able to do. And that's why because like you said before, most of our cars, except for Cybertruck, look the same. So people don't realize that it has so much capability."
},
{
"speaker": "Elon Musk",
"content": "Yeah. But, like, that's better than other cars. But they don't, like, obviously, like, super futuristic. Yes."
},
{
"speaker": "Travis Axelrod",
"content": "So yeah. Great. Thank you very much. The next question is, please provide an update on the semi. What will the next stage of growth look like, and when will FSD be ready?"
},
{
"speaker": "Lars Moravy",
"content": "Sure. So as you we posted in earnings back, we're progressing swiftly on the build of the semi factory in there, in our data factory in Reno. We've released all our major capital expenditures for that program, and we're on track to start, pilot builds in the second half of next year with production starting in the first half of 2026 and ramping really throughout the year to full production. Semi, growth will largely depend on our customers' adoption of the product."
},
{
"speaker": "Elon Musk",
"content": "Well, I don't think we're going to be demand limited, honestly."
},
{
"speaker": "Lars Moravy",
"content": "Yeah. Which I was going to say, which is like a brainer for the semi because it's really a commodity of total cost of ownership."
},
{
"speaker": "Elon Musk",
"content": "Yes. Exactly. It's good. We have kind of ridiculous demand for the semi."
},
{
"speaker": "Unidentified Company Representative",
"content": "In that world where it's about how much do I spend to go to excess lanes per mile, it's a no brainer."
},
{
"speaker": "Lars Moravy",
"content": "Yeah. Fundamentally, if you've got a semi where the fully considered cost per mile or per ton of transport, is better than, say, diesel truck, any company that doesn't adopt an electric semi will lose. It's not -- it's not it's not a subjective thing. It's like whether do you like just a competitive I mean, we like, we want the start we want we want to have a good old semi-truck, but frankly, if we made an oxy semi-truck, it wouldn't matter."
},
{
"speaker": "Lars Moravy",
"content": "And this is proving so in our fleets, in in Pepsi's Partner. In fact, the Pepsi actually said last week, they're having nobody want their drivers don't want to go back."
},
{
"speaker": "Elon Musk",
"content": "Yeah. Yeah. As soon as we give anyone the electric semi, it it's like -- that's like the choice."
},
{
"speaker": "Lars Moravy",
"content": "It's the, what they want to drive."
},
{
"speaker": "Elon Musk",
"content": "Yeah. That's like so the -- like the most, like their top drivers will, they get to drive the Tesla Semi. It's, it's, it's the, it's the thing they want to drive."
},
{
"speaker": "Lars Moravy",
"content": "It's super fun to drive. It's also very easy to drive."
},
{
"speaker": "Elon Musk",
"content": "It's easy to drive and it holds ass. It's like fast."
},
{
"speaker": "Lars Moravy",
"content": "Superfast. Maybe too fast."
},
{
"speaker": "Elon Musk",
"content": "Well, but I mean, like, like, ring like this. Like, you've seen, like, the videos of where, like, I think, like, Tesla Electric Semi, like, can go uphill Just pass. Speed speeding past, like, the diesel truck or even cars. So, like, it's responsive. It it's you floor it and that that truck actually hurt."
},
{
"speaker": "Lars Moravy",
"content": "And that's a benefit not only for the driver and for the goods, but also for safety in terms of other drivers on the road. You don't get stuck behind the semi. You're not, like in a slowdown situation in an on ramp. I mean, how that plays into, you know, FSD, which is the second part of the question. All of the semis have been since the couple hundred we've deployed already, and the ones that we'll be building next year and throughout, the future have all the hardware and the cameras necessary to, deploy FSD, and we're currently training with that small fleet that we have. And as soon as the fleet is trained and the neural nets are up, we'll get FSD onto that platform."
},
{
"speaker": "Elon Musk",
"content": "Yeah. I mean, it'd be a massive improvement in, driver fatigue, because, driver safety, we've got sort of the anti-jack knifing software. You don't have to worry about your brakes overheating if you go down a down a steep hill because the -- we use regenerative, like, that that energy goes back into the pack. It's just like it's like radically better than it is in some way. It's what the drivers love it."
},
{
"speaker": "Travis Axelrod",
"content": "Great, guys. Thank you very much. Our next question is, when will Tesla incorporate X and Grok in all of the Tesla vehicles?"
},
{
"speaker": "Elon Musk",
"content": "Well, I mean, these are relatively small things. But, yeah, with the -- I think, we'll keep expanding, what is available in the car on the on screen and also improving the browser. So, just generally, you can access anything you want in the car. In fact, for the Tesla we're scheduled for autonomy. You actually want fully a system that is can do anything. Like, if you want to browse the Internet, if you want to ask AI questions, if you want to watch a movie, if you want to play a video game, if you want to do some productivity thing, you can do anything you want in an autonomous vehicle because you don't need to drive. So that's why the Cybercab got a nice big screen and a great sound system. So you can watch it -- watch a great movie with, it's like being in a Personal movie theater?"
},
{
"speaker": "Unidentified Company Representative",
"content": "This is why we've been building this functionality, adding gaming to the car, adding movies and other, you know, all sorts of different media applications of the car because the cars, that's what you're going to -- that's the cars will be built today."
},
{
"speaker": "Elon Musk",
"content": "There's some fun games, by the way. People haven't tried it. There's Castle Doombad and Polytopia and a bunch of really fun games in the car."
},
{
"speaker": "Unidentified Company Representative",
"content": "Yes. We're constantly looking at what features to add next and we're paying attention to what's most commonly requested by our customers."
},
{
"speaker": "Elon Musk",
"content": "Yes. Play Castle, Doombad. You want --"
},
{
"speaker": "Travis Axelrod",
"content": "Great. Thank you guys very much. The next question is, Elon mentioned unsupervised FSD in California and Texas next year. Does that mean regulators have agreed to it in the entire state for existing Model 3 and 4 vehicles?"
},
{
"speaker": "Elon Musk",
"content": "No. As I said earlier, California lost regulation. But they have a pathway? Yeah. I mean, there's a pathway. Obviously, Waymo operates in California. So there's just a lot of forms but a lot of approvals that are required. I mean, I'd be shocked if we don't get approval next year, but it's just not something we totally control. But I think we will get approval next year, in California and Texas. And for the end of the year, it will branch out be beyond California and Texas."
},
{
"speaker": "Lars Moravy",
"content": "I mean, I think it's important to reiterate this. Like, homogeneity or certifying a vehicle at the federal level in the U.S. is done by meeting FMVSS regulations. All our vehicles today that are produced that are autonomous capable meet all those regulations, cybertruck need those regulations. And so the deployment of the vehicle to the road is not a limitation. What is a limitation is what you said at the state level where they control autonomous vehicle deployment. Some states are relatively easy as you mentioned for Texas. Yeah. And so other ones have in place like California that may take a little longer. Other ones haven't set up anything yet, and so we will work through those state by state."
},
{
"speaker": "Elon Musk",
"content": "I do think we should have a federal, I agree. Like, autonomous vehicles should be approved. They just should be -- it should be possible to."
},
{
"speaker": "Lars Moravy",
"content": "Congress, if you're listening, let's say the federal AV --"
},
{
"speaker": "Elon Musk",
"content": "There should -- there should be a federal approval process for autonomous vehicles. I mean, that's how the FMVSS is worked. Federal Motor Vehicle. The FMBSS is federal."
},
{
"speaker": "Unidentified Company Representative",
"content": "Yeah. So, I mean, in 2017 and ‘18, they we know it's when regulators started looking at it. And it's really kind of stalled since then, but we would appreciate and would support helping out with those regulators."
},
{
"speaker": "Elon Musk",
"content": "It really needs to be a national approval is important. There's department of government efficiency. I'll try to help make that happen. And you said for everyone, not just Tesla, obviously. But just, like some things in the U.S. are state by state regulated for example, insurance. And it's incredibly painful to do it state by state for 50 states. And, I think we should have there should be a natural approval process for autonomy."
},
{
"speaker": "Travis Axelrod",
"content": "Great. Thanks, guys. The next question is, what is the plan for 2025?"
},
{
"speaker": "Elon Musk",
"content": "I mean, who we just talked?"
},
{
"speaker": "Ashok Elluswamy",
"content": "Yeah. Just. We I mean, basically, we talked through this. There's a lot going on. Elon already mentioned that we're working on cheaper models to come out. I mean, there are work which the team is doing to get the factories ready today to try and make that happen on --"
},
{
"speaker": "Elon Musk",
"content": "And by the way, the amount of work required to make a lower cost car is insanely high. But, like, it is harder to get, like, 20% of the cost out of a car than it is to design the car and build the entire factory in the first place. Yeah. It's, like, excruciating. And it's -- and there's not a lot of movies made about the heroes who got 20% of the cost out of a car. But let me tell you, there should be."
},
{
"speaker": "Unidentified Company Representative",
"content": "He's a little changes. And I it's not like a silver."
},
{
"speaker": "Elon Musk",
"content": "Yeah. It's like there should be you the heroes who got 20% cost out of a car is like, damn, I have a lot of respect to them. It was like movie. It's like, I think you probably could make a compelling movie, but I it just no. No. Like, if you actually saw how hard it if people actually saw how hard it was to do that, you'd be like, wow. That's damn hard."
},
{
"speaker": "Unidentified Company Representative",
"content": "Just yesterday we were talking about party."
},
{
"speaker": "Elon Musk",
"content": "Yeah. I mean, honestly, like, literally yeah. I mean, they've been there's a lot of but I do call it sort of like getting cost out of things. It's kind of like it's -- like game of pennies. So it's like game of thrones but pennies. First approximation, if you've got if you've got 10,000 items, in a car, very rough approximation, and each of them cost $4, then you have a $40,000 car. So if you want to make a $35,000 car, you're going to get $0.50 on average out of the 10,000 items."
},
{
"speaker": "Unidentified Company Representative",
"content": "Every part."
},
{
"speaker": "Elon Musk",
"content": "Yeah. And it's like yeah. And then, obviously, the best is you delete some parts. In fact, we've done we have to delete a lot of parts."
},
{
"speaker": "Unidentified Company Representative",
"content": "I'm very excited about the Cybercab design and the well, how we're rethinking the design of a car for the Cybercab, designing it all for high volume production, and then designing machine that builds the machine, that is that I think is also revolutionary. And it's just there's no other car company that's even trying to do what we're doing. Like, I've even heard of it, actually. In fact, I'm certain there is someone like I'm I think this this the new machine that pulls the machine, like, it's inherent it's like the it's put it's designed to be, like, 5x better than a traditional factory. Like, cycle time –"
},
{
"speaker": "Unidentified Company Representative",
"content": "Cycle time and, like, part deletion and shipment. I don't think any other car company has the same level of, like, integration of thought that we have when it comes to, like, when you design a part from a white sheet of paper, who's going to make it? Where is it going to be made? How is it going be shipped? How is it going to be assembled into the vehicle? And, like, at any one point, if something is done in a silo, it becomes a bottleneck of either cost or time or efficiency. But with the robotaxi, the development, like, we've done a good job on the like, combining all that and then, like, blowing up how it's made and saying it should be made this way and rethinking it also. It's the most efficient factory possible. That shows in our -- it will show in our CapEx efficiency when we deploy it. It shows in the number of parts. It shows in the simplicity of the vehicle, but also how it performs in in terms of, like, end user, state."
},
{
"speaker": "Vaibhav Taneja",
"content": "Just to close-up, just on the energy front also in ‘25, we will have started with flashing up mega factory Shanghai. We'll continue to increase our storage deployments with Powerwall 3. We plan to continue expanding our supercharging network, getting more OEMs on our network. 4680 that as Elon talked about. That would keep going. And then, there's we're also we'll have our lithium refinery starting to produce. So there's a lot which is going on."
},
{
"speaker": "Elon Musk",
"content": "Yes, so many things. Like crazy thing is like Tesla is winning basically on almost every single thing we're doing. If we're not running now, we're in a where their entire large companies, that's the only thing they do."
},
{
"speaker": "Vaibhav Taneja",
"content": "Yeah. I mean, it's a company -- there are multiple companies within the company."
},
{
"speaker": "Elon Musk",
"content": "Yeah. Tesla's like many companies in one."
},
{
"speaker": "Travis Axelrod",
"content": "Yeah. Guys, just a few more. What is going on with the Tesla Roadster?"
},
{
"speaker": "Elon Musk",
"content": "Some things. Well, I just thought to go back to our long-suffering deposit holders of the Tesla Roadster. The reason it hasn't come out yet is because it is -- Roadster is not just icing on the cake, it's the cherry on the icing on the cake. And so our larger mission is to accelerate the progress towards a sustainable energy future, trying to do things that maximize probably the future is good for humanity and for Earth. And so that necessarily means that like the things like that are deserved. We'd like -- we'd all love to work on the Tesla -- next-gen -- it is super fun. And we are working on it, but it has to come behind the more things that have a more serious impact on the -- of the world. So just thank you to all our long-suffering Tesla Roadster deposit holders. And we are actually finally making progress on that. And we're close to finalizing the design on it. It's really going to be something spectacular, mind and some like [Peter Telaria] we're really good friends. Peter was lamenting how the future doesn't have flying cars. Well, we'll see. More to come."
},
{
"speaker": "Travis Axelrod",
"content": "Yeah. Thanks very much. The next one is quite similar to other questions you've had. So when I combine it with the final question. So briefly, could you just detail how robotaxi will roll out? Will it start with a Tesla deployed fleet and then allow customers to add theirs on the subscription model, and then we'll Hardware 3 capable of this."
},
{
"speaker": "Ashok Elluswamy",
"content": "Regarding the Hardware 3, what we saw with was, it was easier to make a progress with starting with Hardware 4 and on the solution and backporting to Hardware 3 instead of directly working on Hardware 3 given that Hardware 4 was more like fundamental hardware capabilities. I think that trend will continue into the next few quarters as well by the first solution rapidly with Hardware 4 and then backwardate and it just takes longer to those things because it's not fundamentally supported in the hardware and it's emulated. But yeah, initially working on Hardware 4, backwarding it to Hardware 3."
},
{
"speaker": "Elon Musk",
"content": "Yes. So answer is we're not 100% sure, but as Ashok mentioned, because by some measure, Hardware 4 has really several times the capability of Hardware 3. It's easier to get things to work with then it takes a lot of effort to sort of squeeze that box analyst hat Hardware 3. And there is some chance that Hardware 3 is -- does not achieve the safety level that allows for unsupervised FSD. There was some chance of that. And if that turns out to be the case, we will upgrade those who bought hardware 3 FSD for free. And we have designed the system to be upgradable. So it's and it's really it's really what just to switch sort of switch out the computer type thing. Like, the camera the cameras are yeah. They're capable. But, anyway, we don't we don't actually know the answers to that. But if it does turn out, we will take we'll make sure we take care of those who are bored FSD on Hardware 3."
},
{
"speaker": "Travis Axelrod",
"content": "Great. In the last few minutes that we have left, we will try to get in some analyst questions. The first question will be coming from, Pierre Ferragu at New Street. Pierre, please feel free to unmute yourself."
},
{
"speaker": "Ferragu Pierre",
"content": "Thanks a lot, guys, for taking my question. I was wondering about, like, the compute you're, you're ramping up. So you gave, like, interesting statistics on how much you have, and you said you don't feel your compute's constrained. And I was wondering, how you are putting to work this additional compute. Is that a game for you of creating, like, larger and larger models, like next generation of models that are larger the way OpenAI go from GPT-3 to GPT-4, or is that more like you're set on your model and you need to throw more and more compute to accelerate the pace of learning to improve reliability. And then I had a quick follow-up really quick on your rollout in Texas and in California next year. The plan as you see today, is it to roll out, like, a fleet or two, with, cars that will start with, like, a supervisory, like, some soup onboard supervision, someone, sitting at the wheel just in case and removing the supervisors progressively, or are you aiming for going, free fledged without even a human super supervisor when you get started?"
},
{
"speaker": "Elon Musk",
"content": "Okay. Well, I guess we're going to I'll answer, yeah, the first part of the question. The nature of real world AI is, different from, say, an LLM in that, you have a massive amount of context. So that, like, the you've got, case of Tesla 7 or 8 cameras, that, 9 up to 9 if you include the internal camera that that that so you got gigabytes of context, and that that is then distilled down into a small number of control outputs. Whereas it's like you don't really it's very rare to have in fact, I'm not sure any LLM out there who can do gigabytes of context. And then you've got to then process that in the car with a very small amount of compute power. So, it's all doable and it's happening, but it is a different problem than what, say, a Gemini or OpenAI is doing. And now part of the way you can make up for the fact that the inference computer is quite small is by spending a lot of effort on training. And just like a human, like, you the more you train on something, the less mental workload it takes when you try to -- when you do it, like when the first time like a driving it absolves your whole mind. But then as you train more and more on driving different than the driving becomes a background task. It doesn't -- it only solves a small amount of your mental capacity because you have a lot of training. So we can make up for the fact that the insurance computers -- it's tiny compared to a 10-kilowatt bank of GPUs because you've got a few hundred watts of inference compute. We can make up that with heavy training. So yeah, that's -- and then there's also vast amounts to the actual petabytes of data coming in tremendous. And then sorting out what training is important of the vast amounts of video training video data coming complete what is actually most important for trading. That's quite difficult. But as I said, we're not currently training compute constraint. -- had you want levering"
},
{
"speaker": "Ashok Elluswamy",
"content": "Like you mentioned, the training has both an large models, also the trend quicker. But in the end, we still got to take which models are performing better. So the validation network to picking the models because as mentioned this pretty large. We had to drive a lot of miles going close to. We do have simulation and other ways to get those metrics. Those two help, but in the end, that's a big bottleneck. That's why we're not trying to compete constraint alone. And there's other access of scaling as well, which is a data figuring office as more useful. That is an important as focusing on that."
},
{
"speaker": "Unidentified Company Representative",
"content": "Yeah. So as it relates to the second part of your question, Pierre, about safety drivers and rolling it out. Each state has different requirements in terms of how many miles and how much time you need to have a safety driver and not have a safety driver. We're going to follow all those were not regulations are out there. But safety is a priority. But the goal is obviously at when we're ready and safety is there, we'll address from the --"
},
{
"speaker": "Elon Musk",
"content": "Yeah. I mean, I guess like we think that we'll be able to have driverless Teslas during paid rides next year, sometime next year."
},
{
"speaker": "Travis Axelrod",
"content": "All right. Thank you. And our next question comes from Adam Jonas at Morgan Stanley. Adam, please feel free to unmute yourself."
},
{
"speaker": "Adam Jonas",
"content": "Okay, thanks, everybody. I just had a question about the relationship between Tesla and xAI. Many investors are still not clear how the work at xAI is truly beneficial to Tesla. Some even take the view that the two companies may even be in competition with each other in terms of talent and tech and even your time, Elon. So what's your message to investors on that relationship between Tesla and xAI? And where do you see it going over time?"
},
{
"speaker": "Elon Musk",
"content": "Well, I should say that xAI has been helpful to Tesla AI quite a few times in terms of things like scaling it, bought it, like training, just even like recently in the last week or so, improvements in training, where if you're doing a big training one and it fails, be able to continue training and is to recover from a training on has been pretty helpful. But it but there are different problems. xAI is working on artificial general intelligence or artificial super intelligence. Tesla's trying to make autonomous cars and autonomous robots. They're different problems. So, yeah. I mean --"
},
{
"speaker": "Ashok Elluswamy",
"content": "I think we've said this before also. Like, all not all AI is equal. Right? I mean, there's AI is a broad spectrum. And we have our own swim lanes. Here, there are certain things which we can collaborate on if needed, but for the most part, we're solving different issues."
},
{
"speaker": "Elon Musk",
"content": "Yeah. Tesla’s focus on real world data. And like I said, saying it is quite a bit different from an element. Because, like, you have you have massive context in the form of video and some other audio, that's going to be distilled very like, with extremely efficient advanced compute. I do think Tesla's the most efficient, in the world in terms of inference compute. Like, because out of necessity, we have to we have to be very good at in in efficient inference. We can't pretend 10 kilowatts of GPUs in a car. We've got a couple 100 watts. So, it's pretty well designed Tesla AI chip, but it's still a couple 100 ones. But there are different problems. I mean, this is, like, the stuff that I said is, like, we're going to running in burns. I mean, it's it is running in burns. Like, answering persons, answering questions on a 10 kilowatt rack. It's like, yeah. Put that in the car. It's a different file. No. Exactly. So, xAI is because I felt there wasn't there wasn't a truth seeking digital super intelligence company out there. Like, that's what it came down to. Like, they needed to be a truth seeking like, an AI company that is very rigorous about, being truthful. So I'm not saying xAI is perfect, but that is but that is at least the explosive aspiration. Even if something is politically incorrect, it should still be truthful. I think this is very important for AI safety. So anyway, I think AI, xAI will it has been helpful to Tesla and will continue to be helpful to Tesla, but they are very different problems. Great. And, I mean, like, if you it also thinking like, what is like, what other car company has that -- has a world class trip design team? Like 0. What other car company has a world class AI team like Tesla does? 0. Those were all startups. They're created from scratch."
},
{
"speaker": "Travis Axelrod",
"content": "Great. Thank you, Elon. And I think that's unfortunately all the time that we have for today. We appreciate all of your questions, and we look forward to hearing you next quarter. Thank you very much and goodbye."
}
] |
tsla | 2,024 | 2 | [
{
"speaker": "Travis Axelrod",
"content": "Good afternoon, everyone and welcome to Tesla's Second Quarter 2024 Q&A Webcast. My name is Travis Axelrod, Head of Investor Relations and I’m joined today by Elon Musk, Vaibhav Taneja, and a number of other executives. Our Q2 results were announced at about 3.00 p.m. Central Time and the Update Deck we published at the same link as this webcast. During this call, we will discuss our business outlook and make forward-looking statements. These comments are based on our predictions and expectations as of today. Actual events or results could differ materially due to a number of risks and uncertainties, including those mentioned in our most recent filings with the SEC. During the question-and-answer portion of today's call, please limit yourself to one question and one follow-up. Please use the raise hand button to join the question queue. Before we jump into Q&A, Elon has some opening remarks. Elon?"
},
{
"speaker": "Elon Musk",
"content": "Thank you. So to recap, we saw large adoption exploration in EVs, and then a bit of a hangover as others struggle to make compelling EVs. So there are quite a few competing electric vehicles that have entered the market. And mostly they’ve not done well, but they’ve discounted their EVs very substantially, which has made it a bit more difficult for Tesla. We don’t see this as long-term issue, but really -- fairly short-term. And we still obviously firmly believe that EVs are best for customers and that the world is headed for a fully electrified transport, not just the cars, but also aircrafts and boats. Despite many challenges the Tesla team did a great job executing and we did achieve record quarterly revenues. Energy storage deployments reached an all-time high in Q2, leading to record profits for the energy business. And we are investing in many future projects, including AI training and inference and great deal of infrastructure to support future products. We won't get too much into the product roadmap here, because that is reserved for product announcement events. But we are on track to deliver a more affordable model in the first half of next year. The big -- really by far the biggest differentiator for Tesla is autonomy. In addition to that, we've scale economies and we're the most efficient electric vehicle producer in the world. So, this, anyway -- while others are pursuing different parts of the AI robotic stack, we are pursuing all of them. This allows for better cost control, more scale, quicker time to market, and a superior product, applying not to -- not just to autonomous vehicles, but to autonomous humanoid robots like Optimus. Regarding Full Self-Driving and Robotaxi, we've made a lot of progress with Full Self-Driving in Q2 and with version 12.5 beginning rollout, we think customers will experience a step change improvement in how well supervised full self-driving works. Version 12.5 has 5x the parameters of 12.4 and will finally merge the highway and city stacks. So the highway stack is still at this point is pretty old. So often the issues people encounter are on highway, but with 12.5, we are finally merged the two stacks. I still find that most people actually don't know how good the system is, and I would encourage anyone to understand the system better, to simply try it out and let the car drive you around. One of the things we're going to be doing just to make sure people actually understand the capabilities of the car is when delivering a new car and when picking up a car for service to just show people how to use it and just drive them around the block. Once people use it at all they tend to continue using it. So it's very compelling. And then this I think will be a massive demand driver, even unsupervised full self-driving will be a massive demand driver. And as we increase the miles between intervention, it will transition from supervised full self-driving to unsupervised full self-driving, and we can unlock massive potential in [V3] (ph). We postponed the sort of Robotaxi the sort of product unveil by a couple of months where it were -- it shifted to 10/10 to the 10th October -end because I wanted to make some important changes that I think would improve the vehicle -- sort of Robotaxi, the thing that we are -- the main thing that we are going to show and we are also going to show off a couple of other things. So moving it back a few months allowed us to improve the Robotaxi as well as add in a couple other things for the product unveil. We're also nearing completion of the South expansion of Giga Texas, which will house our largest training cluster to date. So it will be an incremental for 50,000 H100s plus 20,000 of our hardware 4 AI5 Tesla AI computer. With Optimus, Optimus is already performing tasks in our factory. And we expect to have Optimus production Version 1 in limited production starting early next year. This will be for Tesla consumption. It's just better for us to iron out the issues ourselves. But we expect to have several thousand Optimus robots produced and doing useful things by the end of next year in the Tesla factories. And then in 2026, ramping up production quite a bit, and at that point we'll be providing Optimus robots to outside customers. That will be Production Version 2 of Optimus. For the energy business, this is growing faster than anything else. This is -- we are really demand constrained rather than production constrained. So we are ramping up production in our U.S. factory as well as building the Megapack factory in China that should roughly double our output, maybe more than double -- maybe triple potentially. So in conclusion, we are super excited about the progress across the board. We are changing the energy system, how people move around, how people approach the economy. The undertaking is massive, but I think the future is incredibly bright. I really just can't emphasize just the importance of autonomy for the vehicle side and for Optimus. Although the numbers sound crazy, I think Tesla producing at volume with unsupervised FSD essentially enabling the fleet to operate like a giant autonomous fleet. And it takes the valuation, I think, to some pretty crazy number. ARK Invest thinks, on the order of $5 trillion, I think they are probably not wrong. And long-term Optimus, I think, it achieves a valuation several times that number. I want to thank the Tesla team for a strong execution and looking forward to exciting years ahead."
},
{
"speaker": "Travis Axelrod",
"content": "Great. Thank you very much, Elon, and Vaibhav has opening remarks as well."
},
{
"speaker": "Vaibhav Taneja",
"content": "Thanks. As Elon mentioned, the Tesla team rose to the occasion yet again and delivered on all fronts with some notable records. In addition to those records, we saw our automotive deliveries go sequentially. I would like to thank the entire Tesla team for their efforts in delivering a great quarter. On the auto business front, affordability remains a top of mind for customers, and in response in Q2, we offered attractive financing options to offset sustained high interest rates. These programs had an impact on revenue per unit in the quarter. These impacts will persist into Q3 as we have already launched similar programs. We are now offering extremely competitive financing rates in most parts of the world. This is the best time to buy a Tesla, I mean, if you are waiting on the sidelines, come out and get your car. We had a record quarter on regulatory credits, revenues, and as well. On net, our auto margins remained flat sequentially. It is important to note that the demand for regulatory credits is dependent on other OEMs plans for the kind of vehicles they are manufacturing and selling as well as changes in regulations. We pride ourselves to be the company with the most American-made cars and are continuing our journey to further localize our supply chain, not just in the U.S., but in Europe and China as well for the respective factories. As always, our focus is on providing the most compelling products at a reasonable price. We have stepped up our efforts to provide more trims that have estimated range of more than 300 miles on a single charge. We believe this, along with the expansion of our supercharging network, is the right strategy to combat range anxiety. Since the revision of FSD pricing in North America, we've seen production rates increase meaningfully and expect this to be a driver of vehicle sales as the feature set improves further. Cost per vehicle declined sequentially when we removed the impact of Cybertruck. While we are experiencing material costs trending down, note that there is latency on the cost side and such reductions would show up in the P&L when the vehicles built with these materials get delivered. Additionally, as we get into the second half of the year, it is important to note that we are still ramping Cybertruck and Model 3 and are also getting impacted by varying amounts of tariffs on both raw materials and finished goods. While our teams are working feverishly to offset these, unfortunately it may have an impact on the cost in the near-term. We previously talked about the potential of the energy business and now feel excited that the foundation that was laid over time is bearing the expected results. Energy storage deployments more than doubled with contribution not just from Megapack, but also Powerwall, resulting in record revenues and profit for the energy business. Energy storage backlog is strong. As discussed before, deployments will fluctuate from period to period with some quarters seeing large increases and others seeing a decline. Recognition of storage gigawatt hours is dependent on a variety of factors, including logistics timing as we send units from a single factory to markets across the world, customer readiness and in case of EPC projects on construction activities. Moving on to the other parts of the business, service and other gross profits also improved sequentially from the improvement in service utilization and growth in our collision repair business. The impact of our recent reorg is reflected in restructuring other - on the income statement. Just to level set, this was about $622 million of charge, which got recorded in the period. And I want people to remember that we've called it out separately on the financials. Sequentially, our operating expenses excluding surcharges reduced despite an increase in spend for AI-related activities and higher legal and other costs. On the CapEx front, while we saw a sequential decline in Q2, we still expect the year to be over $10 billion in CapEx as we increase our spend to bring a 50k GPU cluster online. This new cluster will immensely increase our capabilities to scale FSD and other AI initiatives. We reverted to positive free cash flow of $1.3 billion in Q2. This was despite restructuring payments being made in the quarter and we ended the quarter with over $30 billion of cash and investments. Once again, we've begun the journey towards the next phase for the company with the building blocks being placed. It will take some time, but will be a rewarding experience for everyone involved. Once again, I would like to thank the entire Tesla team for their efforts."
},
{
"speaker": "A - Travis Axelrod",
"content": "Great. Thank you very much, Vaibhav. Now let's go to investor questions. The first question is, what is the status on the Roadster?"
},
{
"speaker": "Elon Musk",
"content": "With respect to Roadster, we've completed most of the engineering. And I think there's still some upgrades we want to make to it, but we expect to be in production with Roadster next year. It will be something special, like the whole thing [Indiscernible]."
},
{
"speaker": "Travis Axelrod",
"content": "Fantastic. The next question is about timing of Robotaxi event, which we've already covered. So we'll go to the next question, when do you expect the first Robotaxi ride?"
},
{
"speaker": "Elon Musk",
"content": "I guess that, that's really just a question of when can we expect the first -- or when can we do unsupervised full self-driving. It's difficult, obviously, my predictions on this have been overly optimistic in the past. So I mean, based on the current trend, it seems as though we should get miles between interventions to be high enough that -- to be far enough in excess of humans that you could do unsupervised possibly by the end of this year. I would be shocked if we cannot do it next year. So next year seems highly probable to me based on [quite simply] (ph) plus the points of the curve of miles between intervention. That trend exceeds humans for sure next year, so yes."
},
{
"speaker": "Travis Axelrod",
"content": "Thank you very much. Our third question is, the Cybertruck is an iconic product that wows everyone who sees it. Do you have plans to expand the cyber vehicle lineup to a cyber SUV or cyber van?"
},
{
"speaker": "Elon Musk",
"content": "I think we want to limit product announcements to when we have a special -- specific product announcement event, rather than earnings calls."
},
{
"speaker": "Travis Axelrod",
"content": "Great, thank you. Our next question is, what is the current status of 4680 battery cell production and how is the ramp up progressing?"
},
{
"speaker": "Lars Moravy",
"content": "Yes, 4680 production ramped strongly in Q2, delivering 51% more cells than Q1 while reducing COGS significantly. We currently produce more than 1,400 Cybertrucks of 4680 cells per week, and we'll continue to ramp output as we drive cost down further towards the cost parity target we set for the end of the year. We've built our first validation Cybertruck with dry cathode process made on our mass production equipment, which is a huge technical milestone and we're super proud of that. We're on track for production launch with dry cathode in Q4, and this will enable cell cost to be significantly below available alternatives, which was the original goal of the 4680 program."
},
{
"speaker": "Travis Axelrod",
"content": "Great. Thank you very much. The next question is any update on Dojo?"
},
{
"speaker": "Elon Musk",
"content": "Yes, so Dojo, I should preface this by saying I'm incredibly impressed by NVIDIA's execution and the capability of their hardware. And what we are seeing is that the demand for NVIDIA hardware is so high that it's often difficult to get the GPUs. And there just seems this, I guess I'm quite concerned about actually being able to get state-of-the-art NVIDIA GPUs when we want them. And I think this therefore requires that we put a lot more effort on Dojo in order to have -- in order to ensure that we've got the training capability that we need. So we are going to double down on Dojo, and we do see a path to being competitive with NVIDIA with Dojo. And I think we kind of have no choice because the demand for NVIDIA is so high and the -- it's obviously their obligation essentially to raise the price of GPUs to whatever the market will bear, which is very high. So, I think we've really got to make Dojo work and we will."
},
{
"speaker": "Travis Axelrod",
"content": "Right. The next question is what type of accessories will be offered with Optimus?"
},
{
"speaker": "Elon Musk",
"content": "There's -- Optimus is intended to be a generalized humanoid robot with a lot of intelligence. So it's like saying what kind of accessories will be offered with a human. It's just really intended to be able to be backward compatible with human tasks. So it would use any accessories that a human would use. Yes."
},
{
"speaker": "Travis Axelrod",
"content": "Thank you. The next question is, do you feel you're cheating people out of the joys of owning a Tesla by not advertising?"
},
{
"speaker": "Elon Musk",
"content": "We are doing some advertising, so, want to say something?"
},
{
"speaker": "Vaibhav Taneja",
"content": "Yes, I would say something. Our fundamental belief is that we need to be providing the best products at a reasonable price to the consumers. Just to give you a fact, in U.S. alone in Q2, over two-thirds of our sales were to -- deliveries were to people who had never owned a Tesla before and which is encouraging. We've spent money on advertising and other awareness programs and we have adjusted our strategy. We're not saying no to advertising, but this is a dynamic play and we know that we have not exhausted all our options and therefore plan to keep adjusting, but in the latter half of this year as well."
},
{
"speaker": "Travis Axelrod",
"content": "Great. Thank you very much. The next question is on energy growth, which we already covered in opening remarks, so we'll move on to the next one. What is the updated timeline for Giga Mexico and what will be the primary vehicles produced initially?"
},
{
"speaker": "Elon Musk",
"content": "Well, we currently are paused on Giga Mexico. I think we need to see just where things stand after the election. Trump has said that he will put heavy tariffs on vehicles produced in Mexico. So it doesn't make sense to invest a lot in Mexico if that is going to be the case. So we kind of need to see where the things play out politically. However, we are increasing capacity at our existing factories quite significantly. And I should say that the Cybertaxi or Robotaxi will be produced here at our headquarters at Giga Texas."
},
{
"speaker": "Travis Axelrod",
"content": "All right. Thank you."
},
{
"speaker": "Elon Musk",
"content": "And as well Optimus towards the end of next year for Optimus production Version 2, the high volume version of Optimus will also be produced here in Texas."
},
{
"speaker": "Travis Axelrod",
"content": "Great. Thank you. Just a couple more. Is Tesla still in talks with an OEM to license FSD?"
},
{
"speaker": "Elon Musk",
"content": "There are a few major OEMs that have expressed interest in licensing Tesla full self-driving. And I suspect there will be more over time. But we can't comment on the details of those discussions."
},
{
"speaker": "Travis Axelrod",
"content": "All right. Thank you. And the last one, any updates on investing in xAI and integrating Grok into Tesla software?"
},
{
"speaker": "Elon Musk",
"content": "I should say Tesla is learning quite a bit from xAI. It's been actually helpful in advancing full self-driving and in building up the new Tesla data center. With -- regarding investing in xAI, I think, we need to have a shareholder approval of any such investment. But I'm certainly supportive of that if shareholders are, the group -- probably, I think we need a vote on that. And I think there are opportunities to integrate Grok into Tesla's software, yes."
},
{
"speaker": "Travis Axelrod",
"content": "All right. Thanks very much. And now we will move on to analyst questions. The first question comes from Will Stein from Truist. Will, please go ahead and unmute yourself."
},
{
"speaker": "Will Stein",
"content": "Great. Thanks so much for taking my question. And this relates a little bit to the last one that was asked. Elon, I share your strong enthusiasm about AI and I recognize Tesla's opportunity to do some great things with the technology. But there are some concerns I have about Tesla's commercialization and that's what I'd like to ask about specifically. There were some news stories through the quarter that indicated that you redirected some AI compute systems that were destined for Tesla instead to xAI or perhaps it was to X, I'm not sure. And similarly, a few quarters ago, if you recall, I asked about your ability to hire engineers in this area, and you noted that there was a great desire for some of these engineers to work on projects that you were involved with, but some of them weren't at Tesla, they were instead at xAI or perhaps even X again. So the question is, when it comes to your capital investments, your AI R&D, your AI engineers, how do you make allocation decisions among these various ventures and how do you make Tesla owners comfortable that you're doing it in a way that really benefits them? Thank you."
},
{
"speaker": "Elon Musk",
"content": "Yes, I mean, I think you're referring to a very -- like an old article, regarding GPUs. I think that's like 6 or 7 months old. At Tesla, we had no place to try them on, so it would've been a waste of Tesla capital because we would just have to order H100 and have no place to try them on. So it was just -- there was -- this wasn't a, let's pick xAI of Tesla. There's -- there was no -- the Tesla data centers were full. There was no place to actually put them. The -- we've been working 24/7 to complete the South extension on the Tesla Giga factory in Texas. That South extension is what will house 50,000 H100s and we're beginning to move the H100 server racks into place there. But we really needed -- we needed that to complete physically. You can't just order compute -- order GPUs and turn them on, you need a data center, it's not possible. So I want to be clear, that was in Tesla's interest, not contrary to Tesla's interest. Does Tesla no good to have GPUs that it can't turn on. That South extension is able to take GPUs, which is really just this week. We are moving the GPUs in there and we'll bring them online. With regard to xAI, there are a few that only want to work on AGI. So what I was finding was that when trying to recruit people to Tesla, they were only interested in working on AGI and not on Tesla's specific problems and they want to start -- do a start-up. So it was a case of either they go to a start-up or -- and I am involved or they do a start-up and I am not involved. Those are the two choices. This wasn't they would come to Tesla. They were not going to come to Tesla under any circumstances. So, yes."
},
{
"speaker": "Vaibhav Taneja",
"content": "Yes, I mean, I would even add that AI is a broad spectrum and there are a lot of things which we are focused on full time driving as Tesla and also Optimus, but there's the other spectrum of AI which we're not working on, and that's the kind of work which other companies are trying to do in this case, xAI. So you have to keep that in mind that it's a broad spectrum. It's not just one specific thing."
},
{
"speaker": "Elon Musk",
"content": "Yes. And once again, I want to just repeat myself here. I tried to recruit them to Tesla, including to say like, you can work on AGI, I if you want and they refused. Only then was xAI created."
},
{
"speaker": "Will Stein",
"content": "I really appreciate that clarification. If I can ask one follow-up, it relates to the new vehicles that you're planning to introduce next year. I understand this is not the venue for product announcements, but when we think about the focus, I've heard on the one hand that the focus is on cost reduction. On the other hand, you also said that the Roadster would come out. Should we expect other maybe more limited variants like, similar to the cars that you make today, but with some changes or improvements or different, some other variability in the form factors. It should -- we expect that to be a significant part of the strategy in the next year or two?"
},
{
"speaker": "Elon Musk",
"content": "I don't want to get into details of product announcements. And we have to be careful of the Osborne effect here. So, if you start announcing some great thing, it affects our near-term sales. We're going to make great products in future just like we have in the past, end of story."
},
{
"speaker": "Travis Axelrod",
"content": "Right. The next question comes from Ben Kallo from Baird. Ben, please go ahead and unmute yourself."
},
{
"speaker": "Ben Kallo",
"content": "Hi. Thanks for taking my question. When we think about revenue contribution and with energy growing so quickly and Optimus on the come, how do we think about the overall segments longer term? And then do you think that auto revenue will fall below 50% of your overall revenue? And then my follow-up is just on the last call you talked about, distributed compute on your new hardware. Could you just update us and talk a little bit more about that, the timeline for it and how you would reward customers for letting you use their compute power and their cars? Thanks."
},
{
"speaker": "Elon Musk",
"content": "Yes, I mean, as I've said a few times, I think the long-term value of Optimus will exceed that of everything else that Tesla combined. So, it's simply -- just simply consider the usefulness utility of a humanoid robot that can do pretty much anything you ask of it. I think everyone on earth is going to want one. There's 8 billion people on earth, so it's 8 billion right there. Then you've got, all of the industrial uses, which is probably at least as much, if not way more. So I suspect that the long-term demand for general purpose humanoid robots is in excess of 20 billion units. And Tesla is -- that has the most advanced humanoid robot in the world, and is also very good at manufacturing, which these other companies are not. And we've got a lot of experience -- with the most experienced with the world leaders in real world AI. So we have all of the ingredients. I think we are unique in having all of the ingredients necessary for large scale, high utility, generalized humanoid robots. That's why my rough estimate long-term is in accordance with the ARK [ph] Invest analysis of market cap on the order of $5 trillion for -- maybe more for autonomous transport, and it's several times that number for general purpose humanoid robots. I mean, at that point, I'm not sure what money even means, but in the benign AI scenario, we are headed for an age of abundance where there is no shortage of goods and services. Anyone can have pretty much anything they want. It's a wild -- very wild future we're heading for."
},
{
"speaker": "Ben Kallo",
"content": "On the distributed compute?"
},
{
"speaker": "Elon Musk",
"content": "Yes, distributed compute, that seems like a pretty obvious thing to do. I think the -- where this distributed compute becomes interesting is with our next generation Tesla AI truck, which is hardware viable or what we're calling AI5, which is -- from the standpoint of inference capability comparable toB200 -- and a bit of B200. And we are aiming to have that in production at the end of next year and scale production in '26. So it just seemed like if you've got -- even if you've got autonomous vehicles that are operating for 50 or 60 hours a week, there's a 168 hours in a week. So you have somewhere above I think a 100 [indiscernible] net computing. I think we need a better word than GPU because GPU means graph express in unit. So there's a 100 hours plus per week of AI compute, AI advanced compute from the fleet, from the vehicles and probably some percentage from the humanoid robots that it would make sense to do distributed inference. And if you're -- if there's a fleet of at some point a 100 million vehicles with AI5 and beyond, because you have AI 6 and 7 and whatnot, and there may be billions of humanoid robots that is just a staggering amount of inference compute or that could be used for general purposes at computing. It doesn't have to be used for, the humanoid robot or for the car. So I think, that's just -- that -- that's a pretty obvious thing to say, like, well, it's more useful than having to do nothing."
},
{
"speaker": "Travis Axelrod",
"content": "All right. Thank you. The next question comes from Alex Potter from Piper Alex. Alex, please go ahead and unmute yourself."
},
{
"speaker": "Alex Potter",
"content": "Perfect. Thanks. I wanted to ask a question on FSD licensing. You mentioned that in passing previously, was just wondering if you can elaborate maybe on the mechanics of how that would work. I guess presumably this would not be some sort of simple plug and play proposition that presumably an OEM would need, I don't know, several years to develop its own vehicle platform that's based on FSD. I imagine they would need to adopt Tesla's electrical architecture, compute, sensor stack. So I, correct me if I'm sort of misunderstanding this, but if you had a cooperative agreement of some kind with another OEM, then presumably it would take you several years before you'd be able to recognize licensing revenue from that agreement. Is that the right way to think about that?"
},
{
"speaker": "Elon Musk",
"content": "Yes. The OEMs not real fast. There's not really a sensor suite, it's just cameras. But they would have to integrate our AI computer and have cameras with a 360 degree view. And at least the gateway, like the what talks to the internet, and communicates with the Tesla system, what that you need kind of a gateway computer too. So it's really gateway computer with the cellular and Wi-Fi connectivity, the Tesla AI computer, and seven cameras, or not cameras, again, a 360 degree view. But this will -- given the speed at which, the auto industry moves, it would be several years before you would see this in volume."
},
{
"speaker": "Alex Potter",
"content": "Okay, good. That's more or less what I expected. So then the follow-up here is, if you did sign an FSD licensing agreement with another automaker, when do you think you would disclose that? Would you do it right when you signed the agreement or only after that multiple years has passed and the vehicle is ready to be rolled out? think it depends on the OEM. I guess we'd be happy either way. Yes, it depends on, what kind of arrangement we enter into. A lot of those things are, we are not resolved yet, so we'll make that determination as and when we get to that point."
},
{
"speaker": "Elon Musk",
"content": "And the kind of deals that are obviously relevant are only if, some OEM is willing to do this in a million cars a year or something significant. It's not -- if it's like 10,000 or a 100,000 cars a year. We can just make that ourselves."
},
{
"speaker": "Travis Axelrod",
"content": "All right, thank you. The next question comes from Dan Levy from Barclays. Dan, please go ahead and unmute yourself."
},
{
"speaker": "Dan Levy",
"content": "Hi, good evening. Thanks for taking the questions. First, wanted to start with a question on Shanghai. You've leveraged Shanghai as an export center really due its low cost, and that makes sense. But maybe you can just give us a sense of, of how the strategy changes, if at all, given, the implementation of tariffs in Europe. Also to what extent, your import of batteries from China into the U.S., how that might change given the tariffs. Thank you."
},
{
"speaker": "Elon Musk",
"content": "Yes. I think I covered some part of it in my opening remarks, but just to give you a little bit more, just on the tariff side, the European authorities did sample certain other OEMs in the first round to establish the tariffs for cars being imported from China into Europe. While we were not picked up in our individual examination in the first round, they did pick us up in the second round. They visited our factory. They -- we worked with them, provided them all the information. As a result, we were adjusting our import strategy out of China into Europe. But -- and one other thing to note is in Q2 itself, we started building right hand from model wise out of Berlin and we also delivered it in U.K. And we're adjusting as needed, but we will keep adjust. We're still importing Model 3s into Europe, out of Shanghai. And we are still evaluating what is the best alternate manage all this just on the examination by the European authorities. Like I said, we cooperated with them. Well, we are confident that they, we should get a better rate than what they have imposed for now. But this is literally evolving and we are adjusting as fast as we can with this. It is -- I would also add that, because of this, you've seen the impact that Berlin is doing more imports into places like Taiwan as well as, U.K I just mentioned. So it will keep changing and we will keep adapting as we go about it."
},
{
"speaker": "Dan Levy",
"content": "Great. Thanks. Yes, thank you. As a follow-up, wanted to ask about the Robotaxi strategy and specifically the shareholder deck here notes that the release is going to be -- one of the gating factors is regulatory approval. So maybe you could help us understand which regulations specifically are the ones that we should be looking for? Is it FMVSS, that's standard? And then to what extent does the strategy shift? You've done with FSD more of a nationwide, no boundary approach. Is the Robotaxi approach one that's more geofenced, so to speak, and is more driven by a state by state approach?"
},
{
"speaker": "Elon Musk",
"content": "I mean, our solution is a generalized solution like what everybody else has. They, if you see like Waymo has one of it, they have a very localized solution that requires high density mapping. It's not -- it's quite fragile. So, their ability to expand rapidly is limited. Our solution is a general solution that works anywhere. It would even work on a different earth. So if you're rendered a new Earth, it would work on a new earth. So it's -- there's this capability I think in our experience, once we demonstrate that something is safe enough or significantly safer than human. We are fine that regulators are supportive of deploying deployment of that capability. It's difficult to argue with if you -- if you've got a large number of -- yes, if you've got billions of miles that show that in the future unsupervised FSD is safer than human. What regulator could really stand in the way of that? They would -- they're morally obligated to approve. So I don't think regulatory approval will be a limiting factor. I should also say that the self-driving capabilities of this are deployed outside of North America are far behind that in, in North America. So with the -- with Version 12.5, and maybe a 12.6, but pretty soon we will ask for regular regulatory approval of the Tesla supervised FSD in Europe, China, and other countries. And I, I think we're likely to receive that before the end of the year, which will be a helpful demand driver in those regions obviously."
},
{
"speaker": "Travis Axelrod",
"content": "Thank you. Just to …"
},
{
"speaker": "Elon Musk",
"content": "Go ahead, Travis."
},
{
"speaker": "Travis Axelrod",
"content": "In terms of like, as Elon said, in terms of regulatory approval, the vehicles are governed by FMVSS in U.S., which is the same across all 50 states. The road rules are the same across all 50 states. So creating a generalized solution gives us the best opportunity to deploy in all 50 states, reasonably. Of course there are state and even local and municipal level regulations that may apply to, being a transportation company or deploying taxes. But as far as getting the vehicle on the road, that's all federal and that's very much in line with what you was just suggesting about the data and the vehicle itself."
},
{
"speaker": "Vaibhav Taneja",
"content": "And to add to the technology point, the end-to-end network basically makes no assumption about the location. Like you could add data from different countries and it just like perform equally well there, just like almost like close to zero US specific, um, code in there. It's all just the data that comes from the U.S"
},
{
"speaker": "Elon Musk",
"content": "Yes. To, to that end of the show, it's like, we can go as humans to other countries and drive with some reasonable amount of assessment in those countries. And that's how you design the FSC software. Yes, exactly."
},
{
"speaker": "Travis Axelrod",
"content": "Great. Thanks guys. The next question comes from George from Canaccord. George, please go ahead and unmute yourself."
},
{
"speaker": "George Gianarikas",
"content": "Hi, everyone. Thank you for taking my questions. Maybe just to expand on the regulatory question for a second. And I could be comparing apples and oranges, but GM canceled their pedal less, wheel less vehicle. And according to the company this morning, their decision was driven by uncertainty about the regulatory environment. And from what we understand, and again, maybe I'm wrong here, but the Robotaxi that has been shown at least in images of the public is also pedal less and wheel less. Is there a different regulatory concern just if you deploy a vehicle like that that doesn't have pedal -- pedals or a wheel, and that may not be different from just regular FSD on a traditional Tesla vehicle. Thank you."
},
{
"speaker": "Elon Musk",
"content": "Well, obviously the real reason that they cancel it is because GM can't make it work, not because the regulators, they're blaming regulators. That's misleading of them to do so, because Waymo is doing just fine in those markets. So it's just that their technology is not far."
},
{
"speaker": "George Gianarikas",
"content": "Right. And maybe just as a follow-up, I think you mentioned, that FSD take rates were up materially after you reduced the price. Is there any way you can help us quantify what that means Exactly? Thank you."
},
{
"speaker": "Vaibhav Taneja",
"content": "Yes, we shared the [indiscernible] that there we've seen a meaningful increase. I don't want to get into specific because we started from a low base and -- but we are seeing encouraging results. And the key thing here is, like Elon said, you need to experience it because words can't describe it till the time we actually use it. And that's why we are trying to make sure that every time a car is getting delivered, people are being showed how this thing is working because when you see it working, you realize how great it is. I mean, just to give you one example, so again, there's a bias example, but I have a more than 20 mile commute into the factory almost every day. I have zero interventions on the latest stack, and the card just literally drives me over. And especially with the latest version wherein, we are also tracking your eye movement, the steering wheel lag is almost not there as long as you're not wearing sunglasses."
},
{
"speaker": "Elon Musk",
"content": "Well, we are fixing the sunglasses thing. It's coming soon. So you will be able to drive -- you'll be able to have sunglasses on and have the car drive."
},
{
"speaker": "George Gianarikas",
"content": "Yes."
},
{
"speaker": "Elon Musk",
"content": "So -- but there's number of times I've talked with smart people who like live in New York or maybe downtown Boston and don't ever drive and then ask me about FSD, I'm like, you can just get a car and try it. And if you're not doing that, you have no idea what's going on."
},
{
"speaker": "Travis Axelrod",
"content": "Thank you. The next question comes from Pierre from New Street. Pierre, please unmute yourself."
},
{
"speaker": "Ferragu Pierre",
"content": "Hey, guys. Thank you for taking my question. So it's on Robotaxi again, and I completely get it that with a universal solution, we will get like regulatory approval, we'll get there eventually clicking up miles and compute, et cetera. And my question is more, how you think about deployments, because I'm still like, I'm thinking once you have a car that can drive everywhere, that can replace me, it can replace a taxi, but then to do the right hailing service, you need a certain scale. And that means a lot of cars on the road and so you need an infrastructure to just maintain the cars, take care of them, et cetera. And so my question is, are you already working on that? Do you have already an idea of what, like your plan to deploy looks like? And is that like a test Tesla only plan or are you looking at partners, local partners, global partners to do that? And I'll have a quick follow-up."
},
{
"speaker": "Elon Musk",
"content": "Yes. This would just be the Tesla network. You just literally open the Tesla app and summon a car and resend a car to pick you up and take you somewhere. And you can -- our -- we'll have a fleet that's I don't know, on order of 7 million dedicated global autonomy soon. In the years come it'll be over 10 million, then over 20 million. This is immense scale. And the car is able to operate 24/7, unlike the human driver. So, the capability to -- like, if there's this basically instant scale with a software update. And now this is for a customer on fleet. So you can think of that as being a bit like Airbnb, like you can choose to allow your car to be used by the fleet, or cancel that and bring it back. It can be used by the fleet all the time. It can be used by the fleet some of the time, and then Tesla would take -- would share on the revenue with the customer. But you can think of the giant fleet of Tesla vehicles as like a giant sort of Airbnb equivalent fleet, Airbnb on wheels. The -- I mean, then in addition we would make some number of cars for Tesla that would just be owned by Tesla and be added to the fleet. I guess that would be a bit more like Uber. But this would all be a Tesla network. And there's an important clause we've put in, in every Tesla purchase, which is that the Tesla vehicles can only be used in the Tesla fleet. They cannot be used by a third-party for autonomy."
},
{
"speaker": "Ferragu Pierre",
"content": "Okay. And do you think that scale is like progressively so you can start in a city with just a handful of cars and you grow the number of cars over time? Or do you think there is like a critical mass you need to get to, to be able to offer like a service that is of competitive quality compared to what like the -- like Uber would be typically delivering already?"
},
{
"speaker": "Elon Musk",
"content": "I guess I'm not -- maybe I'm not conveying this correctly. The entire Tesla fleet basically becomes active. This is obviously maybe there's some number of people who don't want their car to own money, but I think most people will. It's instant scale."
},
{
"speaker": "Travis Axelrod",
"content": "Thank you. Our next question comes from Colin from Oppenheimer. Colin, please unmute yourself."
},
{
"speaker": "Colin Rusch",
"content": "Sorry about that guys. I've got two questions around energy storage. With the tight supply and the stationary storage, can you talk about your pricing strategy and how you're thinking about saturation and given geographies given that some of these larger systems are starting to shift wholesale power markets in a pretty meaningful way quickly?"
},
{
"speaker": "Vaibhav Taneja",
"content": "So, I mean, we are working with a large set of players in the market and our pipeline is actually pretty long. And there's actually very -- there's actually long end in terms of where you enter into a contract where delivery started -- starts happening. And so far we have good pricing leverage. And now Mike, chime in on this too."
},
{
"speaker": "Unidentified Company Representative",
"content": "Yes, I mean there's a lot of competition from Chinese OEMs just like there is in the vehicle space. So we're in close contact with our customers and making sure that we're remaining competitive in where they're needing to be competitive to, to secure contracts to sell power and energy in the markets. We had a really strong contracting quarter and continue to build our backlog for 2025 and 2026. So we feel pretty good about where we are in the market. We realize that competition is strong, but we have a pretty strong value proposition with offering a fully integrated product with our own power electronics and site level controls. So …"
},
{
"speaker": "Vaibhav Taneja",
"content": "Yes, and again, the aspect which people miss do not fully understand is that there's also a whole software stack, which comes with from Megapack, right? And that is a unique proposition which we -- which is only available to us, and we are using it with other stuff too, but that gives us a much more of an edge as compared to the competition."
},
{
"speaker": "Elon Musk",
"content": "Yes, we find customers that they can sort of put together a hodgepodge solution. And so, and then sometimes they'll pick that solution, and then that doesn't work. And then they come back to us."
},
{
"speaker": "Unidentified Company Representative",
"content": "Yes, and we're not really seeing saturation for like, on a global scale. There's little pockets of saturation in different markets, but we're more seeing that there's markets opening up given demand on the grid just continues to increase more than anyone expects. So that just opens up markets, really across the world in different pockets."
},
{
"speaker": "Vaibhav Taneja",
"content": "Yes, I mean just even on the AI computer side, right? These GPUs are really powerful already and the amount of new pipeline, which we're getting for people for data center backup and things like that is increasing at a pretty large scale."
},
{
"speaker": "Colin Rusch",
"content": "Yes. Thanks. And then the follow-up here is 4680 process technology and the role to role process. There's some news around your equipment suppliers. Can you talk about how far along you are in, in potentially qualifying an incremental supplier around some of that, those critical process technology steps?"
},
{
"speaker": "Lars Moravy",
"content": "Yes, I can talk about that. As you're probably referring to the lawsuit that we have with one of our suppliers, look, I don't think this is going to affect our ability to roll out 4680. We have very strong IP position in the technology and the majority of the equipment that we use is in-house designed and some of it's in-house build. And so we can take our IP stack and have someone else build it if we need to. So it's, that's not really a concern right now."
},
{
"speaker": "Elon Musk",
"content": "Yes. I, I think people don't understand just how much demand there will be for grid storage. They really just like the [indiscernible] I think are underestimating this demand by probably orders magnitude. So that the actual energy, total energy output of, say the U.S grid is if the power plants can operate a steady state is at least two to three times, the amount of energy it currently produces, because there are a huge gap. There's a huge difference in the -- from peak to trough in terms of energy of power generation. So in order for a grid to not have blackouts, it must be able to support the load at the worst minute of the worst day of the year, the coldest or hottest day, which means that for the rest of the time, the rest of the year, it's got massive excess power generation capability, but it has no way to store that energy. Once you add battery packs, you can now run the power plants at steady state. Steady state means that basically any given grid anywhere in the world can produce in terms of cumulative energy in the course of the year, at least twice what it is currently producing in some cases, maybe three times."
},
{
"speaker": "Travis Axelrod",
"content": "All right. Thank you, Elon. The next question comes from Colin Langan from Wells Fargo. Colin, please unmute yourself."
},
{
"speaker": "Colin Langan",
"content": "Oh, great. Thanks for taking my questions. Do you hear me?"
},
{
"speaker": "Travis Axelrod",
"content": "Yes."
},
{
"speaker": "Colin Langan",
"content": "Yes. Sorry. I guess when we are going to ask, if Trump wins, there's a higher chance that IRA could get cut. I think Elon, you had commented online that Tesla doesn't survive on EV subsidies. But when Tesla lose a lot of support if IRA goes away? I think model Y3 and Y get IRA help for customers, and I think your batteries get production tax credits. So, just one, can you clarify if the end, if IRA ends, would it be a negative for your profitability in the near-term? Why might it not be a negative? And then, any framing of the current support you get, IRA-related?"
},
{
"speaker": "Elon Musk",
"content": "I guess that there would be like some impact, but I think it would be devastating for our competitors. But -- and it would hurt Tesla slightly. But long-term probably actually helps Tesla would be my guess. Yes -- but I've said this before on earnings calls, it -- the value of Tesla overwhelmingly is autonomy. These other things are in the noise relative to autonomy. So I recommend anyone who doesn't believe that Tesla will solve vehicle autonomy should not hold Tesla stock. They should sell their Tesla stock. You should believe Tesla will solve autonomy, you should buy Tesla stock. And all these other questions are in the noise."
},
{
"speaker": "Vaibhav Taneja",
"content": "Yes, I mean, I'll add this just to clarify a few things that -- at the end of the day, when we are looking at our business, we've always been looking at it whether or not IRA is there and we want our business to grow healthy without having any subsidies coming in, whichever way you look at it. And that's the way we have always modeled everything. And that is the way internally also even when we are looking at battery costs, yes, I --, there are manufacturing credits which we get, but we always drive ourselves to say, okay, what if there is no higher benefit and how do we operate in that kind of an environment? And like Elon said, we definitely have a big advantage as compared to a competition on that front. We've delivered it and you can see it in the numbers over the years. Like, so there is you cannot ignore the fundamental size of the business. And then on top of it, once you add autonomy to it, like even said, it becomes meaningless to you think about the short-term."
},
{
"speaker": "Travis Axelrod",
"content": "Okay. I think that's unfortunately all the time we have for today. We appreciate all of your questions. We look forward to talking to you next quarter. Thank you very much and goodbye."
},
{
"speaker": "Elon Musk",
"content": "That's excellent."
}
] |
tsla | 2,024 | 1 | [
{
"speaker": "Martin Viecha",
"content": "Tesla's First Quarter 2024 Q&A Webcast. My name is Martin Viecha, VP of Investor Relations, and I'm joined today by Elon Musk, Vaibhav Taneja, and a number of other executives. Our Q1 results were announced at about 3.00 p.m. Central Time in the Update Deck we published at the same link as this webcast. During this call, we will discuss our business outlook and make forward-looking statements. These comments are based on our predictions and expectations as of today. Actual events and results could differ materially due to a number of risks and uncertainties, including those mentioned in our most recent filings with the SEC. During the question-and-answer portion of today's call, please limit yourself to one question and one follow-up. Please use the raise hand button to join the question queue. But before we jump into Q&A, Elon has some opening remarks. Elon?"
},
{
"speaker": "Elon Musk",
"content": "Thanks, Martin. So to recap in Q1 we navigated several unforeseen challenges as well as the ramp of the updated Model 3 in Fremont. There was, as we all have seen, the EV adoption rate globally is under pressure and a lot of other auto manufacturers are pulling back on EVs and pursuing plug-in hybrids instead. We believe this is not the right strategy and electric vehicles will ultimately dominate the market. Despite these challenges, the Tesla team did a great job executing in a tough environment and energy storage deployments, the Megapack in particular, reached an all time high in Q1, leading to record profitability for the energy business, and that looks likely to continue to increase in the quarters and years ahead. It will increase. We actually know that it will, so significantly faster than the car business as we expected. We also continue to expand our AI training capacity in Q1, more than doubling our training compute sequentially. In terms of the new product roadmap, there has been a lot of talk about our upcoming vehicle line in the next – in the past several weeks. We've updated our future vehicle lineup to accelerate the launch of new models ahead, previously mentioned startup production in the second half of 2025, so we expect it to be more like the early 2025, if not late this year. These new vehicles, including more affordable models, will use aspects of the next generation platform as well as aspects of our current platforms, and will be able to produce on the same manufacturing lines as our current vehicle lineup. So it's not contingent on any new factory or massive new production line. It'll be made on our current production lines much more efficiently. And we think this should allow us to get to over 3 million vehicles of capacity when realized to the full extent. Regarding FSD Version 12, which is the pure AI-based self-driving, if you haven't experienced this, I strongly urge you to try it out. It's profound and the rate of improvement is rapid so – and we've now turned that on for all cars with the cameras and inference computer and everything from Hardware 3 on in North America. And so it's been pushed out to, I think, around 1.8 million vehicles and we're seeing about half of people use it so far and that percentage is increasing with each passing week. So we now have over 300 billion miles that have been driven with FSD V12. Since the launch of full self-driving, supervised full self-driving, it's become very clear that the vision-based approach with end to end neural networks is the right solution for scalable autonomy. It's really how humans drive. Our entire road network is designed for biological neural nets and eyes. So naturally cameras and digital neural nets are the solution to our current road system. To make it more accessible, we've reduced the subscription price to $99 a month, so it's easy to try out. And as we've announced, we'll be showcasing our purpose-built robotaxi, or Cybercab, in August. Yes. Regarding AI compute, over the past few months, we've been actively working on expanding Tesla's core AI infrastructure. For a while there, we were training constrained in our progress. We are, at this point, no longer training constrained and so we're making rapid progress. We've installed and commissioned, meaning they're actually working 35,000 H100 computers or GPUs, GPU is wrong word, they need a new word. I always feel like a wince when I say GPU because it's not – GPU stands – G stands for graphics, and it doesn't do graphics. But anyway roughly 35,000 H100s are active, and we expect that to be probably 85,000 or thereabouts by the end of this year and training, just for training. We are making sure that we're being as efficient as possible in our training. It's not just about the number of H100s, but how efficiently they're used. So in conclusion, we're super excited about our autonomy road map. I think it should be obvious to anyone who's driving Version 12 and it tells that that it is only a matter of time before we exceed the reliability of humans and not much time with that. And we're really headed for an electric vehicle, an autonomous future. And I'll go back to something I said several years ago that in the future, gasoline cars that are not autonomous will be like riding a horse and using a flip phone. And that will become very obvious in hindsight. We continue to make the necessary investments that will drive growth and profits for Tesla in the future, and I wanted to thank the Tesla team for incredible execution during this period and look forward to everything that we have planned ahead. Thanks."
},
{
"speaker": "Martin Viecha",
"content": "Thank you very much, and Vaibhav has some comments as well."
},
{
"speaker": "Vaibhav Taneja",
"content": "Thanks. It's important to acknowledge what Elon said, from our auto business perspective. We did see a seasonal decline in revenues quarter-over-quarter and those were primarily because of seasonality, uncertain macroeconomic environment and the other reasons, which Elon had mentioned earlier. Auto margins declined from 18.9% to 18.5%. Excluding the impact of Cybertruck, the impact of pricing actions was largely offset by reductions in per unit costs and the recognition of revenue from Autopark feature for certain vehicles in the U.S. that previously did not have that functionality. Additionally, while we did experience higher cost due to the ramp of Model 3 in Fremont and disruptions in Berlin, these costs were largely offset by cost reduction initiatives. In fact, if we exclude Cybertruck and Fremont Model 3 ramp costs, the revenue from Autopark, auto margins improved slightly. Currently normalized Model Y cost per vehicle in Austin and Berlin are already very close to that of Fremont. Our ability to reduce costs without sacrificing on quality was due to the amazing efforts of the team, in executing Tesla's relentless pursuit of efficiency across the business. We've also witnessed that as other OEMs are pulling back on their investments in EV, there is increasing appetite for credits, and that means a steady stream of revenue for us. Obviously, seeing others pull back from EV is not the future we want. We would prefer it the whole industry went all in. On the demand front, we've undertaken a variety of initiatives, including lowering the price of both the purchase and subscription options for FSD launching extremely attractive leasing specials for the Model 3 in the U.S. for $299 a month and offering attractive financing options in certain markets. We believe that our awareness activities, paired with attractive financing, will go a long way in expanding our reach and driving demand for our products. Our Energy business continues to make meaningful progress with margins reaching a record of 24.6%. We expect the energy storage deployments for 2024 to grow at least 75% higher from 2023. And accordingly, this business will begin contributing significantly to our overall profitability. Note that there is a bit of lumpiness in our storage deployments due to a variety of factors that are outside of our control, so deployments may fluctuate quarter-over-quarter. On the operating expense front, we saw a sequential increase from our AI initiatives, continued investment in future projects, marketing and other activities. We had negative free cash flow of $2.5 billion in the first quarter. The primary driver of this was an increase in inventory from a mismatch between builds and deliveries as discussed before, and our elevated spend on CapEx across various initiatives, including AI compute. We expect the inventory build to reverse in the second quarter and free cash flow to return to positive again. As we prepare the company for the next phase of growth, we had to make the hard but necessary decision to reduce our head count by over 10%. The savings generated are expected to be well in excess of $1 billion on an annual run rate basis. We are also getting hyper focused on CapEx efficiency and utilizing our installed capacity in a more efficient manner. The savings from these initiatives, including our cost reductions will help improve our overall profitability and ultimately enable us to increase the scale of our investments in AI. In conclusion, the future is extremely bright and the journey to get there while challenging will be extremely rewarding. Once again, I would like to thank the whole Tesla team for delivering great results. And we can open it up to Q&A."
},
{
"speaker": "A - Martin Viecha",
"content": "Okay. Let's start with investor Q&A. The first question is, what is the status of 4680. What is the current output? Lars?"
},
{
"speaker": "Lars Moravy",
"content": "Sure. 4680 production increased about 18% to 20% from Q4 reaching greater than 1K a week for Cybertruck, which is about 7 gigawatt hours per year as we posted on X. We expect to stay ahead of the Cybertruck ramp with the cell production throughout Q2 as we ramp the third of four lines in Phase 1, while maintaining multiple weeks of cell inventory to make sure we're ahead of the ramp. Because we're ramping, COGS continues to drop rapidly week-over-week driven by yield improvements throughout the lines and production volume increases. So our goal, and we expect to do this is to beat supplier cost of nickel-based cells by the end of the year."
},
{
"speaker": "Martin Viecha",
"content": "Thank you. The second question is on Optimus. So what is the current status of Optimus? Are they currently performing any factory tasks? When do you expect to start mass production?"
},
{
"speaker": "Elon Musk",
"content": "We are able to do simple factory tasks or at least, I should say, factory tasks in the lab. In terms of – we do think we will have Optimus in limited production in the natural factory itself, doing useful tasks before the end of this year. And then I think we may be able to sell it externally by the end of next year. These are just guesses. As I've said before, I think Optimus will be more valuable than everything else combined. Because if you've got a sentient humanoid robots that is able to navigate reality and do tasks at request, there is no meaningful limit to the size of the economy. So that's what is going to happen. And I think Tesla is best positioned of any humanoid robot maker to be able to reach volume production with efficient inference on the robot itself. I mean this perhaps is a point that is worth emphasizing Tesla's AI inference efficiency is vastly better than any other company. There is no company even close to the inference efficiency of Tesla. We've had to do that because we were constrained by the inference hardware in the car, we didn't have a choice. But that will pay dividends in many ways."
},
{
"speaker": "Martin Viecha",
"content": "Thank you. The third question is, what is the current assessment of the pathway towards regulatory approval for unsupervised FSD in the U.S. And how should we think about the appropriate safety threshold compared to human drivers?"
},
{
"speaker": "Elon Musk",
"content": "Sure."
},
{
"speaker": "Lars Moravy",
"content": "I can start. There are a handful of states that already have adopted autonomous vehicle laws. These states are paving the way for operations, while the data for such operations guides a broader adoption of driver-less vehicles. I think Ashok can talk a little bit about our safety methodology, but we expect that these states and the work ongoing as well as the data that we're providing will pave a way for a broad-based regulatory approval in the U.S. at least and then in other countries as well?"
},
{
"speaker": "Ashok Elluswamy",
"content": "Yes. It's actually been pretty helpful that other autonomous car companies have been cutting a path through the regulatory jungle, which is absurd. That's actually quite helpful. And they have obviously been operating in San Francisco for a while. I think they got approval for City of LA. So these approvals are happening rapidly. I think if you've got at scale, a statistically significant amount of data that shows conclusively that the autonomous car has, let's say, half the accident rate of a human-driven car, I think, that's difficult to ignore because at that point, stopping autonomy means killing people. So I actually do not think that there will be significant regulatory barriers provided there was conclusive data that the autonomous car is safer than a human-driven car. And in my view, this will be much like elevators. Elevators used to be operated by a guy with relay switch. But sometimes that guy would get tired or drunk or just make a mistake, and shatter somebody in half between floors. So we just get an elevator and press button, we don't think about it. In fact, it's kind of weird if somebody is standing there with a relay switch. And that will be how cars work. You just summon the car using your phone, you get in, it takes you to a destination, you get out."
},
{
"speaker": "Vaibhav Taneja",
"content": "You don't even think about it?"
},
{
"speaker": "Elon Musk",
"content": "You don't even think about it. Just like an elevator, it takes you to your floor. That's it. Don't think about how the elevator is working or anything like that. And something I should clarify is that Tesla will be operating the fleet. So you can think of like how Tesla, think of it’s like some combination of Airbnb and Uber, meaning that there will be some number of cars that Tesla owns itself and operates in the fleet. There will be some number of cars and then there'll be a bunch of cars where they're owned by the end user. That end user can add or subtract their car to the fleet whenever they want, and they can decide if they want to only let the car be used by friends and family or only by 5-star users or by anyone at any time they could have the car come back to them and be exclusively theirs, like an Airbnb. You could rent out your guest room or not, any time you want. So as our fleet grows, we have 7 million cars going to – 9 million cars going to, eventually tens of millions of cars worldwide. With a constant feedback loop, every time something goes wrong, that gets added to the training data and you get this training flywheel happening in the same way that Google Search has the sort of flywheel, it's very difficult to compete with Google because people are constantly doing searches and clicking and Google is getting that feedback loop. It’s the same with Tesla. But at a scale that is maybe difficult to comprehend, but ultimately, it will be tens of millions. I think there's also some potential here for an AWS element down the road where if we've got very powerful inference because we've got a Hardware 3 in the cars, but now all cars are being made with Hardware 4. Hardware 5 is pretty much designed and should be in cars, hopefully towards the end of next year. And there's a potential to run – when the car is not moving to actually run distributed inference. So kind of like AWS, but distributed inference. Like it takes a lot of computers to train an AI model, but many orders of magnitude less compute to run it. So if you can imagine future, perhaps where there's a fleet of 100 million Teslas, and on average, they've got like maybe a kilowatt of inference compute. That's 100 gigawatts of inference compute distributed all around the world. It's pretty hard to put together 100 gigawatts of AI compute. And even in an autonomous future where the car is, perhaps, used instead of being used 10 hours a week, it is used 50 hours a week. That still leaves over 100 hours a week where the car inference computer could be doing something else. And it seems like it will be a waste not to use it."
},
{
"speaker": "Martin Viecha",
"content": "Ashok, do you want to chime in on the air process and safety?"
},
{
"speaker": "Ashok Elluswamy",
"content": "Yes, we have multiple tiers of validating the safety in any given week, we train hundreds of neural networks that can produce different trajectories for how to drive the car, we replay them through the millions of clips that we have already collected from our users and our own QA. Those are like critical events, like someone jumping out in front or like other critical events that we have gathered database over many, many years, and we replay through all of them to make sure that we are net improving safety. And on top of it, we have simulation systems that also try to recreate this and test this in closed loop fashion. And some of this is validated, we give it to our own QA drivers. We have hundreds of them in different cities, in San Francisco, Los Angeles, Austin, New York, a lot of different locations. They are also driving this and collecting real-world miles, and we have an estimate of what are the critical events, are they a net improvement compared to the previous week’s builds. And once we have confidence that the build is a net improvement, then we start shipping to early users, like 2,000 employees initially that they would like it to build, they will give feedback on like if it's an improvement there or they're noting some new issues that we did not capture in our own QA process. And only after all of this is validated, then we go to external customers. And even when we go external, we have like live dashboards of monitoring every critical event that's happening in the fleet sorted by the criticality of it. So we are having a constant pulse on the build quality and the safety improvement along the way. And then any failures like Elon alluded to, we get the data back, add it to the training and that improves the model in the next cycle. So we have this like constant feedback loop of issues, fixes, evaluations and then rinse and repeat. And especially with the new V12 architecture, all of this is automatically improving without requiring much engineering interventions in the sense that engineers don't have to be creative in like how they code the algorithms. It's mostly learning on its own based on data. So you see that, okay, every failure or like this is how a person shows, this is how you drive this intersection or something like that, they get the data back. We add it to the neural network, and it learns from that trained data automatically instead of some engineers saying that, oh, here, you must rotate the steering wheel by this much or something like that. There's no hard inference conditions, it's everything is neural network, it's very soft, it's probabilistic. So it will adapt its probability distribution based on the new data that it's getting."
},
{
"speaker": "Elon Musk",
"content": "Yes. We do have some insight into how good the things will be in like, let's say, three or four months because we have advanced models that are far more capable than what is in the car, but have some issues with them that we need to fix. So they are like there'll be a step change improvement in the capabilities of the car, but it will have some quirks that are – that need to be addressed in order to release it. As Ashok was saying, we have to be very careful in what we release the fleet or to customers in general. So like – if we look at say 12.4 and 12.5, which are really could arguably even be Version 13, Version 14 because it's pretty close to a total retrain of the neural nets in each case are substantially different. So we have good insight into where the model is, how well the car will perform, in, say, three or four months."
},
{
"speaker": "Ashok Elluswamy",
"content": "Yes. In terms of scaling laws, people in the AI community generally talk about model scaling laws where they increase the model size a lot and then their corresponding gains in performance, but we have also figured out scaling laws and other access in addition to the model side scaling, making also data scaling. You can increase the amount of data you use to train the neural network and that also gives similar gains and you can also scale up by training compute, you can train it for much longer or make more GPUs or more Dojo nodes and that also gives better performance, and you can also have architecture scaling where you count with better architectures that for the same amount of compute for produce better results. So a combination of model size scaling, data scaling, training compute scaling and the architecture scaling, we can basically extract like, okay, with the continue scaling based on this – at this ratio, we can sort of predict future performance. Obviously, it takes time to do the experiments because it takes a few weeks to train, it takes a few weeks to collect tens of millions of video clips and process all of them, but you can estimate what’s going to be the future progress based on the trends that we have seen in the past, and they’re generally held true based on past data."
},
{
"speaker": "Martin Viecha",
"content": "Okay. Thank you very much. I’ll go to the next question, which is, can we get an official announcement of the time line for the $25,000 vehicle?"
},
{
"speaker": "Lars Moravy",
"content": "I think we – Elon mentioned it in the opening remarks. But as you mentioned, we’re updating our future vehicle lineup to accelerate the launch of our low-cost vehicles in a more CapEx efficient way. That’s our mission to get the most affordable cars to customers as fast as possible. These new vehicles we built on our existing lines and open capacity, and that’s a major shift to utilize all our capacity with marginal CapEx before we go spend high CapEx to do anything."
},
{
"speaker": "Elon Musk",
"content": "Yes. We’ll talk about this more on August 8. But really, the way to think of Tesla is almost entirely in terms of solving autonomy and being able to turn on that autonomy for a gigantic fleet. And I think it might be the biggest asset value appreciation history when that day happens when you can do unsupervised full self-driving."
},
{
"speaker": "Lars Moravy",
"content": "5 million cars?"
},
{
"speaker": "Elon Musk",
"content": "Yes."
},
{
"speaker": "Lars Moravy",
"content": "A little less?"
},
{
"speaker": "Elon Musk",
"content": "Yes. It will be 7 million cars in a year or so and then 10 million and then eventually, we’re talking about tens of millions of cars. Not eventually, it’s like, yes, for the end of the decade, its several tens of millions of cars I think."
},
{
"speaker": "Martin Viecha",
"content": "Thank you. The next question is, what is the progress of Cybertruck ramp?"
},
{
"speaker": "Lars Moravy",
"content": "I can take that one too. Cybertruck had 1K a week just a couple of weeks ago. This happened in the first four to five months since we SOP [ph] late last year. Of course, volume production is what matters. That’s what drives costs and so our costs are dropping, but the ramp still faces like a lot of challenges with so many new technologies, some supplier limitations, et cetera, and continue to ramp this year, just focusing on cost efficiency and quality."
},
{
"speaker": "Martin Viecha",
"content": "Okay. Thank you. The next question, have any of the legacy automakers contacted Tesla about possibly licensing FSD in the future?"
},
{
"speaker": "Elon Musk",
"content": "We’re in conversations with one major automaker regarding licensing FSD."
},
{
"speaker": "Martin Viecha",
"content": "Thank you. The next question is about the robotaxi unveil. Elon already talked about that. So we’ll have to wait till August. The following question is about the next-generation vehicle. We already talked about that. So let’s go to the semi. What is the time line for scaling semi?"
},
{
"speaker": "Elon Musk",
"content": "I think…"
},
{
"speaker": "Lars Moravy",
"content": "So we’re finalizing the engineering of the semi to enable like a super cost-effective high-volume production with our learnings from our fleet and our pilot fleet and Pepsi’s fleet, which we are expanding this year marginally. In parallel, as we showed in the shareholders’ deck, we have started construction on the factory in Reno. Our first vehicles are planned for late 2025 with external customers starting in 2026."
},
{
"speaker": "Martin Viecha",
"content": "Okay. A couple more questions. So our favorite, can we make FSD transfer permanent until FSD is fully delivered with Level 5 autonomy?"
},
{
"speaker": "Lars Moravy",
"content": "Yes."
},
{
"speaker": "Martin Viecha",
"content": "Okay. Next question, what is the getting the production ramp at Lathrop, where do you see the Megapack run rate at the end of the year. Mike?"
},
{
"speaker": "Unidentified Company Representative",
"content": "Yes. Yes, Lathrop is ramping as planned. We have our second GA line allowing us to increase our exit rate from 20 gigawatt hours per year to – at the start of this year to 40 gigawatt hours per year by the end of the year, that lines commissioned. There’s really nothing limiting the ramp. Its given the longer sales cycles for these large projects, we typically have order visibility 12 months to 24 months prior to ship dates. So we’re able to plan – the build plan several quarters in advance. So this allows us to ramp the factory to align with the business and order growth. Lastly, we’d like to thank our customers globally for their trust in Tesla as a partner for these incredible projects."
},
{
"speaker": "Martin Viecha",
"content": "Okay. Thank you very much. Let’s go to analyst questions. The first question comes from Tony Sacconaghi from Bernstein. Tony, please go ahead and unmute."
},
{
"speaker": "Tony Sacconaghi",
"content": "Thank you for taking the question. I was just wondering if you can elaborate a little bit more on kind of the new vehicles that you talked about today. Are these like tweaks on existing models, given that they’re going to be running on the same lines? Are these like new models? And how should we think about them in the context of like the Model 3 Highland update, what will these models be like relative to that? And given the quick time frame, Model 3 Highland has required a lot of work and a lot of retooling. Maybe you can help put that all in context. Thank you, and I have a follow-up, please."
},
{
"speaker": "Elon Musk",
"content": "I think we've said, we were on that front. So what’s your follow-up?"
},
{
"speaker": "Tony Sacconaghi",
"content": "It’s a more personal one for you, Elon, which is that you’re leading many important companies right now. Maybe you can just talk about where your heart is at in terms of your interests and do you expect to lessen your involvement with Tesla at any point over the next three years?"
},
{
"speaker": "Elon Musk",
"content": "Tesla constitutes a majority of my work time and I work pretty much every day of the week. It’s rare for me to take a Sunday afternoon. So I’m going to make sure Tesla is quite prosperous. And it is – like it is prosperous and it will be very much so in the future."
},
{
"speaker": "Martin Viecha",
"content": "Okay. Thank you. Let’s go to Adam Jonas from Morgan Stanley. Adam, please go ahead and unmute."
},
{
"speaker": "Adam Jonas",
"content": "Okay. Great. Hey, Elon. So you and your team on volume expect a 2024 growth rate, notably lower than that achieved in 2023. But what's your team's degree of confidence on growth above 0%? Or in other words, does that statement leave room for potentially lower sales year-on-year?"
},
{
"speaker": "Elon Musk",
"content": "No, I think we'll have higher sales this year than last year."
},
{
"speaker": "Adam Jonas",
"content": "Okay. My follow-up, Elon, on future product. If you had nailed execution, assuming that you nail execution on your next-gen cheaper vehicles, more aggressive giga castings, I don't want to say one piece, but getting closer to one piece, structural pack, unboxed, 300-mile range, $25,000 price point, putting aside robotaxi, those features unique to you. How long would it take your best Chinese competitors to copy a cheaper and better vehicle that you could offer a couple of years from now? How long would it take your best Chinese competitors to copy that? Thanks."
},
{
"speaker": "Elon Musk",
"content": "I mean, I don't know what our competitors could do, except we've done relatively better than they have. If you look at the drop in our competitors in China sales versus our drop in sales, our drop was less than theirs. So we're doing well. But I think Cathy Wood said it best, like really, we should be thought of as an AI or robotics company. If you value Tesla as just like an auto company, you just have to – fundamentally, it's just the wrong framework and it will come to be. If you ask the wrong question, then the right answer is impossible. So I mean, if somebody doesn't believe Tesla is going to solve autonomy, I think they should not be an investor in the company. Like, that is – but we will and we are. And then you have a car that goes from 10 hours of use a week, like 1.5 hours a day to probably 50%, but it costs the same."
},
{
"speaker": "Vaibhav Taneja",
"content": "I think that's the key thing to remember, right, especially if you look at FSD Supervised, if you didn't believe in autonomy, this should give you a review that this is coming. It's actually getting better day by day."
},
{
"speaker": "Elon Musk",
"content": "Yes. If you've not tried the FSD 12.3, and like I said, 12.4 is going to be significantly better and 12.5 even better than that. And we have visibility into those things. Then you really don't understand what's going on. It's not possible."
},
{
"speaker": "Vaibhav Taneja",
"content": "Yes. And that's why we can't just look at just as a car company because a car company would just have a car. But here, we have more than a car company because the cars can be autonomous. And like I said, it's happening."
},
{
"speaker": "Ashok Elluswamy",
"content": "Yes. This is all in addition to Tesla – the overall AI community is just like increasing – like, improving rapidly."
},
{
"speaker": "Elon Musk",
"content": "Yes. I mean we're putting the actual auto in automobile. So sort of – we go like, well, sort of like tell us about future horse carriages you're making. I'm like, well, actually, it doesn't need a horse that's the whole point. That's really the whole point."
},
{
"speaker": "Martin Viecha",
"content": "Okay, thank you. The next question comes from Alex Potter from Piper Sandler. Alex, please go ahead and unmute."
},
{
"speaker": "Alex Potter",
"content": "Great, thanks. Yes, so I couldn't agree more. The thesis hinges completely on AI, the future of AI, full self-driving neural net training, all of these things. In that context, Elon, you've spoken about your desire to obtain 25% voting control of the company. And I understand completely why that would be. So I'm not necessarily asking about that. I'm asking if you've come up with any mechanism by which you can ensure that you'll obtain that level of voting control. Because if not, then the core part of the thesis could potentially be at risk. So any additional commentary you might have on that topic."
},
{
"speaker": "Elon Musk",
"content": "Well, I think no matter what Tesla, even if I got kidnapped by aliens tomorrow, Tesla will solve autonomy, maybe a little slower, but it would solve autonomy for vehicles at least. I don't know if it would winon with respect to Optimus or with respect to future products, but it would that there's enough momentum for Tesla to solve autonomy even if I disappeared for vehicles. Yes, there's a whole range of things we can do in the future beyond that. I'll be more reticent with respect to Optimus, if we have a super-sentient humanoid robot that can follow you indoors and that you can escape, we're talking terminator-level risk. And yes, I'd be uncomfortable with. If there's not some meaningful level of influence over how that is deployed. And if there's shareholders have an opportunity to ratify or reratify the sort of competition because I can't say that. That is a fact. They have an opportunity. And yes, we'll see. If the company generates a lot of positive cash flow, we could obviously buy back shares."
},
{
"speaker": "Alex Potter",
"content": "All right. That's actually all very helpful context. Thank you. Maybe one final question and I'll pass it on. OpEx reductions, thank you for quantifying the impact there. I'd be interested also in potentially more qualitative discussion of what the implications are for these headcount reductions. What are the types of activities that you're presumably sacrificing as a result of parting ways with these folks? Thanks very much."
},
{
"speaker": "Vaibhav Taneja",
"content": "So like we said, we've done these headcount reductions across the board. And as companies grow over time, there are certain redundancies. There's some duplication of efforts, which happens in certain areas. So you need to go back and look at where all these pockets are, get rid of it. So we're basically going through that exercise wherein we're like, hey, how do we set this company right for the next phase of growth. And the way to think about it is any tree which grows, it needs pruning. This is the pruning exercise which we went through. And at the end of it, we'll be much stronger and much more resilient to deal with the future because the future is really bright. Like I said in my opening remarks, we just have to get through this period and get there."
},
{
"speaker": "Elon Musk",
"content": "Yes, we're not giving up anything that is significant that I'm aware of. So we've had a long period of prosperity from 2019 to now. And so if a company sort of organizationally is 5% wrong per year, that accumulates to 25%, 30% of inefficiency. We've made some corrections along the way. But it is time to reorganize the company for the next phase of growth and you really need to reorganize it, just like a human when we start off with one cell and kind of zygote, blastocyst and you start growing arms and legs and briefly, you have a tail. And so…"
},
{
"speaker": "Alex Potter",
"content": "But you shed the tail."
},
{
"speaker": "Elon Musk",
"content": "You shed the tail, hopefully. And then you're baby, you basically, you have to be the organism – a company is kind of like creature growing. And if you don't reorganize it for different phases of growth, it will fail. You can't have the same organizational structure if you're 10 cells versus 100 cells versus 1 million cells versus 1 billion cells versus 1 trillion cells. Humans are around 35 trillion cells, doesn't feel like it feels like, like one person. But you're basically a walking cell colony of roughly 35 trillion depending on your body mass and about three times that number in bacteria. So anyway, you've got to reorganize the company for a new phase of growth or will fail to achieve that growth."
},
{
"speaker": "Martin Viecha",
"content": "Thank you. Let's go to Mark Delaney from Goldman Sachs. Mark please go ahead and unmute."
},
{
"speaker": "Mark Delaney",
"content": "Yes. Good afternoon. Thanks very much for taking the question. The company previously characterized potential FSD licensing discussions in the early phase and some OEMs had not really been believing in it. Can you elaborate on how much the licensing business opportunity you mentioned today has progressed? And is there anything Tesla needs to achieve with the technology in terms of product milestones in order to be successful at reaching a licensing agreement in your view?"
},
{
"speaker": "Elon Musk",
"content": "Well, I think we just need to – it just needs to be obvious that our approach is the right approach. And I think it is. I think we've now with 12.3, if you just have the car drive you around; it is obvious that our solution with a relatively low-cost inference computer and standard cameras can achieve self-driving. No LiDARs, no radars, no ultrasonic nothing."
},
{
"speaker": "Vaibhav Taneja",
"content": "No heavy integration work for vehicle manufacturers."
},
{
"speaker": "Elon Musk",
"content": "Yes. So it really just be a case of having them use the same cameras and inference computer and licensing our software. But once it becomes obvious that if you don't have this in a car, nobody wants your car. It's a smart car. I still remember in, back when Nokia was king of the hill, Yes, crushing. And they certainly come out with a smartphone that was basically a break with limited functionality. And then the iPhone and Android, people still do not understand that all the phones are going to be that way. There's not going to be any flip [ph] phones. If there will be a niche product."
},
{
"speaker": "Lars Moravy",
"content": "Or home phones."
},
{
"speaker": "Elon Musk",
"content": "Yes, no even exactly. When is the last time you saw a home phone."
},
{
"speaker": "Lars Moravy",
"content": "No idea in a hotel, sometimes in hotels."
},
{
"speaker": "Elon Musk",
"content": "Yes, the hotels have them. Yes. So the people don't understand all cars will need to be smart cars, or you will not sell or the car will not – nobody would buy it. Once that becomes obvious, I think licensing becomes not optional."
},
{
"speaker": "Mark Delaney",
"content": "It becomes a method of survival?"
},
{
"speaker": "Elon Musk",
"content": "Yes, absolutely, it is. License it or nobody will buy your car."
},
{
"speaker": "Vaibhav Taneja",
"content": "I mean one other thing which I'll add is in the conversations, which we've had with some of these OEMs, I just want to also point out that they take a lot of time in their product life cycle."
},
{
"speaker": "Elon Musk",
"content": "Yes."
},
{
"speaker": "Vaibhav Taneja",
"content": "They're talking about years before they will put it in their product. We might have a licensing deal earlier than that, but it takes a while. So this is where the big difference between us and them is, right?"
},
{
"speaker": "Elon Musk",
"content": "Yes, I mean, really a deal signed now would result in it being in a car probably three years."
},
{
"speaker": "Vaibhav Taneja",
"content": "That would be early."
},
{
"speaker": "Elon Musk",
"content": "Yes. That's like lightening basically."
},
{
"speaker": "Lars Moravy",
"content": "That's in eager [ph] OEM."
},
{
"speaker": "Elon Musk",
"content": "Yes. So I wouldn't be surprise if we do sign a deal. I think we have a good chance we do sign a deal this year, maybe more than one. But yes, it would be probably three years before it's integrated with a car. Even though all you need is cameras and our inference computer. So just talking about a massive design change."
},
{
"speaker": "Vaibhav Taneja",
"content": "Yes. And again, just to clarify, it's not the work which we have to do. It's the work which they have to do, which will take the time."
},
{
"speaker": "Elon Musk",
"content": "Yes."
},
{
"speaker": "Vaibhav Taneja",
"content": "Mark, is it helpful?"
},
{
"speaker": "Mark Delaney",
"content": "Yes, very helpful. Thank you. My follow-up was to better understand Tesla's approach to pricing going forward. Previously, the company had said that the price reductions were driving incremental demand with how affordable the cars have become, especially for vehicles that have access to IRA credits and some of the leasing offers that Tesla has in place. Do you still see meaningful incremental price reductions as making sense from here for the existing products? And can the company meaningfully lower prices from here and also stay free cash flow positive on an annual basis with the current product set? Thanks."
},
{
"speaker": "Elon Musk",
"content": "Yes. I think we can be free cash flow positive meaningfully."
},
{
"speaker": "Lars Moravy",
"content": "I think Vaibhav said it in his opening remarks, like our cost down efforts, we basically were offsetting the price cut like we’re trying to give it back to the customers."
},
{
"speaker": "Elon Musk",
"content": "Yes. I mean the end of the day, like for any given company, if you sell a great product at a great price – if you have a great product at a great price, the sales will be excellent. That’s true of any area. So over time, we do need to keep making sure that we’re – that it’s a great product at a great price. And moreover, that price is accessible to people. So it’s not – you have to solve both the value for money and the fundamental affordability question. The fundamental affordability question is sometimes overlooked. If somebody is earning several hundred thousand dollars a year, they don’t think of a car from a fundamental affordability standpoint. But from vast majority of people are living paycheck to paycheck. So it actually makes a difference if the cost per month for lease refinancing is $10 one way or the other. So it is important to keep improving the affordability and to keep making the price."
},
{
"speaker": "Lars Moravy",
"content": "More accessible."
},
{
"speaker": "Elon Musk",
"content": "Yes, exactly. Make the price more accessible, the value for money better, and to keep improving that over time."
},
{
"speaker": "Lars Moravy",
"content": "But also make kick as cost that people want to buy."
},
{
"speaker": "Elon Musk",
"content": "Yes, it’s going to be a great product and at a great price. And the standards for what constitutes great product at a great price keep increasing. So there’s like – you can’t just be static. You have to keep making the car better, improving the price, but improving the cost of production, and that’s what we’re doing."
},
{
"speaker": "Vaibhav Taneja",
"content": "Yes. And in fact, like I said in my opening remarks also, like the revised – the updated Model 3 is a fantastic car. I don’t think people fully even understand that lot of engineering effort which has gone and Lars and team have actually put out videos explaining how much the car is different. I mean it looks and feels different. Not only it looks and feels different. We’ve added so much value to it, but you can lease it for like as low as $299 a month."
},
{
"speaker": "Lars Moravy",
"content": "Without gas."
},
{
"speaker": "Vaibhav Taneja",
"content": "Yes."
},
{
"speaker": "Martin Viecha",
"content": "All right. The next question comes from George from Canaccord. George, please go ahead and unmute."
},
{
"speaker": "Unidentified Analyst",
"content": "Hi, thank you for taking my question. First, could you please help us understand some of the timing of launching FSD in additional geographies, including maybe clarifying your recent comment about China? Thank you."
},
{
"speaker": "Elon Musk",
"content": "I mean like new markets, yes, we are – there are a bunch of markets where we don’t currently sell cars that we should be selling cars in. We’ll see some acceleration of that."
},
{
"speaker": "Unidentified Analyst",
"content": "And FSD new markets?"
},
{
"speaker": "Elon Musk",
"content": "Yes. So think about the end-to-end neural net-based autonomy is that just like a human, it actually works pretty well without modification in almost any market. So we plan on – with the approval of the regulators, releasing it as a supervised autonomy system in any market that – where we can get regulatory approval for that, which we think includes China. So yes, it’s – just like a human, you can go rent a car in a foreign country and you can drive pretty well. Obviously, if you live in that country, you’ll drive better. And so we’ll make the car drive better in these other countries with country-specific training. But it can drive quite well almost everywhere."
},
{
"speaker": "Vaibhav Taneja",
"content": "The basics of driving are basically same everywhere like car is a car, the traffic lights, road is the road. Yes."
},
{
"speaker": "Elon Musk",
"content": "It understands that it shouldn’t hit things, no matter what the road rules are."
},
{
"speaker": "Vaibhav Taneja",
"content": "Exactly. There are some road rules that you need to follow. And in China, you shouldn’t cross over a solid line to do a lane change. In U.S. it’s a recommendation I think. In China, you get fined heavily if you do that. We have to do some more actions, but it’s mostly smaller reduction. It’s not like the entire change or type or something."
},
{
"speaker": "Elon Musk",
"content": "Yes."
},
{
"speaker": "Martin Viecha",
"content": "Hey, George, do you have a follow-up?"
},
{
"speaker": "Unidentified Analyst",
"content": "Yes. So my follow-up has to do with the first quarter deliveries and I’m curious as to whether or not you feel that supply constraints that you mentioned throughout the release impacted the results and maybe can you help us quantify that? And is that why you have some confidence in unit growth in 2024?"
},
{
"speaker": "Vaibhav Taneja",
"content": "Yes. I think we did cover this a little bit in the opening remarks to you. Q1 had a lot of different things which are happening. Seasonality was a big one, continued pressure from the macroeconomic environment. We had attacks at our factory. We had Red Sea attacks, we are ramping Model 3, we’re ramping Cybertruck. All these things are happening. I mean, it almost feels like a culmination of all those activities in a constrained period. And that gives us that confidence that, hey, we don’t expect these things to recur."
},
{
"speaker": "Elon Musk",
"content": "Yes. We think Q2 will be a lot better."
},
{
"speaker": "Vaibhav Taneja",
"content": "Yes."
},
{
"speaker": "Lars Moravy",
"content": "It’s just one thing after another. Our Cybertrucks are crazy. Thank you."
},
{
"speaker": "Elon Musk",
"content": "Yes, exactly. It’s just – if you’ve got cars that are sitting on ships, they obviously cannot delivered to people. And if you’ve got the excess demand for Model 3 and Model Y in one market, but you don’t have it there. It’s quite a – it’s extremely complex logistics situation. So I’d say also the – we did overcomplicate the sales process, which we’ve just in the past week or so have greatly simplified. So it became far too complex to buy a Tesla, whereas it should just be you can buy the car in under a minute. So we’re getting back to that you can buy a Tesla in under an minute interface from what was quite complex."
},
{
"speaker": "Martin Viecha",
"content": "Okay, thank you. Let’s go to Colin Rusch from Oppenheimer. Colin, go ahead and unmute, please."
},
{
"speaker": "Colin Rusch",
"content": "Thanks so much, guys. Given the pursuit of Tesla really as a leader in AI for the physical world, in your comments around distributed inference, can you talk about what that approach is unlocking beyond what’s happening in the vehicle right now?"
},
{
"speaker": "Elon Musk",
"content": "Do you want to say something?"
},
{
"speaker": "Ashok Elluswamy",
"content": "Yes. Like Elon mentioned like the car even when it's a full robotaxi it's probably going to be used 150 hours a week."
},
{
"speaker": "Elon Musk",
"content": "That's my guess like a third of the hours of the week."
},
{
"speaker": "Ashok Elluswamy",
"content": "Yes. It could be more or less, but then there's certainly going to be some hours left for charging and cleaning and maintenance in that world, you can do a lot of other workloads, even right now we are seeing, for example, these LLM companies have these like batch workloads where they send a bunch of documents and those run through pretty large neural networks and take a lot of compute to chunk through those workloads. And now that we have already paid for this compute in these cars, it might be wise to use them and not let them be idle, be like buying a lot of expensive machinery and leaving to them idle. Like we don't want that, we want to use the computer as much as possible and close to like basically 100% of the time to make it a use of it."
},
{
"speaker": "Elon Musk",
"content": "That’s right. I think it's analogous to Amazon Web Services, where people didn't expect that AWS would be the most valuable part of Amazon when it started out as a bookstore. So that was on nobody's radar. But they found that they had excess compute because the compute needs would spike to extreme levels for brief periods of the year and then they had idle compute for the rest of the year. So then what should they do to pull that excess compute for the rest of the year? That's kind of..."
},
{
"speaker": "Ashok Elluswamy",
"content": "Monetize it"
},
{
"speaker": "Elon Musk",
"content": "Yes, monetize it. So, it seems like kind of a no-brainer to say, okay, if we've got millions and then tens of millions of vehicles out there where the computers are idle most of the time that we might well have them do something useful."
},
{
"speaker": "Ashok Elluswamy",
"content": "Exactly."
},
{
"speaker": "Elon Musk",
"content": "And then, I mean, if you get like to the 100 million vehicle level, which I think we will, at some point, get to, then – and you've got a kilowatt of useable compute and maybe your own hardware 6 or 7 by that time. Then you really – I think you could have on the order of 100 gigawatts of useful compute, which might be more than anyone more than any company, probably more than a company."
},
{
"speaker": "Ashok Elluswamy",
"content": "Yes, probably because it takes a lot of intelligence to drive the car anyway. And when it's not driving the car, you just put this intelligence to other uses, solving scientific problems or answer in terms of someone else."
},
{
"speaker": "Elon Musk",
"content": "It's like a human, ideally. We've already learned about deploying workloads to these nodes"
},
{
"speaker": "Ashok Elluswamy",
"content": "Yes. And unlike laptops and our cell phones, it is totally under Tesla's control. So it's easier to distribute the workload across different nodes as opposed to asking users for permission on their own cell phones to be very tedious."
},
{
"speaker": "Elon Musk",
"content": "Well, you're just draining the battery on the phone."
},
{
"speaker": "Ashok Elluswamy",
"content": "Yes, exactly. The battery is also..."
},
{
"speaker": "Elon Musk",
"content": "So like technically, I suppose like Apple would have the most amount of distributed compute, but you can't use it because you can't get the – you can't just run the phone at full power and drain the battery."
},
{
"speaker": "Ashok Elluswamy",
"content": "Yes."
},
{
"speaker": "Elon Musk",
"content": "So, whereas for the car, even if you're a kilowatt level inference computer, which is crazy power compared to a phone. If you've got 50 or 60 kilowatt hour pack, it's still not a big deal to run if you are plugged it – whether you plugged it or not – you could be plugged in or not like you could run for 10 hours and use 10-kilowatt hours of your kilowatt of compute power."
},
{
"speaker": "Lars Moravy",
"content": "Yes. We got built in like liquid cold thermal management."
},
{
"speaker": "Elon Musk",
"content": "Yes, exactly."
},
{
"speaker": "Lars Moravy",
"content": "Exactly for data centers, it's already there in the car."
},
{
"speaker": "Elon Musk",
"content": "Exactly. Yes. Its distributed power generation – distributed access to power and distributed cooling, that was already paid for."
},
{
"speaker": "Ashok Elluswamy",
"content": "Yes. I mean that distributed power and cooling, people underestimate that costs a lot of money."
},
{
"speaker": "Vaibhav Taneja",
"content": "Yes. And the CapEx is shared by the entire world sort of everyone wants a small chunk, and they get a small profit out of it, maybe."
},
{
"speaker": "Elon Musk",
"content": "Yes."
},
{
"speaker": "Colin Rusch",
"content": "Thanks so much guys. And just my follow-up is a little bit more mundane. Looking at the 4680 ramp, can you talk about how close you were to target yields and when you might start to accelerate incremental capacity expansions on that technology?"
},
{
"speaker": "Elon Musk",
"content": "We're making good progress on that. But I don't think it's super important for at least in the near term. As Lars said, we think it will be exceed the competitiveness of suppliers by the end of this year and then we'll continue to improve."
},
{
"speaker": "Lars Moravy",
"content": "Yes. I mean, I think it's important to note also that like the ramp right now is relevant to the Cybertruck ramp."
},
{
"speaker": "Elon Musk",
"content": "Yes."
},
{
"speaker": "Lars Moravy",
"content": "And so like we're not going to just randomly build 4680s unless we have a place to put them and so we're going to make sure we're prudent about that. But we also have a lot of investments with all our cell suppliers and vendors. They're great partners, and they've done great development work with us and a lot of the advancements in technologies and chemistry we found 4680, they're also putting into their cells."
},
{
"speaker": "Elon Musk",
"content": "Yes. I mean a big part of the 4680, Tesla doing internal cells was a hedge against what would happen with our suppliers because for a while they are it was very difficult because every big carmaker put in massive battery orders, and so the price per kilowatt hour of lithium-ion batteries went to crazy numbers, crazy levels."
},
{
"speaker": "Vaibhav Taneja",
"content": "Bonkers."
},
{
"speaker": "Elon Musk",
"content": "Yes, just bonkers. So like, okay, we've got to have some hedge here to deal with cost per kilowatt hours of numbers that were double what we anticipated. If we have an internal cell production, then we have that hedge against demand shocks, we have too much demand. That's really the way to think about it. It's not like we want to take on a whole bunch of problems just for the hell of it. We did the cell program in order to address the crazy increase in cost per kilowatt hour from our suppliers due to gigantic orders placed by every carmaker on earth."
},
{
"speaker": "Martin Viecha",
"content": "Okay. Thank you. And the last question comes from Ben Kallo from Baird. Ben, go ahead and unmute. Ben, you're still muted."
},
{
"speaker": "Elon Musk",
"content": "Well, I want to say again, we'd just like to strongly recommend that anyone who is, I guess, thinking about the Tesla stock should really drive FSD 12.3. It really – you can't – it's impossible to understand the company if you do not do this."
},
{
"speaker": "Martin Viecha",
"content": "All right. So since Ben is not unmuting. Let's try Shreyas Patil from Wolfe Research. Final question."
},
{
"speaker": "Shreyas Patil",
"content": "Thanks so much. Just Elon, during the Investor Day last year, you mentioned that auto COGS per unit for the next-gen vehicle would decline by 50% versus the current three and Y. I think that was implying something around $20,000 of COGS. About one-third of that was coming from the on-box manufacturing process. But I'm curious if you see an opportunity that the – some of the other drivers around powertrain cost reduction or material cost savings, would those be largely transferable to some of the new products that you're now talking about introducing?"
},
{
"speaker": "Lars Moravy",
"content": "Yes, sure. I mean, in short, yes, I mean, like the on-box manufacturing method is certainly great and revolutionary, but with it comes some risks because new production lines and not, but all the subsystems we developed, whether it was powertrains, drive units, battery improvements in manufacturing and automation, thermal systems, seating, integration of interior components and reduction of LV controllers, all that's transferable, and that's what we're doing, trying to get it in their products as fast as possible. And so yes, that engineering work, we're not trying to just throw it away and put a cars and we're going to take it and utilize it and utilize it to the best advantage of the cars we make and the future cars make."
},
{
"speaker": "Shreyas Patil",
"content": "Okay. Great. And then just on that topic of 4680 cells, I know you mentioned it, you really thought of it more as like a hedge against rising battery costs from other OEMs. But it seems even today, it seems like you would have a cost advantage against some of those other automakers. And I'm wondering, given the rationalizing of your vehicle manufacturing plans that you're talking about now, if there's an opportunity to maybe convert the 4680 cells and maybe sell those to other automakers and really generate an additional revenue stream. I'm just curious if you have any thoughts about that."
},
{
"speaker": "Elon Musk",
"content": "Great. What seems to be happening is that the I'm missing something, the orders for batteries from other automakers have declined dramatically. So we're seeing much more competitive prices for sales from our suppliers, dramatically more competitive than in the past. It is clear that a lot of our suppliers have excess capacity."
},
{
"speaker": "Vaibhav Taneja",
"content": "Yes. In addition to what Elon, this is kind of in addition to what Elon said, about 4680, what 4680 did for us from a supply chain perspective was help us understand the supply chain that's upstream of our cell suppliers. So a lot of the deals that we had struck for 4680, we can also supply those materials to our partners, help reducing the overall cost back to Tesla. So we're basically inserting ourselves in the upstream supply chain by doing that. So that's also been beneficial in reducing the overall pricing in addition to the excess capacity that these suppliers have."
},
{
"speaker": "Elon Musk",
"content": "Yes. No, I mean this is going to wax and wane, obviously. So there's going to be a boom and bust in battery cell production where production exceeds supply and then supply exceeds production and back and forth kind of like, I don't know, DRAM or something. But Yes. So it's like what is true today will not be true in the future, there's going to be somewhat of a boom and bust cycle here. And then there are additional complications with government incentives like the Inflation Reduction Act, the IRA, Joe [ph] has found like a funny name."
},
{
"speaker": "Vaibhav Taneja",
"content": "Comical name."
},
{
"speaker": "Elon Musk",
"content": "Yes, it is like Irish Republican Army, The Internet Research Agency from Russia."
},
{
"speaker": "Vaibhav Taneja",
"content": "Independent retirement account."
},
{
"speaker": "Elon Musk",
"content": "Yes, exactly. Roth IRA. It's like Spider-Man situation, which IRA wins. So but it is complicate the incentive structure. So that is there's the stronger demand for cells that are produced in the U.S. than outside the U.S. But then how long is that the IRA last, I don't know."
},
{
"speaker": "Vaibhav Taneja",
"content": "Which is why it's important that we have both internet [ph] cells and vendor cells that hedge against all of this."
},
{
"speaker": "Martin Viecha",
"content": "Okay. Thank you very much. That's all the time we have today. But at the same time, I would like to make a short announcement. And I wanted to let the investment community know that about a month ago, I met up with Elon and Vaibhav and announced that I'll be moving on from the world of Investor Relations. I'll be hanging around for another couple of months or so. So feel free to reach out at any time. But after the seven year sprint, I'm going to be taking a break and spending some good quality time with my family. And I wanted to say that these seven years have been the greatest privilege of my professional life. I'll never forget the memories from I started literally at the beginning of production hell and just watching the company from the inside to see what it's become today. And especially super thankful to the people in this room and dozens of people outside of this room that I've worked for over the years. I think the team's strength and teamwork at Tesla is unlike anything else I've seen in my career. Elon, thank you very much for this opportunity that I got back in 2017. Thank you for seeking investor feedback and regularly and debating it with me."
},
{
"speaker": "Elon Musk",
"content": "Yes. Well, I mean the reason I reached out to you was because I thought your analysis of Tesla was the best that I had seen."
},
{
"speaker": "Martin Viecha",
"content": "Thank you."
},
{
"speaker": "Elon Musk",
"content": "So, thank you for helping Tesla to get to where it is today over seven years. It's been a pleasure working with you."
},
{
"speaker": "Martin Viecha",
"content": "Thank you so much. And yes, thank you for all the thousands of shareholders that we've met over the years and walked around factories and loved all the interactions, even the tough ones. And yes, looking forward to the call in the next three months, but I'll be on the other side, listening in. Thank you very much."
},
{
"speaker": "Vaibhav Taneja",
"content": "Thanks."
}
] |
tsn | 2,024 | 4 | [
{
"speaker": "Operator",
"content": "Good morning and welcome to the Tyson Foods Fourth Quarter 2024 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions]. Please note this event is being recorded. I would now like to turn the conference over to Mr. Sean Cornett. Please go ahead."
},
{
"speaker": "Sean Cornett",
"content": "Good morning and welcome to Tyson Foods fiscal fourth quarter 2024 earnings conference call. On today's call, Tyson's President and Chief Executive Officer Donnie King; and Chief Financial Officer, Curt Calaway will provide some prepared remarks followed by Q&A. Additionally, joining us today are Brady Stewart, Group President Beef Fork and Chief Supply Chain Officer; Kyle Narron, Group President Prepared Food; Wes Morris, Group President Poultry; Devin Cole, President International and Golden McDonald's; and Melanie Boulden, Chief Growth Officer. We've also provided a supplemental presentation which may be referenced on today's call and is available on Tyson's Investor Relations website and via the link in our webcast. During today's call, we will make forward-looking statements regarding our expectations for the future. These forward-looking statements made during this call are provided pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements include all comments reflecting our expectations, assumptions, or beliefs about future events or performance that do not relate solely to historical period. These forward-looking statements are subject to risks, uncertainties, and assumptions which may cause actual results to differ materially from our current projections. Please refer to our forward-looking statements disclaimers on Slide 2 as well as our SEC filings for additional information concerning risk factors that could cause our actual results to differ materially from our projections. We assume no obligation to update any forward-looking statements. Please note that references to earnings per share, operating income, and operating margin in our remarks are on an adjusted basis unless otherwise noted. For reconciliation of these non-GAAP measures to their corresponding GAAP measures, please refer to our earnings press release. Now, I'll turn the call over to Donnie"
},
{
"speaker": "Donnie King",
"content": "Thanks, Sean, and thank you to everyone for joining us. This morning, we reported our fourth quarter and fiscal year 2024 results. Performance in Q4 was strong. In fact, adjusted operating income and adjusted earnings per share were both the best results in the past eight quarters, and both more than doubled compared to Q4 last year. The momentum we've built led to significant improvement in full-year profitability in 2024. For the year, AOI of more than $1.8 billion, nearly doubled versus fiscal 2023, while adjusted EPS of $3.10 increased more than 130%. We're clearly pleased with our performance this year, where a significant turnaround in chicken combined with strong results in prepared food and improvements in pork offset well-known challenges in beef. Our disciplined capital allocation drove strong cash performance in 2024 as well. Free cash flow increased by more than $1.6 billion versus last year and came in at more than twice the dividend this year. This result was driven by increased AOI and prudent CapEx management, while still investing for profitable growth. Overall, our financial health strengthened significantly from where we ended fiscal 2023. Each of our team members across the organization contributed to this strong performance in 2024. I'm very thankful for the hard work they do every day to make us a world-class food company and recognized leader in protein. I want to point out that beyond the results in fiscal 2024, we're providing guidance for fiscal 2025, which builds on our momentum. At the midpoint, AOI is growing and our financial strength is improving. It's important to note that our guidance at midpoint for prepared food and chicken reflects AOI expectations of more than $2 billion combined. Our outlook for next year highlights the benefits of our multi-protein, multi-channel portfolio. Our strategy remains the same and reflects the continued focus on our business fundamentals. Our priority on controlling the controllables has clearly delivered positive benefits in fiscal 2024 and we expect that to continue in 2025. I want to emphasize that I remain optimistic about our future and I am highly confident in our ability to drive long-term value for shareholders. Let's move to segment highlights, starting with prepared food, which has been a solid and stable driver of profitability. AOI results for the quarter and the year came in just as we expected, with the midpoint of our segment guidance remaining constant all year. FY '24 AOI grew 2% year-over-year and was the best performance since fiscal year '18, overcoming headwinds of startup costs at our new Bowling Green plant in a challenging consumer environment. Overall volume grew nearly 1% as we continue to broaden our customer base and expand our presence in broad line distribution categories. Moving to chicken, AOI results came in above the high end of our most recent guidance range. While we benefited from lower grain costs, our focus on the fundamentals of live operations, where hatch and livability again improved year-over-year in Q4, and plant efficiencies also contributed to the strong results for the quarter and the year. It's clear that we've built a fundamentally stronger chicken business as evidenced by the significant turnaround in AOI from fiscal '23 to '24, which was our best full-year AOI performance in the past seven years. While results in beef were better than anticipated for Q4, we continue to see compressed spreads versus last year, driving the decline of profitability for both the quarter and full year. Obviously, the current cattle cycle remains challenging as there are no clear signs of sustained herd rebuilding intentions. We will remain focused on the things we can control as we've managed through it. Turning to pork, improved spreads highlighting herd health and solid demand drove a $270 million year-over-year increase in AOI for fiscal '24. As I mentioned, our focus on controlling the controllables has produced solid results for fiscal 2024, and we expect this to continue. We have five strategic enablers that drive our priorities for 2025 and beyond. This is our roadmap for success, and we're building on this foundation. Let's look at our enterprise priorities for 2025. Operational excellence never gets old or goes out of style. For us, a key element of operational excellence is gaining enterprise scale and unlocking savings in our controllables by modernizing our operations and driving performance to standards. You've seen the benefits of this in our results for 2024, and we've embedded this approach in our guidance for 2025 across the business with a noticeable impact in prepared foods. As we are in service to our customers and consumers, we are building on our iconic brands to value up our core proteins. We have three of the top 10 brands in protein behind Tyson, Jimmy Dean, and Hillshire Farm. While our brands are healthy, we have opportunities to expand our household penetration by better serving consumers with innovation for new meal locations, categories, and channels. One of the ways we will achieve our strategic goals is by investing in our digital capabilities, utilizing big data, predictive analytics, and artificial intelligence for better decision-making and outcomes. Our data and digital delivery priority enables improved yield and mix across many of our operations and is important as we modernize customer engagement and drive consumer insights. We are accelerating digitalization in our end-to-end demand and supply planning, becoming platform-driven with an exception management strategy that optimizes working capital. Capital allocation is an important strategic priority that unlocks fuel for the enterprise. As Curt will elaborate on shortly, we made tremendous strides in our cash management in '24, and we plan to be just as disciplined in '25 with a continued focus on managing CapEx and working capital to drive free cash flow. Importantly, we're focused on team member development as the foundation of our planned delivery and to build on our strong history of our winning culture. With these strategic priorities outlined, let's move to our segment priorities for the next year, starting with prepared foods. There is significant opportunity to drive profitability in prepared foods by operating with an increased level of discipline, increasing throughput and yield by performing to standards, eliminating waste, reducing complexity, and continuing to improve service levels. Our focus on data analytics drives insight into consumer preferences, as well as disciplined investment to support and grow our core products and drive innovation. As an example, Jimmy Dean is one of our strongest brands, but there is still room to expand its appeal and market opportunities in adjacent morning eating occasions. To capture trends towards spicier foods and convenience, we recently launched Spicy Chicken Honey Biscuits, a restaurant-quality breakfast sandwich. We previously mentioned the success of our grill cake platform, which has strong customer adoption and repeat rates. We're leveraging the success of these innovations and further leaning into our other top-performing SKUs to capture opportunities to expand distribution. Moving to chicken, there's no clear demonstration of the benefits of operational excellence than the efficiencies we drove in chicken in fiscal '24. We plan to sustain and improve our live and plant operations and maintain a disciplined S&OP process in 2025. As you've seen, when our live operations are running well and our demand plan is more accurate, we can operate much more efficiently while better servicing our customers and reducing inventory, all in support of generating more stable and predictable results. At the heart of our strategy lies a commitment to long-term partnerships with strategic customers. By fostering these collaborations, we ensure stable demand for our products and create mutually beneficial win-win relationships focused on growing the category with our customers. Next, I want to touch upon how we can build value through investments in our branded and value-added chicken portfolio. Tyson holds the number one brand position in value-added chicken across both retail and food service. Over the past year, we've made significant investments to enhance and expand our portfolio of high-quality, innovative, and convenient products. We're also excited to debut our revitalized packaging, which reflects Tyson's relentless focus on quality and generates consumer excitement. The new packaging rollout in October coincides with the launch of our new Tyson-branded advertising campaign, Always Been Tyson. More broadly, our fully-cooked portfolio is a high-ROI area where we will continue to deploy capital to expand our market presence and maximize returns. For example, we accelerated the ramp-up of our new Danville facility this year and are now exploring our next Danville-scale operation. This approach not only strengthens our financial performance, but also solidifies our competitive positioning in the industry. As you know, our beef business is challenged by the dynamics of the current cattle cycle. Our focus for FY'25 and beyond is to build a best-in-class operation so that we are well prepared when the cycle turns as we fully believe it will. At the same time, we continue to align every aspect of our operations from procurement, where we are strengthening our relationship with key suppliers, to production and distribution to meet customer and consumer demand. In addition, we continue to improve our cost structure with tight spend management and increased efficiencies while enhancing yield and mix to add value. We're meeting consumers' demand for convenience with an expanded assortment of pre-seasoned beef available in a variety of new flavors and forms. We are a leader in beef, and we want to be a valued partner for our customers by having the right product at the right time to meet their needs. We made good progress on operational improvement in our pork business in fiscal '24, which allowed us to capture the benefits of a better market condition, and we expect to make incremental progress this year. The network optimization initiative we completed in '24 is expected to drive better capacity utilization and allow us to improve our mix by leveraging the capabilities of our remaining plants. We're also scaling up our use of data to make better decisions on mix and to improve yield. Like beef, our pork team has been expanding our portfolio of seasoned and marinated products to drive increased value-added offerings while strengthening our partnership with key customers. Across the business, our focus on controlling the controllables can drive sustainable cash flow, better operational execution, and improve mix and deliver a solid performance in fiscal 2025. Before I hand things over to Curt to review our financials in more detail, I want to share the positive results from the execution of our strategy, demonstrated by the momentum of our value-added businesses in prepared foods and chicken, while we are also managing through and acknowledging the challenges of the current beef cycle. As our value-added businesses grow and drive a larger portion of our profitability over time, we should expect a more stable earnings profile. Looking at prepared foods in fiscal '24, we delivered AOI growth of over $100 million as compared to the five-year average from fiscal '19 to '23, and its share of overall profitability has increased from a quarter to a half. Additionally, at the midpoint of our fiscal '25 guidance, we're also expecting nearly a $100 million increase in earnings. With that, I'll turn the call over to Curt."
},
{
"speaker": "Curt Calaway",
"content": "Thanks, Donnie. Total company net sales were up 1.6% year-over-year in Q4 and 0.8% for fiscal '24. Beef and chicken were the primary drivers for the quarter, while beef and pork led the sales increase for the full year, partially offset by chicken. Q4 adjusted operating income of $512 million, margin of 3.8%, and adjusted EPS of $0.92 were the strongest quarterly results this year, all more than doubling versus Q4 of '23. And as Donnie mentioned, the best performance in the past eight quarters. Full-year AOI of more than $1.8 billion, nearly doubled, and adjusted EPS of $3.10 grew over 130%. Significant improvement in chicken profitability was the largest driver of year-over-year growth for both the quarter and the full year, with contributions from prepared foods and pork offsetting declines in beef. Now let's review our segment results for Q4. In prepared foods, Q4 revenue declined 1.2% versus last year, driven by lower retail volume. It's worth noting that we continued to make progress in total volume growth outside of retail in both Q4 and fiscal '24. As we expected, AOI in Q4 increased noticeably year-over-year, benefiting from lower raw material costs, operational efficiencies, and reduced MAP spending as we have focused on reducing inefficient support costs. These drivers also contributed to the best full-year AOI performance in the past six years, overcoming startup costs and unfavorable mix. Moving to chicken, sales in the quarter increased 2.3% inclusive of a legal contingency accrual recorded in Q4 last year. While volume declined modestly year-over-year, it grew approximately 1% versus Q4 of fiscal '22, as we continued to better align supply and demand. AOI increased $281 million versus last year to $356 million. Lower input costs, net of pass-through pricing, and improved operational efficiencies and execution drove the growth in AOI. For the year, chicken AOI improved by nearly $1.1 billion, leading to the strongest AOI performance since fiscal '17. In beef, revenue is up 4.6% year-over-year in the quarter, primarily due to volume, driven by higher average carcass weights and higher head throughput. While revenue increased, AOI decreased, primarily reflecting compressed spreads as expected. Moving to pork, Q4 revenue decreased 3.7%, driven by lower pricing on dropped credit items, partially offset by increased volume. AOI increased $27 million year-over-year, benefiting from improved operational execution. For the full year, AOI increased $270 million, highlighting improved spread. Shifting to our financial position, our commitment to disciplined capital allocation remains constant. Our priorities are to maintain financial strength, invest in the business, and return cash to shareholders, all while maintaining our investment-grade credit rating. Full-year cash flow from operations increased nearly $840 million, driven by improved profitability and working capital management. Operating cash flows of $2.6 billion was more than double our CapEx, which came in at just over $1.1 billion for the year, reflecting our disciplined capital deployment while continuing to invest for profitable growth. Fiscal '24 free cash flow improved by more than $1.6 billion year-over-year. This increase was driven by roughly equal contributions from higher operating cash flow and lower CapEx. Free cash flow of nearly $1.5 billion was more than 2x our total dividend. As you saw in our earnings release, we raised our dividend for the 13th consecutive year, reflecting confidence in our cash flow generation. We remain committed to the dividend as our primary way of returning cash to shareholders. Additionally, we ended the year with $4 billion of liquidity after repaying our 2024 senior notes in August for $1.25 billion. Net leverage declined again sequentially, ending the fiscal year at 2.6x. This is a full one and a half turns of improvement versus where we exited fiscal '23. We've made good progress, but continue to focus on returning net leverage to our long-term target of at or below 2x net debt to adjusted EBITDA. Our plan for fiscal '24 was to apply our controlling the controllables approach to improve our financial strength. As you can see in our free cash flow and net leverage performance, we've clearly over-delivered on that plan and remain committed to deploying resources to maximize long-term shareholder value. Now let's look at our guidance for fiscal '25. We anticipate sales dollars to be flat to down 1%. We expect volume growth in chicken and prepared foods to be offset by lower beef and pork volumes. However, total company AOI is expected to be between $1.8 billion and $2.2 billion, reflecting approximately 10% growth at the midpoint driven by prepared foods and chicken. Rounding out key P&L items, we anticipate interest expense to be roughly $380 million and our tax rate to be between 24% and 25%. As Donnie mentioned, we're going to maintain tight controls on spending and CapEx to be between $1 billion and $1.2 billion this year. While there are a range of outcomes for AOI, we expect our free cash flow to exceed $700 million, which is approximately our new expected annual cash dividend. Moving to the breakdown of total company AOI by segment, starting with prepared foods. While we don't anticipate material changes in consumer behavior, we still see a pathway to significant growth in prepared foods AOI by focusing on operational improvements that are in our control, as you saw in our segment priorities for fiscal '25. We expect AOI to be in a range of $900 million to $1.1 billion, representing double-digit growth at the midpoint driven by these initiatives. In chicken, we plan to sustain and build on the operational improvements we put in place in fiscal '24. We are reinvesting a portion of these benefits into our value-added portfolio, highlighted by our master brand relaunch and new marketing campaign. We anticipate chicken AOI to be in the range of $1 billion to $1.2 billion, highlighting high single-digit growth at the midpoint. Now on to our beef segment, where uncertainties remain, including the timing and pacing of meaningful herd rebuild intentions. These market dynamics are reflected in our range of outcomes for AOI for fiscal '25, where we expect a loss of $400 million to $200 million, which reflect a similar level of profitability year-over-year at the midpoint. In pork, we also expect a similar level of profitability in '25, as in '24, with AOI in the range of $100 million to $200 million. At the midpoint, benefits of our ongoing operational initiatives may be offset by tighter spreads. Our international business made strides in improving operations in fiscal '24, leading to a notable increase in AOI. We expect to make further progress in fiscal '25. Our outlook for the coming year reflects the benefit of our multi-protein, multi-channel portfolio. The middle of our range highlights solid earnings growth and continued progress on our operations and financial strength. Now I'll pass things back to Donnie to wrap up."
},
{
"speaker": "Donnie King",
"content": "Thanks, Curt. I'm proud of our fiscal 2024 results. We drove significant improvements in our P&L and on our balance sheet. These accomplishments are a direct result of our team's unwavering discipline in executing our strategic priorities. I'd like to take this time and opportunity again to thank each of our team members. Your focus and commitment has been essential to our success. Looking ahead, we still have room for improvement, but I'm optimistic about what's to come. We have a solid foundation as one team, one Tyson, and I'm confident we will continue making progress in fiscal '25, building on our iconic brands to value up our core proteins and striving to operate with excellence. Before we move to Q&A, I'd like to welcome Kyle Narron as our new Group President of Prepared Foods. With more than two decades of industry experience, Kyle is a proven leader with strong operational expertise and a deep understanding of our business. As you recall, Melanie Boulden came to us as Chief Growth Officer in early 2023 and shortly after agreed to take on additional responsibilities as Group President of Prepared Foods. I'd like to extend my gratitude to Melanie for delivering the fiscal '24 plan and creating momentum for growth in the future. Her role as Chief Growth Officer remains central to our growth strategy, especially as we move forward with the most robust innovation pipeline in our company's history. Her efforts to deliver continued breakthrough marketing and growth initiatives, including digital enablement, will be pivotal as we bring new consumers to the Tyson Foods portfolio. Kyle's appointment has been a seamless transition. We're confident his experience and leadership will ensure continued momentum for the business. Thank you for your time today and I look forward to updating you on our progress next quarter. Now, I'll turn the call back to Sean for Q&A instructions."
},
{
"speaker": "Sean Cornett",
"content": "Thanks, Donnie. We will now move to your questions. Please recall that our cautions on forward-looking statements and non-GAAP measures apply to both our prepared remarks and the following Q&A. Operator, please provide the Q&A instructions."
},
{
"speaker": "Operator",
"content": "We will now begin the question-and-answer session. [Operator Instructions] Our first question comes from Ben Theurer of Barclays. Please go ahead."
},
{
"speaker": "Ben Theurer",
"content": "Donnie and team congrats on a good finish of fiscal '24, first of all. So, along the line, Q4 obviously was very strong and the full year came in even a little bit better than you expected. You're still calling for some nice growth looking into '25. So, Donnie, maybe help us unpack a little bit the puts and takes within your outlook for '25 and maybe in a little bit more detail what gives you confidence of growth into next year. That would be my first question."
},
{
"speaker": "Donnie King",
"content": "Sure, and thank you, Ben, and good morning, everyone. Let me start with just saying how pleased we are with Q4 and the full year of 2024. We continue to see the benefits of our multi-protein portfolio where chicken, prepared pork, and international are all sitting the headwinds in beef. In Q4, momentum continues to strengthen. We saw significant cash generation with free cash flow more than 2x our dividend and substantial reduction of net leverage ratio to 2.6x. In FY '24, and this is why you should be confident, those enterprise priorities continue to deliver results. Our focus on operational excellence are delivering best-in-class operations by gaining efficiency and eliminating waste. Our focus on the customer and the consumer is allowing us to strengthen our iconic brand to expand reach and deliver innovation for new occasions. Our focus on data and digital tools allows us to use big data, analytics, and AI to improve operational decision-making and drive consumer insights and ultimately actions. Our focus on capital allocation is improving cash flow by managing CapEx and working capital. Our focus on team member development is foundational for our culture and delivering our plan. We expect prepared foods and chicken each to deliver approximately 50% of our AOI in fiscal year '25, a significant shift to a more valuable mix. Approximately 10% of our AOI growth in FY '25 at midpoint is driven by prepared foods and chicken. Now into each of the segments, a little color there. In prepared foods, AOI performance was the best full year since 2018. Would expect FY '25 AOI to have double-digit profitability growth at midpoint. In chicken, best full year AOI performance since fiscal year 2017. Market tailwinds and operational improvements driving results. Would expect FY '25 AOI to have high single-digit profitability growth at the midpoint. In pork, better spreads and improved performance drove significant year-over-year AOI increase. Would expect similar profitability at midpoint in '25. In beef, spread compression continues driven by a tight cattle supply but would expect similar profitability at the midpoint. In international, a nice improvement, a nice AOI performance taken with the 4Q one-time adjustments. Would expect FY '25 AOI performance to continue to improve as execution and capacity utilization improves. In total, would expect FY '25 AOI growth to be 10% at midpoint on a range of 1.8 billion to 2.2 billion. Now, five key takeaways from Q4 and as we think about '25. We will continue to shift our mix from core protein to branded value-added. Number two, we will increase household penetration in branded and value-added. Number three, protein is part of every healthy diet and protein is a clear winner in food. Number four, we will improve the returns on our invested capital and create shareholder value. And number five, we will execute with excellence in all that we do. In terms of just one adder here, in terms of volume for the year, we expect beef based on tight cattle supplies to be volume to be down slightly. Pork, because of some of the network optimization, should be down slightly. We would expect increases in volume in prepared foods chicken. So, that's the breakdown on the mix. With that, I will turn the question back to you, Ben."
},
{
"speaker": "Ben Theurer",
"content": "All right. That was very complete. One quick one on chicken, and this is really just like kind of maybe stretching a little bit of the expectations here. If we go back 12 months in time, you were kind of looking for maybe up to 700 million in AOI for chicken, and then it turned out to be more than a billion in FY '24. So, as we think about this, and obviously how the market conditions performed over the last couple of months and quarters now, how much of that do you think you can potentially carry over? And what are potential upside scenarios that would take you even beyond the current chicken outlook of call it maybe 1.2 billion at the higher end?"
},
{
"speaker": "Donnie King",
"content": "Ben, I would just say we have a fundamentally different and better chicken business than we had even a year ago, certainly two, three years ago. But our guidance for '25, the range is from 1 billion to 1.2 billion, which is really a high single-digit growth at midpoint. We're doing that at the same time we're investing back in the business with the new ad campaign, product innovation, and so forth, something on the order of about $100 million. So, with that, Wes, do you want to add anything?"
},
{
"speaker": "Wes Morris",
"content": "Yes, I'd love to. Ben, thank you for the question. And let me give you a little background so that it'll clear up a little bit. And I'd like to answer specifically your question around '25. And so, we executed our strategy in '24. It was a great team effort as we drove over a $0.5 billion in operational improvement across live plants and then matching up our supply and demand. And so, we delivered our strongest Q4 in history. But here's the part that most people don't know. While we were working on the cost side, we were also resetting the stage for the revenue side and winning with consumers. And so, Donnie mentioned our number one shared retail value added. We did a complete do-over in which we upgraded our quality to the point that our testing exceeded consumer expectations. Not I like it, but it exceeds my expectations. We've got a big innovation pipeline, both experimental and better for you. And experimental is form and flavor, what I call where food meets fun. And then the better for you is capitalizing on the protein content. We upgraded our packaging and it's based on basically decision trees of shopper's shop, brand, and then form and flavor. Donnie referenced our new advertising campaign. And what's exciting about that is that campaign resonates with our core shopper. Just as importantly, it resonates with the younger shopper, creating sustainability of demand over time. And so, we do have a stronger business and an impressive leadership team. We're well positioned into '25 and beyond to have a successful, sustainable business. And let me make one more comment about commercial, because that's something we've not talked about on the calls and a big step change going into '25. Our speed and improvement and go-to-market has been greatly increased. And so, business growth and R&D are a highly functioning team to not only understand them by consumer needs, but to create products and get them to commerce quickly. We've got the strongest pipeline of new products that I've seen in my career across any segment. And so, with that, let me transition to your question around 2025 outlook and how good is the number. And let me start with, hey, last year, my team surprised me with the speed and intensity of the improvement, right? So, yes, we did say 700, and we continued to perform faster and better than I anticipated. We think we've got good balance, good analytics, and good insight into what 2025 looks like. I'm very encouraged by 2025 as we've got a good team, we've got better fundamentals. Overarching markets appear stable. We've got a plan, performance improvement plan more than offsetting inflation. Then we'll spend around $100 million driving that mixed change of value added. And while our volume looks a little soft, last year, our fully cooked mix was up 5%. So, we've already started that mix adjustment to improve profitability. And so, all-in-all, we got a better cost structure, we got strong value added go-to-market hitting with a lot of intensity in 2025. And so, our guidance based on current market outlook, understanding we're more insulated than most companies, I feel good about. Now, we also think we're realistic about the macroeconomic impact of total demand, what's the industry supply potential, any impact to exports, ongoing weather patterns, which seem to be more frequent, and feed costs and global feedstocks. And so, we feel very good that based on what we know, our guidance is more accurate than any time in the past."
},
{
"speaker": "Operator",
"content": "Our next question comes from Heather Jones of Heather Jones Research. Please go ahead."
},
{
"speaker": "Heather Jones",
"content": "Congratulations on the quarter. My first question is a follow-up to Ben's. As far as on the chicken guide, I was you all have made a lot of changes in your operations there. You've pulled some complexes. So, I was just wondering if you could give us a little more specificity as far as your year-on-year growth for that cycle. How much of that is, things that [TyChic] [ph] in control as far as cost savings, more productivity, and how much is it you're assuming as far as the overall market dynamics?"
},
{
"speaker": "Donnie King",
"content": "Sure. I will tell you that the chicken business is performing. Wes, just a moment ago, talked about a number of those things. Think of this as a continuous mindset, continuous improvement mindset, operational excellence. Those are the gifts that keep on giving, if you will. And for us, that's not going out of style. And we'll do many of those same things as we here in 2025. We're off to a good start in 2025. Wes, why don't you touch on some of those specifics around controllables?"
},
{
"speaker": "Wes Morris",
"content": "Yes. I think in an effort to keep it fairly simple, if you use 2023 as a baseline, we have materially made a step change that has nothing to do with markets of over $500 million, right? We know where the continuous improvement opportunities are from there. So, I'm going to bake in another 185 that has nothing to do with markets. And so, we've made a major step change that regardless of meat values or corn values, those fundamental improvements are worth between $500 million and $700 million a year."
},
{
"speaker": "Heather Jones",
"content": "That's super helpful. And then, my follow-up is on beef. And basically, production there, just due to new feed additives, longer time on feed, just production has come in much higher than anyone would have expected this year. And those weight gains are likely to continue in 2025. So, given that we haven't had this hole in supply that was expected, the wholesale price gap between chicken and beef has been pretty narrow, as narrow as in two years, whereas the retail price gap is the highest ever. And so, just wondering what you all are hearing from retailers, given that supply has not been as bad as people thought, is there a possibility that retailers start promoting beef more at the expense of chicken in 2025? So, would love your thoughts on that."
},
{
"speaker": "Brady Stewart",
"content": "Well, good morning, Heather. Appreciate the question. It's Brady. First of all, I think it's really important to point out just where we sit from a beef demand perspective, just kind of set the stage. And when we look at '24 versus '23, we saw it from a choice cutout perspective increase just relative to the wholesale price as well. And it was up a little more than 2%, which signals really good beef demand. And we've seen that in our business as well. Then when we go and we kind of dissect it by primal and by product, it gets a little bit more interesting as well. And so, really kind of flattish prices across the board on the rib and lion. But we've seen a significant increase in price on the grinds. And so, I'm not sure that every single one of the products on beef is really a clear substitute with chicken and with pork. But where we have seen that increased demand in price has really been on lean trim. It's been on the grind. And we've seen some substitution opportunities between the round complex and the lean complex as well. From a retailer perspective, we have seen several different strategies deployed. And because we've seen the steady demand for beef, we know that the consumer is going to stay in there, continue to buy beef. And so, some retailers have certainly taken that promotional opportunity to work on that rib and loin complex to drive those market baskets higher in general. So, I guess the overarching sentiment, just relative to beef, is really good demand, even with these higher prices, and expect that to continue into 2025."
},
{
"speaker": "Wes Morris",
"content": "Hi, Ms. Heather. This is Wes again. And I was so focused on the cost side of your question, I think I should have mentioned a big unlock on the revenue side as well as we go into 2025. So, as you know, we opened five fully cooked wines in our Danville, Virginia, new plant earlier in 2024. Through great efforts from both retail and food service, that plant is actually sold out. And so, that mixed change that I referenced earlier, also changing economics, is baked into our 2025 plan. And I'm excited to announce that we're already starting to work on the next five fully cooked wines."
},
{
"speaker": "Operator",
"content": "The next question comes from Ken Goldman of JPMorgan. Please go ahead."
},
{
"speaker": "Ken Goldman",
"content": "Hi, thank you. I'll stay with chicken. And thank you for all the help, both of you, in terms of the mixed changes and, Curt, in terms of some of the permanent dollar changes to your operating income that you would expect. I wanted to ask, though, is it possible that there's a potential partial offset coming in the next year just from higher supply? And I know we're getting some mixed signals there, but we have seen chick placements increase to some extent. I'm just curious, not trying to rain on what's a pretty great parade here, but just wanted to get a sense for what's in your guidance for potentially higher industry chicken supply in the coming months."
},
{
"speaker": "Donnie King",
"content": "Thanks, Ken. Let me start out and answer that question. And if we want to go into more detail, I'll give it to Wes. But I would tell you in our guidance that 1 to 1.2, we have contemplated all those things that you just mentioned. So we're comfortable with the guidance that we've given. I think one thing that I'll just add to in terms of how this mix is shifting for us, not only in chicken, but for the other businesses, but for chicken specifically today. If you look at volume, while it is positive or projected positive for '25, what you don't see in that is this, that the outsized growth of the value-added branded business is up about 5%. Thus, we're filling up the Danville, Virginia plant, and then we're looking at another plant to do that. So what we're doing in shifting this core or commodity into more value added is working, which has been part of the Tyson history for many decades now. And so we'll do more of that. And we're aware of the market conditions, but we're trying to operate and be a company that is a little different in terms of what we do."
},
{
"speaker": "Wes Morris",
"content": "Yes. I'll share my perspective. If I could, I'll share my perspective real quick. We see the record exits, and I think it's reflecting strong demand for poultry, plus the industry's continued challenge in hatch and livability. Fortunately, Tyson's performance has dramatically outpaced the industry. We're able to service our customers. We referenced the 2.6% increase for the full year. But given the robust demand, I think there's good reason to believe that supply and demand are fairly balanced. But I want to be clear on something that we talk about internally. We really grow chickens for two reasons. We don't grow a lot of chickens to sell for whatever they're worth next Wednesday. We grow a lot of chickens for strategic customers to create win-win solutions who are looking for a continuity. And that has built-in mechanisms that if we perform, we make money. And then the second reason we grow chickens is as ingredients to our fully cooked and par-fry business, which we're growing exponentially. So the industry will do whatever it's going to do. I think we're well-positioned to win either way."
},
{
"speaker": "Ken Goldman",
"content": "Thank you. And if I could just ask a quick follow-up, you have a new administration coming in the White House. I think a lot of uncertainty, maybe both on the upside and downside. I'll leave this question open-ended, but just in terms of labor tariffs in both direction, regulations, is it possible to even analyze what might be some upside and downside drivers at this time, or is it just way too early to say?"
},
{
"speaker": "Donnie King",
"content": "Well, there's a lot that we don't know at this point, but I would remind you that we've successfully operated this business for over 90 years, no matter the party in control, the environment. We look forward to working with the incoming administration. Like all businesses, we'll assess any new policies and plan accordingly. So we're going to control, again, what we can control in this environment. So I'll leave it at that Ken."
},
{
"speaker": "Operator",
"content": "The next question comes from Pooran Sharma of Stephens Inc. Please go ahead."
},
{
"speaker": "Pooran Sharma",
"content": "Congratulations on the strong quarter."
},
{
"speaker": "Donnie King",
"content": "Thank you."
},
{
"speaker": "Pooran Sharma",
"content": "I was hoping just to gain a little bit more clarity for myself on beef and kind of your outlook, and more specifically, just wanted to understand just heifer retention or herd rebuilding dynamics. I understand we haven't seen that yet, but just looking at your guidance at the midpoint for beef, we're kind of looking flattish. My understanding is if you see signs of heifer retention, you are going to see the number of head going to slaughter plants going even lower, which fundamentally to me would put more compression on margins. Does the lower end of your operating income range factor in potential heifer retention? Or help me kind of think about potential heifer retention in your beef outlook for next year."
},
{
"speaker": "Donnie King",
"content": "Sure. Let me start off with that. In terms of the guidance, we're guiding to a loss of $400 million to a loss of $200 million. So the challenge continues. But as I mentioned earlier, this 2025 will be similar based on all of our modeling to '24. There's some influx, yes, heifer retention, and we're not seeing meaningful heifer retention. But there's also the influx of heavier weight cattle. There's the influx of some dairy into the supply and a number of other things. I'll flip it to Brady to let him give you some of the finer details of that."
},
{
"speaker": "Brady Stewart",
"content": "Sure. Thanks, Donnie. I think it's also important to understand what Tyson can control. I'm proud of the team relative to some of the improvements we made in '24. To have operating costs in our plants that are lower in '24 versus '23 when we saw some inflation and some lower headcount numbers is really meaningful to the outlook of our business as well and provides some visibility in terms of where we can control. This is one of the most dynamic beef environments in history, and we've gone through these cycles approximately every decade. But this one's really unique, and we've seen record cutout prices, some record weights that you referenced as well, and how all of these different pieces shape into the outlook is very interesting. So we've layered on a significant amount of data platforms to help us analyze our business better than we ever have before and make better business decisions that really drive outcomes that are important and meaningful And so from a cutout perspective, I mentioned earlier that we've seen really, really good demand, and we need to continue to understand that that good demand and really high cutout values provides greater importance now on our yields than it ever has in the history of the business as well. And so there's initiatives to continue to move forward and continually improve in that area as well. Grind is very, very important. I mentioned the record high prices we've seen on lean trim. How we convert lean trim into chubs or patties or their grind material to meet the consumer wherever they want to go is a good opportunity for us, and we've seen great initiatives and move in that area. Donnie mentioned the seasoned marinated progress, and we want to provide convenience to our customers as well and provide different platforms for them to purchase our beef products. Really proud of the team to continue to innovate and come up with different solutions for the future. And then just lastly, I just want to go back and reiterate the efficiency improvements that we have made year-over-year are absolutely meaningful as well and will help us navigate through whether we start to see additional heifer retention and potentially some lower harvest numbers, or it's more of a static demand case."
},
{
"speaker": "Pooran Sharma",
"content": "Great. No, I appreciate it. Thanks for the color. I guess for my second question, just kind of wanted to shift over to the work you've done to optimize your network. If maybe you could just remind us of all the work that you have done, how many plants you've closed, and then do you see further kind of work being done? You guys are really kind of seeing benefits from operational excellence. So just want to kind of get a sense for how you're thinking about it in the future."
},
{
"speaker": "Donnie King",
"content": "Sure. Great question. And I won't hit on every specific location, but I will tell you how we start. We start with controlling the controllables in the business. And then we began, as many have talked today, about executing with excellence. We simply want to be best-in-class operations end-to-end. I don't care if it's chick or beef, pork prepared, international, or a function across Tyson Foods. So let's start with that. So when we look at the network, we consider a number of things. We consider the age of the asset. We consider the profitability of an asset. We consider the scale of an asset. We consider how competitive it is in the marketplace. Can it win? And we also then look at what future capital would be spent on that particular asset. And as we run all these things through a funnel, we make a long-term decision. And I must tell you, these are always challenging, painful decisions to make. But I think we have demonstrated the ability to look everywhere, to challenge ourselves to be the best, and then make decisions accordingly based on what we find. Operator Our next question comes from Thomas Palmer of Citi. Please go ahead."
},
{
"speaker": "Thomas Palmer",
"content": "I was hoping to get a little more specific on the expected drivers for prepared foods. Sounds like mix is a factor. I wondered maybe about your outlook for other items, anything maybe quantifiable on volume expectations, and then kind of thinking about cost inflation and productivity. And then just kind of in context to that expected improvement in prepared foods, would you expect to see this 10% operating profit growth starting in the first quarter, or is there a period later in the year where we might see outsized growth? Thanks."
},
{
"speaker": "Donnie King",
"content": "Thanks. Yes, great question, and thank you for that. I would remind you that in 2024, it was the best year we've had since 2018. I've said on calls, this call before, that there's upside to our prepared foods business. What we are doing, what we did in 2024, 2023, and we'll do in 2025 and beyond, is continue to drive out waste from our business. We'll continue to connect with that consumer and our customer with new and meaningful innovation. I've talked about what protein impact is and where it sits relative to inside the category of food, but we're literally pulling every lever within prepared foods. We're already seeing benefits of that. We saw it in 2024. We see that momentum continuing in 2025 and beyond. And a reminder, we're at midpoint. We are expecting a 10% growth from 2024 to 2025. Now let me introduce you to Kyle Narron, who now leads our prepared foods business. Thank you, Melanie, for outstanding 2024. And Kyle, give us a little more color relative to the question."
},
{
"speaker": "Kyle Narron",
"content": "Yes, thanks, Donnie. And thanks, Thomas, for the question. As I look at 2024, we were entering the beginning of our multi-year strategy focused on operating our business with discipline, and that's exactly what we did, as Donnie mentioned, the best performance in six years and in line with expectations. I guess I'll start by thanking all of our team members for their contribution to the improvements that we recognized in 2024. The key drivers for that performance were really along three pillars. Our operational performance is delivering tangible results. We experienced significant improvements in yield and throughput. Our service levels improved over 170 points year-over-year. Distress sales down 26%. When you look from a commercial execution perspective, we're delivering some sizable wins. We continue to see distribution increases across our core business, gaining over 240 TDPs on our core items that have proven to add value to our customers and consumers. We continue to see momentum from an innovation perspective relative to the launch of our Jimmy Dean griddle cakes and our chicken biscuit. We continue to realize increased distribution on those items on the backs of high trial and repeat rates. And then we continue to leverage our data and digital to drive promotional efficiency and long-term share growth. And so, as I wrap that up, Thomas, and I think of the momentum we carry into 25, which would be year two of this multi-year strategy, I would just call out that over 100% of the step change in profitability is built on controllable improvements. Those key drivers will remain unchanged. We will continue to be focused on the growth initiatives that I mentioned on core distribution and launching items from our robust innovation pipeline. And from an operational perspective, we are laser focused on our performance to standard. We'll continue to focus on running our assets at standard on every line every day. We'll continue to be focused on reducing complexity and eliminating waste. And so, again, expect to carry that momentum that we gained in 24 into 25 as we continue to execute this multi-year strategy."
},
{
"speaker": "Curt Calaway",
"content": "And, Tom, this is Curt. I might add just on top of Kyle as well. Part of your question, I think, was around kind of the cadence that you might see it materialize. I think this would be a year where it might be a little more balanced across the year, different than kind of more of our historical norms, a little bit of seasonality, which is really what Kyle was speaking about relative to the operational efficiencies we continue to gain throughout the year."
},
{
"speaker": "Operator",
"content": "The next question comes from Michael Lavery of Piper Sandler. Please go ahead."
},
{
"speaker": "Michael Lavery",
"content": "I just wanted to come back to chicken supply. I know you gave some thoughts on how you're factoring that in and thinking about it. I guess just would love to follow up on you cite the USDA expectations for around 3% supply growth. More recently, we've seen that the egg set and chick hatched up closer to 6%. Do you expect that to come in? I guess, how do you think about just reconciling those two data points?"
},
{
"speaker": "Wes Morris",
"content": "Yes. I'd be glad to take that. And good morning, Michael. The industry's continued challenges on both hatch and livability. These increased egg sets and chicks placed physically aren't making it to the processing plants. And so, that makes a big difference. It's been a much tougher grow out environment between avian influenza, metapneumovirus. And so, I think you'll continue to see that disconnect as we go through 2025. The only offset being in higher bird weights, and that's actually driving the 2.6% increases through bird weight per head."
},
{
"speaker": "Michael Lavery",
"content": "Okay, that's helpful. And just back on prepared foods, I know you're lapping the plant startup costs. Can you just help us remember how to quantify that?"
},
{
"speaker": "Kyle Narron",
"content": "Yes, thanks for the question, Michael. Startup cost year-over-year, or what we realized in FY '24, was somewhere around $20 million. But I would remind you, certainly, that we would be lapping a first half with lower depreciation from an overhead perspective as well."
},
{
"speaker": "Operator",
"content": "Our next question comes from Andrew Strelzik of BMO. Please go ahead."
},
{
"speaker": "Andrew Strelzik",
"content": "My first one, I wanted to go back to some of the operational improvements in the beef segment that you're talking about. My understanding or assumption was that there wasn't a whole lot internally that you could do to really cushion against the market environment. But you sound more optimistic on that now, and certainly listed a number of things that you've been working on. So, I was just curious if you could quantify how much you think that can move the needle, similar to what you said in chicken, or just maybe give a framework for how that could impact the business relative to kind of underlying margin environment."
},
{
"speaker": "Brady Stewart",
"content": "Yes, thanks for the question, Andrew. Just relative to how we look at the business, 85% of the business really is somewhat uncontrollable relative to these market spreads. And so, that obviously provides some outsized weighting. But when you talk about the amount of resources that we deploy from a labor perspective, the amount of opportunity we have at $3 plus cutouts to continue to improve on yield, it's certainly meaningful on how we push forward and move forward in the business as well. And so, I'll just say that there's a great opportunity for us to continue to march forward towards world-class. We want to make sure that we minimize the losses in this challenging cycle. And we really have the right to win relative to the utilization of our six harvest assets as we move forward throughout the bottom side of this cycle."
},
{
"speaker": "Andrew Strelzik",
"content": "Okay. All right. That's helpful. And my other question is just on capital deployment and cash flow generation, I guess. Leverage has been coming down. I know you're not quite to the target levels yet, and this will be still a pretty disciplined year. I guess I'm just curious if the business is headed in the direction that it seems to be. Are we getting closer maybe next year to a time when maybe you can start to loosen the purse strings a little bit on that front? Or how are you thinking about whether it's CapEx or other investments returning cash to shareholders kind of more broadly over the next several years? Thanks."
},
{
"speaker": "Curt Calaway",
"content": "Thanks for the question. And I appreciate the comments. And we certainly did have a very disciplined approach from cash, cash deployment scenario in 2024, and drove net leverage down from 4.1x to 2.6x across the year. But we did still invest, $1.1 billion in CapEx. And at the guidance range that we've provided for next year, we would invest between $1 billion and $1.2 billion in CapEx in 2025. And we also had a comment in our guidance relative to free cash flow that would exceed our annual dividend, expected to be in the range of about $700 million. But we'll stay very constant relative to our capital allocation priorities around build financial strength, but also investing in our business and returning cash to shareholders, as you said. And obviously, make note, we did increase our dividend announced this morning, as well. And very proud of the accomplishments we've made, but we stay committed to our investment grade credit rating, and our long-term target leverage of at or below two times."
},
{
"speaker": "Donnie King",
"content": "So, Andrew, if I could, just maybe one additional comment, just to make sure the takeaway from the first question I answered this morning, we will continue to spend capital and return money to shareholders. But one of our focal points right now is to improve the return on the capital that we have already invested. And so, there's a lot of upside in that. And so, that's also a priority as you think about this in terms of the whole mix."
},
{
"speaker": "Operator",
"content": "This concludes our question-and-answer session. I would like to turn the conference back over to Mr. Donnie King for closing remarks."
},
{
"speaker": "Donnie King",
"content": "Thanks for your continued interest in Tyson Foods, and we look forward to speaking with you again soon."
},
{
"speaker": "Operator",
"content": "The conference has now concluded. Thank you for attending today's presentation. You may now disconnect."
}
] |
tsn | 2,024 | 3 | [
{
"speaker": "Operator",
"content": "Good day and welcome to the Tyson Foods Third Quarter 2024 Earnings Conference Call. All participants will be in a listen-only mode. [Operator Instructions]. After today’s presentation, there will be an opportunity to ask questions. [Operator Instructions]. Please note this event is being recorded. I would now like to turn the conference over to Sean Cornett, VP, Investor Relations. Please go ahead."
},
{
"speaker": "Sean Cornett",
"content": "Good morning and welcome to Tyson Foods’ fiscal third quarter 2024 earnings conference call. On today’s call, Tyson’s President and Chief Executive Officer, Donnie King and Interim Chief Financial Officer, Curt Calaway will provide some prepared remarks, followed by Q&A. Additionally, joining us today are Brady Stewart, Group President - Beef, Pork, and Chief Supply Chain Officer; Melanie Boulden, Group President - Prepared Foods and Chief Growth Officer; Wes Morris, Group President - Poultry, and Devin Cole, President - International and Global McDonald’s. We also have provided a supplemental presentation which may be referenced on today’s call and is available on Tyson’s Investor Relations website and via the link in our webcast. During today’s call, we will make forward-looking statements regarding our expectations for the future. These forward-looking statements made during this call are provided pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements include all comments reflecting our expectations, assumptions, or beliefs about future events or performance that do not relate solely to historical periods. These forward-looking statements are subject to risks, uncertainties, and assumptions which may cause actual results to differ materially from our current projections. Please refer to our forward-looking statements disclaimer on Slide 2, as well as our SEC filings for additional information concerning risk factors that could cause our actual results to differ materially from our projections. We assume no obligation to update any forward-looking statements. Please note that references to earnings per share, operating income and operating margin in our remarks are on an adjusted basis unless otherwise noted. For a reconciliation of these non-GAAP measures to their corresponding GAAP measures, please refer to our earnings press release. Now I’ll turn the call over to Donnie."
},
{
"speaker": "Donnie King",
"content": "Thanks Sean and thank you to everyone for joining us this morning. Q3 was another solid quarter as momentum continues to build. Compared to the third quarter of last year, AOI is up more than $300 million growing nearly 175% and adjusted EPS increased by more than $0.70 or almost 500%. Q3 not only dramatically improved versus last year but also marked the highest profitability in the last seven quarters. What's even more impressive is that we delivered these results despite well-known headwind in the cattle cycle as we benefited from our diverse portfolio. I want to take this opportunity to thank all of our team members across every segment and function for their hard work in contributing to these results, in Q3 and for their dedication to driving operational excellence which as you know has been a priority for us. Let me highlight the performance in chicken. We delivered segment AOI of more than $300 million, the best third quarter profit result in eight years. We are raising our guidance in chicken for the third consecutive quarter. The midpoint of our outlook is now $350 million better than our initial expectations coming into the fiscal year. I want to emphasize that the operational improvements we've been driving are enabling us to benefit from the market tailwinds, invest in our value-added portfolio, but also enhancing our results. In fact, all of our businesses are more agile, collaborative, and disciplined than they have been in some time. Beyond the strong results in chicken in Q3, pork also came in better than we anticipated, while beef and prepared foods were in line with our expectations. Our disciplined approach to capital allocation continues to improve cash flow. Year-to-date free cash flow is better by more than $1.2 billion compared to last year. This growth was driven by improved profitability and our focus on managing working capital and controlling capital expenditures. While still investing for profitable growth, and again, we're delivering these results in the face of a challenging environment for beef. Better performance has helped us to reduce our net leverage ratio for the third consecutive quarter. Before I talk more about the performance in the quarter by segment, let me remind you that we have some of the most iconic retail brands in all of food with top brands in protein. Behind Tyson, Jimmy Dean, Hillshire Farm, and Ball Park, we have the number one or number two market share in eight of our core business lines and enjoy favorite brand status in key categories. I remain highly confident in our strategy and optimistic about our future and the ability to drive long-term value for shareholders. Let's move to segment performance starting with Prepared Foods. In Food Service, we continue to broaden our customer base, grow in margin accretive channels, and expand our presence in broad line distribution categories. This led to overall volume and sales growth in Q3. AOI for the quarter was right in line with our expectations. Operational execution including supply chain improvements and more efficient and effective marketing support through digital are delivering results. In addition, we are leaning into our top performing skews to capture opportunities to expand distribution. While our brands remain strong, we are continually focused on new innovations to expand the appeal and market opportunities for our products. For instance, the Jimmy Dean Griddle Cakes platform is an innovation we are very proud of. We've launched two flavors, maple and blueberry, and we're seeing an exceptionally strong repeat rate and customer adoption making it one of the most successful Prepared Foods innovation over the past five years. Our focus on execution and innovation are keeping us on track to deliver another solid performance for the year. As I mentioned, chicken had one of its best quarters in some time, but we are clearly benefiting from better market conditions including lower grain costs, our actions and focus on the fundamentals across all aspects of the value chain are also contributing to these strong results. Our live operations continue to improve with hatch rate and livability up year-over-year. We generate efficiencies and improve utilization in our plants by optimizing our network. Our demand planning and customer service have also taken significant steps forward as we improve order bill rates and continued to build long-term partnerships with customers all the while reducing inventory. We've reinvested some of the proceeds from these improvements into the long-term growth of our value added chicken business. For instance, we've accelerated the ramp up of our Danville Fully Cooked facility and launched new products like honey bites and restaurant quality wings. In summary, our focus on the basics has built a fundamentally stronger chicken business with an eye on the future. Moving to beef, as expected, elevated cattle costs continue to compress spreads in fiscal Q3. While pasture conditions have improved this year, clear size of meaningful herd rebuilding have not emerged. We continue to be laser-focused on the things we can control, such as labor utilization, yield, and mixed management to meet consumer demand and customer needs as we manage through the challenges of the cattle cycle. Turning to pork, the overall health of the herd and the productivity of styles remain strong, driving an ample supply of lean hog, combined with solid demand and the benefits of our improved operational execution. AOI increased noticeably versus last year. Now let me take a moment to reflect on who we are. Our purpose is to feed the world like family, where protein remains clearly at the center of the plate. In fact, protein is the largest category in the retail food and beverage sector, accounting for about one third of sales in the U.S. We believe protein plays a central role in any healthy diet. This is why we see consumption growth is up 1.3% across feed, chicken, and pork in fiscal Q3 per Nielsen [ph]. And is also why we have protein as a foundational core. Our strategy encompasses our differentiated capabilities and scale and our diverse portfolio across channels, categories, and eating occasion. Our strategic pillars are supported by key enablers of operational excellence, customer and consumer obsession, along with data and digital. One key goal is building on our iconic brands to value up our core proteins. Today, Tyson, Jimmy Dean, and Hillshire Farm are three of the top 10 protein brands with room to expand household penetration. Brands are our best opportunity to drive faster growth, higher margin, and stronger returns, and is the most effective way to generate long-term shareholder value. As I've emphasized all year, our priorities are centered on controlling the controllables, including cash management. Our cash flow performance this year demonstrates the success we've had on this front. We're also focused on operational excellence by continuously improving chicken, strengthening Prepared Foods, navigating beef through a difficult cattle cycle, and driving efficiencies in pork. We came into fiscal 2024 with plans to deliver against these priorities. Our focus on being intentional and deliberate on executing those plans is delivering tangible results. With that, I'll turn the call over to Curt to review our financial performance in more detail."
},
{
"speaker": "Curt Calaway",
"content": "Thanks, Donnie. Total company net sales of 13.35 billion in Q3 were up 1.6% year-over-year. The increase was led by beef with contributions from pork and Prepared Foods partially offset by declines in chicken and international. Adjusted operating income improved $312 million to nearly $500 million, driven primarily by another quarter of substantial increase in chicken profitability. Operational improvements and substantially higher AOI led to a $0.72 increase in adjusted EPS, which came in at $0.87 in Q3. As Donnie mentioned earlier, this is our best AOI, AOI margin, and adjusted EPS in the past seven quarters. Now let's review our segment results starting with Prepared Foods. In Prepared Foods, Q3 revenue grew 2.1% versus last year driven by volume growth in Food Service. As we expected, AOI in Q3 was down modestly, higher raw material costs were partially offset by lower map spend versus an elevated level last year, and the benefits of operational efficiencies and top-line growth. Moving to chicken, sales in Q3 declined 3.2%, primarily due to the pass-through of lower input costs and pricing. While volume is roughly flat year-over-year, as we continue to better align supply with customer demand, it was up approximately 2% from Q3 of fiscal 2022. AOI increased $370 million versus last year to $307 million. Lower input costs, net-of-pass-through pricing, along with the benefits of the strategic actions we have taken and the efficiencies the business has driven across our operations, drove the growth in AOI. We also experienced favorable year-over-year derivative impact of $63 million, primarily related to a $65 million net derivative loss in Q3 last year. In beef, revenue was up 5.8% year-over-year in the quarter primarily due to the volume impact of higher average carcass weights, with pricing increasing 1.4%. While revenue increased, AOI decreased primarily reflecting compressed spreads as expected, which more than offset our continued progress on operational efficiencies. Moving to pork, Q3 revenue increased a net 10.4% driven by higher price per pound reflecting healthy global demand. AOI also increased $92 million year-over-year benefiting from improved spreads and better operational execution. Shifting to our financial position and capital allocation. Our commitment to disciplined capital allocation remains unchanged. Our priorities are to maintain financial strength, invest in the business, and return cash to shareholders all while maintaining our investment grade credit rating. Cash flow from operations remains strong, with year-to-date approaching $2 billion, highlighting improved profitability and working capital management. Operating cash flows was more than double our CAPEX, which came in at $884 million year-to-date. CAPEX in Q3 of $263 million declined sequentially for the sixth consecutive quarter, reflecting our focus on controlling capital deployment while continuing to invest for profitable growth. Year-to-date free cash flow of $1.1 billion is more than two and a half times better than the previous two fiscal years combined over the same period. We ended Q3 with $4.8 billion of liquidity. Improving profits and strong cash management are also benefiting our net leverage, which declined sequentially again, coming in at three times in Q3, more than a full-turn lower than where we exited fiscal 2023. We continue focusing on returning net leverage to our long-term target of at or below two times net debt to adjusted EBITDA. We entered fiscal 2024 with a plan of applying our controlling the controllables approach to enhance free cash flow generation. We've over-delivered on that plan and remain committed to deploying resources to maximize long-term shareholder value. Now let's look at our updated outlook for fiscal 2024. We are reiterating our overall sales guidance at roughly flat year-over-year. Based primarily on our improved outlook for chicken, we are raising our AOI guidance and tightening the range. For the total company we now expect between $1.6 billion and $1.8 billion. Moving to the segments, in chicken, given the strong performance we're raising our AOI guidance range to be between $850 million and $950 million. For Prepared Foods, we are reiterating our AOI outlook of $850 million to $950 million as we continue to perform in line with expectations. In beef, we are tightening our AOI guidance range to a loss between $400 million and $300 million, reflecting well-known challenges in the cattle cycle. In pork, we are raising our AOI outlook to be between $100 million and $200 million highlighting improved year-to-date results versus expectations. To round out the key P&L items, we continue to anticipate interest expense to be roughly $395 million and our tax rate to be between 23% and 24%. Turning to CAPEX, we are maintaining our tight controls on spending in line with profitability and cash flows, and are narrowing our CAPEX range to be between $1.2 billion and $1.3 billion this year. Before I turn the call back over to Donnie, I want to emphasize that our multi-protein, multi-channel strategy is enabling us to raise the midpoint of our full year AOI guidance by $100 million. Now, I'll hand it over to Donnie to wrap up before we move to Q&A."
},
{
"speaker": "Donnie King",
"content": "Thanks, Curt. Before we get to your questions, I want to express my deep gratitude to our incredible team members. Your dedication and hard work are the driving forces behind our mission to feed the world-like family and bring high-quality food to every table in the world. Together, we have achieved a remarkable turnaround and our momentum continues. Finally, I am grateful to our customers and consumers for their trust, loyalty, and partnership. I couldn't be more excited for the opportunities ahead of us and remain confident that our strategy will enable us to deliver long-term shareholder value. Now, I'll turn the call back over to Sean for Q&A instructions."
},
{
"speaker": "Sean Cornett",
"content": "Thanks, Donnie. We will now move to your questions. Please recall that our cautions on forward-looking statements and non-GAAP measures apply to both our prepared remarks and the following Q&A. Operator, please provide the Q&A instruction."
},
{
"speaker": "Operator",
"content": "[Operator Instructions]. The first question comes from Ken Goldman with J.P. Morgan. Please go ahead."
},
{
"speaker": "Kenneth Goldman",
"content": "Hi, good morning, and thank you. I wanted to ask, I appreciate a lot of the information you gave about each segment, thank you for that. Donnie, as you think about taking a step back, looking at kind of the underlying fundamentals, especially in your two biggest segments, chicken and beef, but across the company, kind of what were the more important puts and takes in the quarter versus your expectations, just in terms of how fundamentals came in against what you were initially anticipating?"
},
{
"speaker": "Donnie King",
"content": "Good morning Ken and thank you for the question. Let me start with we are pleased with our Q3 results which is the best quarter in the last seven. We are seeing the benefits of our multi-protein portfolio where chicken, prepared and pork are offsetting the headwinds in beef. In Q3 momentum continues to strengthen, and all of our businesses are executing better than they have in quite some time. We're executing against the priorities we laid out for fiscal year 2024. In short, we are controlling the controllables, we are optimizing our network, and we remain focused on operational excellence. We have taken decisive action to drive performance and to build financial strength. Our performance has given us confidence to raise our guidance again. Now let me step into the segments, and I'll start with chicken. Our focus on the fundamentals behind the number one brand is delivering results. Chicken had a strong Q3. We had the best adjusted operating income since fiscal year 2016, it was eight years ago. Best capacity utilization since Q4 of 2018, six years ago. The best livability since fiscal year 2020. Supply chain and S&OP processes is allowing us to improve order fill rate while simultaneously lowering our inventory and working capital. In beef, we're managing through volatility and spread tightening. We continue to focus on operational excellence. In pork, better spreads and ongoing operational execution led to better profitability. In Prepared Foods, our results were in line with our expectations, our brands are strong, and our share remains healthy."
},
{
"speaker": "Kenneth Goldman",
"content": "Okay, thank you for that Donnie. And then I had a quick follow-up. As a company, you have a unique view into how restaurants are performing, particularly quick service. And I'm just wondering, we've heard from some quick service restaurants lately that they're not necessarily seeing real improvements in traffic yet, but maybe there are some green shoots, just as we -- as they experience some of the initial early benefits as the companies lean harder into promotions and actions that appeal to maybe some lower income consumers. So I'm just curious what you're seeing from your perspective from the restaurant industry in general, how it affects you, and if there's any real changes to your outlook in QSRs in particular? Thank you."
},
{
"speaker": "Donnie King",
"content": "So, thanks Ken. Just as a reminder, in the protein space, there typically are lower levels of elasticity. And protein is a consumer staple. And I'd also remind you, Ken, and then I'll pass this over to Melanie to add a little more color on Food Service. But in retail, we hold leadership positions in 8 of 10 categories, and three of the top 10 brands in protein. So with that, Melanie, why don't you speak a little bit to..."
},
{
"speaker": "Melanie Boulden",
"content": "Thank you, Donnie. Happy to do so. And Ken, I'm going to talk to you with my enterprise CGO hat on. So first of all, the Food Service industry, as you know, is large. And demand for protein is strong as consumers see protein as an essential staple in their diets and meal routines. And at Tyson Foods we are advantaged because Tyson's diverse food servers portfolio spans major proteins, chicken, beef and pork. And this year, we've also seen a particular interest in our poultry offerings as quick-serve restaurants have been emphasizing value menu offerings. These factors, combined with our large and flexible manufacturing infrastructure, have been instrumental in driving our performance. For example, our ability to quickly partner with customers on LTOs or limited time offerings to meet their business objectives, we're operating is best-in-class. At the same time, that flexibility is also helping us to better partner with our customers to quickly develop innovation. Now our commercial scale is also a strategic advantage. On any given day, you'll find our products in school lunch programs, quick-serve restaurants, fine dining establishments, and hospitals. You'll also find us in travel and entertainment venues such as airports, cruise ships, movie theaters, amusement parks, and concert venues. This allows us to meet consumers where they are. Look, we remain focused on what we can control in Food Service, including improving our product pipeline with innovation to drive operator value and new customer acquisition. We're also focused on leveraging the diversity and flexibility of our broad manufacturing base to better serve our partners. And finally, we're focused on shifting the mix to advantaged channels. So because of these actions, we're building momentum going into fiscal year 2025 and are positioned well for continued growth."
},
{
"speaker": "Operator",
"content": "Next question comes from Adam Samuelson with Goldman Sachs. Please go ahead."
},
{
"speaker": "Adam Samuelson",
"content": "Yes, thank you. Good morning everyone. I was hoping to dig into the results in chicken a bit more and really parse some of the drivers of operating margin improvement between the lower grain costs, which I believe at least on a gross basis in the Q were quantified at $305 million versus some of the underlying cost and mix actions that you've been undertaking and how should we think about that progressing, there's obviously implication in the guidance for 4Q, but help us think about what's embedded in the fourth quarter guidance from a net grain cost tailwind would be helpful? Thank you."
},
{
"speaker": "Donnie King",
"content": "So Ken, thank you for the question. Let me start by saying, I'm going to take this opportunity to pass this question over to our Chief Architect in Poultry, Wes Morris. He's been the person responsible. He and his team for the chicken turnaround that we have seen. So Wes?"
},
{
"speaker": "Wes Morris",
"content": "Yeah, thanks Donnie. Overall, I'd say I'm very pleased with the improvement in our cost fundamentals, and we're well poised for growth. Nothing's really changed. The big three areas that we've talked about the last few quarters around our live plant and S&OP. Our live results continued to improve. Our hatch was up 360 basis points versus a year ago, just short of 83. Our livability improved 50 points to 93.71 [ph] in a pretty tough grow-out environment. And then our cost 500 on the in bench mail [ph] and then a very deliberate focus on our live fundamentals are paying big dividends. The network changes that are paying off. Capacity utilization, as Donnie said, continues to improve sequentially and we still have room to grow. And then our S&OP process continues to add value. Service was up 100 basis points on an order field, while reducing our working capital around $260 million. We have a really highly functioning demand planning and supply planning team and our total poultry group is engaged in that area. Now we invested some of that operational improvements back into the business. As you know, we have the number one share in retail and Food Service, and we're focused on investing there. So our Danville fully cooked plant is well started up, that location is about a year ahead of schedule from what we originally anticipated. We've got a strong innovation pipeline. We've invested in quality and consumer promotions. And so I think our range is good. We've raised our guidance 850 to 950. Historically, Q1 and Q3 is our best quarters with Q2 and Q4 being a little softer and then the ongoing investments. So I feel well balanced at the midpoint."
},
{
"speaker": "Adam Samuelson",
"content": "Okay, that's helpful. And then if I could just ask a follow-up on beef. Donnie, you alluded to in the prepared remarks, no obvious signs of herd rebuilding. Just as we think about the implication of that over the next couple of years with just fewer cattle’s that are still going to not coming to market. How do we think about your own capacity utilization and industry capacity utilization in the sector and kind of if you reach a breaking point there that we might have to see some capacity rationalization?"
},
{
"speaker": "Brady Stewart",
"content": "Well, thanks Adam for the question. And I'll just start with saying this, it's going to be very challenging to continue to really forecast the outcomes relative to this beef cycle. Every beef cycle has some differences embedded within it. And one of the key indicators relative to the cycle is droughts and monitoring drought in specific areas. So as you alluded to, we haven't seen really any notable retention to date. We've seen some differences relative to specific regions. And I would say that correlates really well relative to what those specific regions have from a climate and drought perspective. So when you definitely really evaluate as we move forward, what we do know is we're not expecting any incremental supply here in the short-term, which is consistent with these beef cycles. However, we're really focused on what we can control. And the highlights for our beef team have been decreased costs year-over-year relative to our manufacturing and our efficiencies have improved in our assets. We continue to see improvements in our yields, in our plants. We're doing a better job of balancing our supply and demand of cattle to beef and what our consumers and customers are demanding as well. So when you parlay all of those things together, we'll continue to manage what we can control and focus on really indications in the future on this rebuild."
},
{
"speaker": "Donnie King",
"content": "So if I could add one thing to that. Thank you, Brady. Our asset base is we're well invested, and we are capable of running with the very best in the industry. I'll remind you, Adam and others that the benefits of our multi-protein portfolio, which is driving our momentum with the strength in chicken and prepared foods and pork, and we see that offsetting challenges in beef. We see that continuing for the balance of the year."
},
{
"speaker": "Operator",
"content": "The next question comes from Andrew Strelzik with BMO. Please go ahead."
},
{
"speaker": "Andrew Strelzik",
"content": "Hey, good morning. Thanks for taking my questions. So my first question on the chicken business, you're certainly seeing very strong improvements. But my question is about opportunities for -- yes, further improvement from here. And where I'm coming from is the margins were in the lower end of what typically is your normal range despite those internal improvements, the seasonality benefits in the quarter, the strong external environment. So can you maybe reflect on where the business is versus where it needs to be longer term and the path to more sustainably getting into that kind of normal chicken margin range?"
},
{
"speaker": "Wes Morris",
"content": "Yeah, this is Wes. I would say that we continue to focus on the fundamentals. We got a little different business mix and business volatility than some of the commodity players as we don't sell a lot of outside raw materials where price is immediate. We've got several pricing models. Some are grain-based and so as grain has come off, we pass that on to the customers, and that's fair. And then we have a high percentage of packaged goods and so we're going to stay focused on stabilization of earnings over time, strong relationships with key customers, and sustainable value creation. So regardless of what markets are doing, I expect us to deliver best-in-class results over time and stay focused on the controllables."
},
{
"speaker": "Andrew Strelzik",
"content": "Okay, that's helpful. And then on beef, I guess the guidance implies for the fourth quarter, bigger losses. And so I guess just directionally, and I appreciate your comments on the difficulties with forecasting this part of the beef cycle here. I guess, is there any way that you want us to think about directionally 2025 versus 2024, or what the implications are for the fourth quarter into next year and then when you talk about controlling the controllables in beef, what are some of those key controllables that you're most focused on or the levers that you can pull from here? Thank you."
},
{
"speaker": "Donnie King",
"content": "Sure. Andrew, let me just say this. In terms of 2025 outlook, it's a little bit early for us. We'll be happy to discuss at length in Q4. So look forward to that. Just a reminder, there is no -- data doesn't support herd rebuild at this point but -- on a positive note, pasture conditions and feed costs are supportive of a herd rebuild. Interest rates, for example, might be a headwind, but there's no clear sign of herd retention. Brady, why don't you go deeper into that?"
},
{
"speaker": "Brady Stewart",
"content": "Sure. And thanks for the question, Andrew. And specifically on our beef performance, we are completely dialed in to making sure that we have cost-effective operations. And so everything from our harvest efficiencies and our assets to our yields to making sure that we are dialed in with our customers and consumers and balancing that to the type and kind of cattle that we're procuring and making sure that we understand those value equations, is where we've seen improvements in our operations. And the real call out for us, again, is the significant year-over-year decrease in our manufacturing cost and our assets. We're running a much better operation today than we were a year ago, and we're certainly proud of that and thank the team for their continued improvements in these areas."
},
{
"speaker": "Operator",
"content": "The next question comes from Heather Jones with Vertical Group. Please go ahead."
},
{
"speaker": "Heather Jones",
"content": "Good morning. Congratulations on the quarter. I want to start with chicken and specifically the strong improvements you all made there. And Wes, I think you said hatch was up 360 bps year-on-year, it's nearly 83%, which is far better than the industry is doing. So just wondering if you could help us understand how much of that is sustainable improvements in the breed or in husbandry versus, I would assume there's been some early liquidation of some flocks related to plant closures, and so I'm just trying to figure out how to model that going forward?"
},
{
"speaker": "Wes Morris",
"content": "Yes, sure, Heather. Thank you for the question. We see the USDA data and no question the industry exits and wages are well up, but the bird simply aren't making it to the plant. And so our genetics and strategic focus are just the opposite. I did say our hatch is up 360 basis points. I do believe it is sustainable. I think we've got the right programs in place. We're seeing intense focus on the execution. Our grower partners are buying into the performance and our livability is up 50 points even in a tough grow-out environment. So we're obviously outperforming in live. And yes, I believe that to be not only sustainable when we hit the fall cooler weather, I expect it to improve."
},
{
"speaker": "Heather Jones",
"content": "Okay, thank you for that. And then my follow-up is on beef, and I just -- I hate to beat a dead horse, but just there's some big differences between the last cycle. So the rebuild has been very slow in coming and it's likely to be more extended. You've got plants being added this time. Your imports are far larger than they were last time. So I am just wondering if you have a sense of how long you think this downturn could last and if Tyson needs to maybe permanently reduce days of slaughter at certain plants or just how you are all planning on tackling that?"
},
{
"speaker": "Brady Stewart",
"content": "Thanks for that question Heather. And again, I just go back to that drought monitor, the USDA and NOAA published and produced. And so through the last cycle, obviously, we saw a drought in that 2012, 2013 and then a relatively good rebound in 2014, 2015 and 2016. And then really, from a drought perspective in beef cow country, really, really low persistence relative to drought in the 2019 that led into some really good numbers here within the last three to five years. And so we'll continue to evaluate and understand and focus on that. That's really a prerequisite to this rebuild. Donnie outlined some of the other factors that are in play relative to the rebuild as well. But just to reiterate what Donnie said as well, we've made really good investments in our beef operations, and we like our asset base. We like our team. We like the supply partnerships we have, both on the cattle supply and the partnerships we have with our customers as well and really have laid out a variety of range of outcomes and understanding where the cycle really go and win most importantly, and we'll continue to evaluate that as we move forward."
},
{
"speaker": "Donnie King",
"content": "And if I could, I would add this to Brady's comments, once again, Heather, the benefits of our multi-protein portfolio the momentum and the strength which we have there where chicken, prepared foods, pork and even our international business offsetting those -- this cattle cycle that we're in. So we've been able to do that, did that well in Q3, and I would expect that for the balance of the year, and we think we will have a good overall fiscal 2025. It's too early to talk about that in great detail, but we're very optimistic about 2025."
},
{
"speaker": "Operator",
"content": "The next question comes from Michael Lavery with Piper Sandler. Please go ahead."
},
{
"speaker": "Michael Lavery",
"content": "Thank you, good morning. Just wanted to come back to Prepared Foods. You said the volume growth was driven by Food Service, but overall price was pretty flat. I'm just trying to get a sense of the promotional environment. And maybe if you could give us a little split between Food Service and retail, how they looked and just what sort of price expectations you have going forward, are you seeing -- we're hearing from a lot of companies that consumers are kind of balking at some of the prices, are you having to promote a little bit more, can you just give us kind of a finger on the pulse of where the consumer is these days?"
},
{
"speaker": "Melanie Boulden",
"content": "Yes. So thanks, Michael. Let me give you first an overview of our Q3 performance, and then I'll dive a little bit deeper into kind of the promotional environment that we're seeing. So overall, our Prepared Foods third quarter performance, as you know, was in line with our expectations, and we're pleased with the results as we delivered both volume and sales growth. But as you know, we made a number of investments in our plans to add new capacity and capabilities. That's important to remember, as our profit was roughly flat to year ago when you adjust for the incremental expenses associated with the ramp-up of those additions. Also important to note is that our results were accomplished despite lapping a period of higher merchandising levels and lower input costs. And there's really three key factors that drove our performance in the quarter: First, our operational excellence has improved dramatically. We've had tremendous commercial success. And then as you noted, our Food Service volume growth was strong. Now as I think about our promotional environment, please know that our teams closely monitor in market pricing dynamics, elasticities, and promotional performance at a granular level. We have a disciplined approach to pricing and promotions, and we make changes to our strategy as the consumer landscape evolves. Now this doesn't mean that we're just reactive. The strength of our brands, our customer relationships, our data-driven consumer insights, and our leadership position across multiple categories affords us the opportunity to act fast when the marketplace changes. And now pricing and promotion, there are a couple of the key levers, but we're also focused on ensuring that our items are in the right package and in the right channel to meet consumers' needs. I would say it's also important to remember what Donnie highlighted that protein, which consumers see as an essential staple, enjoy lower elasticities than other food categories. Therefore, we believe consumers will continue to prioritize protein. I'd point to all these factors as the reason that Tyson's retail volume grew in the quarter."
},
{
"speaker": "Michael Lavery",
"content": "Okay, great. Thank you so much."
},
{
"speaker": "Operator",
"content": "The next question comes from Ben Theurer with Barclays. Please go ahead."
},
{
"speaker": "Benjamin Theurer",
"content": "Yeah, good morning. Donnie and Curt. Thanks for taking the questions. So I just wanted to dig a little bit into like the cadence 3Q into 4Q because if I remember right, roughly three months ago, you've talked about potential downside risk in the third fiscal quarter, atypical seasonality, it seems like that did turn out. So maybe can you help us understand what was different in the quarter versus what you initially expected to come out to that close to $500 million in operating income and how that then relates into, call it, maybe the higher end versus lower end of that remaining guidance for 4Q, that would be my first question? Thank you."
},
{
"speaker": "Curt Calaway",
"content": "Yeah, thanks. This is Curt. I'll kick it over to Wes in just a minute. But principally speaking, right, we talked about the back half of the year and a little bit of seasonality challenges that we perhaps could have. But to be specific on your question before I turn it over to Wes, it was really some stronger chicken performance than we had anticipated when we talked three months ago. But overall, kind of the construct that we thought about the back half of the year relatively in line. But certainly, as we said earlier, increased the overall midpoint of our guidance by $100 million, really with the strength of Q3 and I'll turn it over to Wes to talk a little bit about chicken’s performance."
},
{
"speaker": "Wes Morris",
"content": "Yes. I'll take a big part of that change and it's pretty simple. Our poultry team is improving faster than I expected or that we modeled in a lot of different areas. Like live for instance, that we just talked about or our supply demand planning group. And so we haven't called a different play. We've just executed it faster than I expected."
},
{
"speaker": "Benjamin Theurer",
"content": "Okay. And then my follow-up, I know it tends to not get that much of attention, but it feels like it's coming together a little bit better on the international side. Could you share some of the initiatives you're currently doing and how that international business, how you think about this in the medium term because I know, Donnie, you always talk about the growth -- demand growth is in the international market, so just to understand how you think of investing and positioning yourself to even further accelerate the growth in the international segment?"
},
{
"speaker": "Donnie King",
"content": "Sure. Our international business does continue to grow. And if you'll recall, over the last couple of years, we've invested heavily behind a number of assets in China and Southeast Asia. I would tell you, in those marketplaces, there are a number of macroeconomic and geopolitical headwinds. We have seen a little better improvement in raw materials. But to go any deeper into that, let me introduce Devin Cole, who is new to this call, but not new to Tyson and he's just returned to our company in March. He's been the Head of our Global McDonald's business. And now we've added the International business on to him. And so with that, Devin, welcome, and please go ahead."
},
{
"speaker": "Devin Cole",
"content": "Thank you, Donnie. Of course, it's pretty early in the process of evaluating this business from my standpoint. But I would tell you, I'm encouraged by the quality of our team, assets that I've had the chance to see around the world. We're really focused on some very key metrics, and that's just to keep our team members safe, make sure we've got the best food safety, the best product quality innovation for all of our customers around the world and also focused highly on operational excellence as we bring these new facilities up to speed. And I am convinced that we have the assets and the team to deliver the portfolio of products to meet both customer and consumer needs around the world. And really what this will allow us to do is to provide the growth in results that we expect and that we need to drive the operational efficiencies and capacity utilization in these assets."
},
{
"speaker": "Donnie King",
"content": "So if I may just add one other thing to that, Devin and thank you. As many of you will recall, Amy, too, was the leader of our International business. Since we were together last, Amy has decided to retire. And I know she is probably listening today, and I just want to say that we miss her and thank her for many contributions to the company. We wish Amy and her husband Christian well. But we have Devin in the seat now and look forward to many exceptional things as it relates to International."
},
{
"speaker": "Operator",
"content": "The next question comes from Peter Galbo with Bank of America. Please go ahead."
},
{
"speaker": "Peter Galbo",
"content": "Hey guys, good morning. Thanks for taking the question. Donnie and Wes, maybe just a quick one on chicken because I know we've spent quite a bit of time on it on the call. Just help us parse out maybe as we think about sustainability of chicken profitability in 2025. How much in the quarter kind of you attribute to market factors relative kind of to the underlying and not looking for specific numbers, but if it's percentages or however you kind of think about what drove the Q3 over delivery, again, as we try and project that forward into 4Q and 2025?"
},
{
"speaker": "Wes Morris",
"content": "Yeah, thanks for the question Peter. As I've said, we had solid improvement in our fundamentals, and we partially offset those by investments. If I had to call the year today, I'd call it 40% performance base, 60% market-based. But if I adjust for the investments, I'd call it around 50-50. But it's important that my team stay focused on sustainable performance and driving value over time regardless of what those market conditions are."
},
{
"speaker": "Peter Galbo",
"content": "Great, no, that's very helpful. Thanks Wes. Curt, maybe, welcome to the call, nice to hear you on the call. I think there's a pretty big bond maturity coming due in the fourth quarter. So maybe you can just talk a bit about how you're thinking about approaching that, I saw the lowered interest expense guidance, but how we should think about that particularly large debt maturity? Thanks very much."
},
{
"speaker": "Curt Calaway",
"content": "Thanks Peter. Yes, you're right. Maybe the best way to handle that is think about our liquidity. And we finished the quarter, right, with about $4.8 billion of liquidity. And that was partially driven by a bond offering that we did earlier this year to effectively prefund that, if you will. So yes, the bond maturity is coming up here in August of $1.25 billion, and we'll look to pay that off this month."
},
{
"speaker": "Operator",
"content": "The next question comes from Alexia Howard from Bernstein. Please go ahead."
},
{
"speaker": "Alexia Howard",
"content": "Good morning everyone. So a couple of quick ones. Can you -- talking about chicken again, what are the key risks from here, is it as simple as if grain prices go up again, that could put pressure on the business, I'm just wondering where the growth from here comes or whether we're kind of approaching peak at this point? And then I have a follow-up."
},
{
"speaker": "Wes Morris",
"content": "So again, Alexia, thank you for the question. We're laser focused on the fundamentals of our business. Certainly, grains have an impact. Our commercial relationships, we continue to work with some key customers to help stabilize earnings and create win-win solutions with those key customers. So it's -- for me, it's about staying focused on what we do and getting better at it every day."
},
{
"speaker": "Donnie King",
"content": "So if I could add one thing to that Wes has mentioned two or three times, but just to make sure it's clear, that from a mix perspective, Wes and his team are continuing to value up the mix from, let's call it, more commodity-oriented products to more value-added branded across Retail and Food Service."
},
{
"speaker": "Alexia Howard",
"content": "Great, thank you very much. And can I just pick up on one word that you used early in the prepared remarks. You talked about collaboration across the businesses improving or being as good as you've seen it. Can you be more specific about what has improved on the collaboration side and how that's manifesting itself in the organization? Thank you and I will pass it on."
},
{
"speaker": "Donnie King",
"content": "Sure. If I look at the team that's sitting around the table here this morning, we have some of the best people in the industry, in their specific discipline. They have a great deal of experience, and they are very passionate and competitive in everything they do. But the mantra that we have here at Tyson is one team, one Tyson, all behind our mission, feeding the world like family. And at the same time, making sure that there's high-quality protein on every table in the world. But the collaboration component of that is a team coming together and really being united around this one Tyson approach."
},
{
"speaker": "Operator",
"content": "The next question comes from Thomas Palmer with Citi. Please go ahead."
},
{
"speaker": "Thomas Palmer",
"content": "Good morning and thanks for the question. Maybe start out on the prepared foods side. The midpoint of guidance implies profit in 4Q, might not have as big of a seasonal pullback relative to 3Q as it might in a typical year. I know you mentioned this possibility a quarter ago. Could you just give us a reminder as to why this seasonality might not be as pronounced as normal? Thanks."
},
{
"speaker": "Curt Calaway",
"content": "Tom, this is Curt. I'll add a couple of things and then let Melanie add to it. But we are hopefully very clear last quarter where we talked about midpoint of the guidance of $900 million and implying obviously $400 million in the back half, and it would be split relatively even. I'll add to that, right. We -- while we've tightened the guidance range throughout the year, our midpoint has been consistent across the whole year. And specifically as well, our thoughts around Q4 and the profit outlook also were very unchanged and consistent as we've thought about it. But I'll let Melanie add a couple of elements from her perspective."
},
{
"speaker": "Melanie Boulden",
"content": "Yeah, so thanks for the question. And as I think about the future seasonality and Q4, we expect to have a strong Q4 compared to prior years. First, the cost associated with the new capacity and capabilities I touched on earlier, will be significantly reduced as those assets ramp up. This is true both sequentially and versus year ago. Second, the operational excellence initiatives we're driving are accretive. And -- or additive, I should say, meaning the total dollar impact will grow each quarter as we reduce cost and drive out inefficiencies. We also expect to continue strong commercial performance behind our Food Service business. And then finally, I'd also point to our growth in bacon, which is enabled by the successful start-up of our Bowling Green Facility and because of the new capacity and capabilities that we brought online, we're growing and gaining share in bacon. So as I think about Q4 as well as the momentum going into 2025, we're confident in our path forward. And a lot of this is obviously driven by our team that has been working really, really hard and is focused on delivering our goals."
},
{
"speaker": "Thomas Palmer",
"content": "Thanks for that. And then just on an income statement item, SG&A has been trending sequentially lower throughout the year. What's driving this and is there a segment where we would see these reductions being most apparent?"
},
{
"speaker": "Curt Callaway",
"content": "Just a couple of comments from me. I think we've had a fairly disciplined approach over this last year relative to our SG&A management. It will feel a little lumpy in a couple of quarters because we've got some higher performance-based compensation impacting each of the quarters. But overall, a very disciplined focus on our cost control spending this year."
},
{
"speaker": "Operator",
"content": "This concludes our question-and-answer session. I would like to turn the conference back over to Donnie King for any closing remarks."
},
{
"speaker": "Donnie King",
"content": "Thank you for your continued interest in Tyson Foods, and we look forward to speaking with you again soon."
},
{
"speaker": "Operator",
"content": "The conference has now concluded. Thank you for attending today's presentation. You may now disconnect."
}
] |
tsn | 2,024 | 2 | [
{
"speaker": "Operator",
"content": "Good day, and welcome to the Tyson Foods Second Quarter 2024 Earnings Conference Call."
},
{
"speaker": "",
"content": "[Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Sean Cornett, Investor Relations. Please go ahead."
},
{
"speaker": "Sean Cornett",
"content": "Good morning, and welcome to Tyson Foods' Fiscal Second Quarter 2024 Earnings Conference Call."
},
{
"speaker": "",
"content": "On today's call, Tyson's President and Chief Executive Officer, Donnie King; and Chief Financial Officer, John R. Tyson, will provide some prepared remarks followed by Q&A. Additionally, joining us today are Brady Stewart, Group President, Beef, Pork and Chief Supply Chain Officer; Melanie Boulden, Group President, Prepared Foods and Chief Growth Officer; Wes Morris, Group President, Poultry; and Amy Tu, President, International."
},
{
"speaker": "",
"content": "We also have provided a supplemental presentation, which may be referenced on today's call and is available on Tyson's Investor Relations website via the link in our webcast. During today's call, we will make forward-looking statements regarding our expectations for the future. These forward-looking statements made during this call are provided pursuant to the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements include all comments reflecting our expectations, assumptions or beliefs about future events or performance that do not relate solely to historical periods."
},
{
"speaker": "",
"content": "These forward-looking statements are subject to risks, uncertainties and assumptions, which may cause actual results to differ materially from our current projections. Please refer to our forward-looking statements disclaimer on Slide 2 as well as our SEC filings for additional information concerning risk factors that could cause our actual results to differ materially from our projections. We assume no obligation to update any forward-looking statements. Please note that references to earnings per share, operating income and operating margin in our remarks are on an adjusted basis, unless otherwise noted. For reconciliation of these non-GAAP measures to the corresponding GAAP measures, please refer to our earnings press release."
},
{
"speaker": "",
"content": "Now I'll turn the call over to Donnie."
},
{
"speaker": "Donnie King",
"content": "Thanks, Sean, and thank you to everyone for joining us this morning."
},
{
"speaker": "",
"content": "I'm pleased with our performance in Q2, and I want to thank our team members for their ongoing commitment to driving operational excellence. We've certainly come a long way from where we were a year ago and wouldn't be where we are today without their hard work. Our momentum continues to strengthen, and all of our businesses are running better today than they were last year. Our results this quarter are part of a solid performance in the first half of fiscal 2024 compared to the first half of last year. Adjusted EPS and adjusted operating income are both up nearly 60%, while operating cash flow increased by more than 50% and CapEx decreased by more than 40%. This performance gives us confidence in our improved outlook for the fiscal year and in our long-term future."
},
{
"speaker": "",
"content": "As you saw in our results, tailwinds in Chicken again offset headwinds in Beef as we benefit from our multi-protein portfolio. While we're not immune to the macro environment, we are taking steps to reduce our exposure to commodity markets. We are expanding our offerings in seasoned and marinated meats to value up our portfolio across Beef, Pork and Chicken to provide consumers convenience and new flavor options. Across our brands, we are focusing on meeting the consumers where they are by offering convenient restaurant-quality food options at home."
},
{
"speaker": "",
"content": "We are a leader in protein with some of the most iconic brands in food with offerings that span the value spectrum. This is why our share remains healthy despite a more challenging environment for consumers. We continue to support our brands through efficient marketing, effective innovation and strong partnerships with our customers. We continue to build financial strength by being disciplined in our capital deployment to improve cash flow and position us well to tackle challenges and capture opportunities. We also continue to take bold actions to improve performance and drive long-term value for shareholders, and I remain highly confident in our strategy and optimistic about our future."
},
{
"speaker": "",
"content": "Now let's delve into an update on market share. At Tyson Foods, we have a broad portfolio of offerings across foodservice and retail at a range of price points to meet consumers where they are, even as they manage through a challenging macro environment. We also have some of the strongest and most iconic brands across food and beverage behind the Tyson, Jimmy Dean and Hillshire Farm names, which allows us to make efficient choices to maintain margin, while strengthening our shelf position. We see this in the strength of our dollar share in our core business lines, which we believe reflects the quality of our share position. Since Q2 of fiscal 2019, we've added 400 basis points of dollar share in our core business lines."
},
{
"speaker": "",
"content": "While our share is down modestly versus last year as we lap some record performance, we have gained dollar share over each of the past 3 quarters. Our core bacon brands, Wright and Jimmy Dean have contributed to this recent growth. In fact, our dollar share in bacon for Q2 was at a record high level over the past 5 years, and we were the fastest growing in the category during the quarter. I'm excited about our opportunities in bacon and expect our share to continue improving as our new bacon facility that opened in January ramps up. The value proposition of our iconic brands resonate strongly with our consumers, and our market share and household penetration rates remain healthy. We continue to have opportunity to expand the household penetration of our great brands, leaving room for continued share growth over the long run."
},
{
"speaker": "",
"content": "Moving on to the segment performance, starting with Prepared Foods. Consumers' focus on value continues to impact our retail volumes. However, our share remains healthy. And as I mentioned, we are gaining dollar share in bacon. Our volumes outside of retail continue gaining traction as we strive to grow this business with a focus on customer diversification and margin-accretive channels. Operational efficiencies and lower raw material costs drove solid profitability both in Q2 and the first half of fiscal '24."
},
{
"speaker": "",
"content": "In Chicken, the momentum established in the second half of fiscal '23 continued in Q2. In fact, versus the second quarter of last year, AOI increased more than $325 million. While we are benefiting from better market conditions, including lower grain costs, our bold actions and focus on the fundamentals are also evident in our results. We have made progress across the value chain. Our live operations are substantially better. We've improved yield, labor efficiencies and utilization in our plants. Our demand planning and customer service have also taken significant steps forward. When our live operations are running well and our demand plan is more accurate, we can operate more efficiently and better service our customers. In summary, our focus on getting back to the basics in Chicken is working."
},
{
"speaker": "",
"content": "As you all know, in Beef, limited cattle supplies led to spread compression. Despite some quarterly volatility reflecting market conditions, our results for the first half of fiscal year have come in as we expected. Our goal remains to offset some of the challenges of a tight cattle supply environment by focusing on the controllables, such as labor utilization and managing mix to meet customer and consumer demand."
},
{
"speaker": "",
"content": "Turning to Pork. Better spreads and ongoing operational execution led to improved profitability in the quarter in the first half of the year. As you may have seen, we made the difficult decision to close one of our pork facilities. This is part of our efforts to optimize our footprint and improve performance by reallocating resources to nearby more efficient plants, while improving mix and better serving our customers."
},
{
"speaker": "",
"content": "Now let me take a step back and talk about our recent corporate rebranding initiative. We launched a new corporate logo earlier this year that captures our One Team, One Tyson Spirit. It encompasses our differentiated capabilities and scale and our diverse portfolio across channels, categories and eating occasions. Our Tyson Foods corporate logo represents our company's legacy and our team's purpose, which is to feed the world like family."
},
{
"speaker": "",
"content": "Our approach to driving long-term value hasn't changed and is built on a core of 3 key pillars. First, we are fortifying our foundation of core proteins. We strive to be best-in-class operators while continuing to look for ways to value up our portfolio. Second, we are building our brands by delivering innovation for new occasions, categories and channels to better serve consumers. Today, we have 3 of the top 10 protein brands with room to expand our household penetration. Brands are our best opportunity to drive faster growth, higher margins and stronger returns. Third, we're growing globally. Our international business grew revenue eightfold to $2.5 billion over the 5 years through fiscal '23."
},
{
"speaker": "",
"content": "We expect to drive profitable growth over time by capturing expanding consumer markets, particularly in Asia, and we believe we are well positioned to win. These strategic pillars are supported by key enablers of operational excellence, customer and consumer obsession, along with data and digital. A key element of operational excellence is to gain enterprise scale and unlock savings in our controllables by modernizing our operations and driving performance to standards. We win with our customers by building long-term partnerships and delivering top-tier experiences. We enrich consumers' lives by creating best-in-class marketing and innovation. Finally, we continue to build our digital capabilities utilizing data, automation and AI tech for better decision-making and outcomes."
},
{
"speaker": "",
"content": "Before I hand it over to John to review our financial performance, let me remind you of our priorities this year, where we focused on controlling the controllables. Our results for the first half of the year clearly shows that we are controlling our CapEx and working capital to drive strong cash flow. Another priority is to optimize our footprint and network. We've closed the last of the 6 chicken facilities that we announced in 2023, along with the 2 case-ready beef facilities. And as mentioned earlier, we are closing one of our pork plants."
},
{
"speaker": "",
"content": "We're also focused on operational excellence by restoring performance in Chicken, strengthening Prepared Foods, managing Beef through a difficult cattle cycle and driving efficiencies in Pork. As you have seen in our results so far this year, we are making tangible progress in all these areas."
},
{
"speaker": "",
"content": "With that, I'll turn the call over to John."
},
{
"speaker": "John Tyson",
"content": "Thanks, Donnie. I'll start with an overview of our total company results before moving on to our individual segments. Sales in Q2 were essentially in line year-over-year at $13.1 billion as a decrease in Chicken was nearly offset by an increase in Beef. Adjusted operating income increased $341 million year-over-year to $406 million, driven primarily by significant improvement in Chicken profitability. Operational performance and substantially higher AOI led to a $0.66 increase in adjusted EPS, which came in at $0.62 in Q2."
},
{
"speaker": "",
"content": "Now let's review our segment results, starting with Prepared Foods. In Prepared Foods, Q2 revenue was down slightly year-over-year. Volume growth was led by benefits from the Williams acquisition. The pricing decline reflects the mix impact of the lower contribution from retail. AOI in Q2 was down modestly versus last year. Lower raw material costs and operational efficiencies were more than offset by start-up costs and mix. Despite the decline in AOI, our margin for the first half of the fiscal year remained in the low double digits."
},
{
"speaker": "",
"content": "Moving to Chicken. Sales in Q2 declined 8.2% year-over-year, primarily due to lower volume. Volume declined 6.1%, driven by lower production as we better aligned our supply to customer demand, while the 2.1% reduction in pricing was due in part to the pass-through of lower input costs. Despite the decline in sales, AOI increased $326 million year-over-year to $160 million. The benefits of our strategic actions and the substantial operational improvements we've executed since last year are clear. Market conditions, including lower input costs, net of pass-through pricing and a better supply-demand balance were also key contributors to improved profitability. The current quarter results include a $55 million derivative loss compared to a $35 million loss in the year ago quarter. As a reminder, our grain hedging program is part of an overarching risk management strategy and not a speculative tool."
},
{
"speaker": "",
"content": "In our Beef segment, revenue was up 7.3% year-over-year in Q2, with both volume and pricing increases. The 2.8% increase in volume was primarily driven by higher average carcass weights, while pricing increased 4.5%. While revenue increased, AOI decreased versus last year, primarily reflecting compressed spreads as expected. This more than offset continued progress on our operational efficiencies, including better labor utilization and better management of product mix to meet customer and consumer demand."
},
{
"speaker": "",
"content": "Moving to Pork. Q2 revenue increased 4.6%, driven by volume growth and higher pricing. Volume growth of 2.9% was led by more plentiful hog supply. Pricing improved due to healthy global demand. AOI also increased year-over-year going from a loss of $31 million last year to a profit of $33 million this year in Q2, benefiting primarily from improved spreads and better operational execution. Year-to-date, pork AOI has improved $151 million."
},
{
"speaker": "",
"content": "Finally, our International Business continues to make progress towards stronger profitability. AOI increased versus last year as we begin to lap some of the start-up costs of our newer facilities and continue to focus on operational execution."
},
{
"speaker": "",
"content": "Shifting to our financial position and capital allocation. Year-to-date showcased strong operating cash flow of approximately $1.2 billion as we continue to manage working capital. We remain very disciplined with CapEx, which came in at $621 million for the first half. The $267 million in CapEx for Q2 was the lowest quarterly spend in several years and represents the fifth quarter in a row of sequential decline as we lap our elevated CapEx from the previous 2 fiscal years and focus on controlling where and when we deploy capital. Year-to-date, free cash flow of $556 million, increased nearly $900 million versus the first half of last year and was more than $200 million ahead of our year-to-date dividend payments."
},
{
"speaker": "",
"content": "Our balance sheet management approach remains unchanged as we are committed to building financial strength, investing in our business and returning cash to shareholders, while maintaining our investment-grade credit rating and returning net leverage to at or below 2x net debt to EBITDA. Our net leverage again declined sequentially, coming in at 3.6x in Q2, driven by improving last 12 months EBITDA, and we expect it to continue to improve for the balance of the year."
},
{
"speaker": "",
"content": "We ended Q2 with $4.4 billion of liquidity. As you may have seen from our press release in March, we successfully raised $1.5 billion in new senior notes, and we paid down a portion of our term loans. We plan to use the remaining proceeds to retire our outstanding notes coming due this August. We remain committed to maintaining a disciplined yet opportunistic capital allocation strategy, ensuring that we deploy resources to maximize long-term shareholder value."
},
{
"speaker": "",
"content": "Now let's take a look at our updated outlook for fiscal 2024. We are reiterating our overall sales guidance to be roughly flat year-over-year. However, given our strong year-to-date results, we are raising our AOI guidance driven primarily by an improved outlook for Chicken. For the total company, we now expect between $1.4 billion and $1.8 billion of operating income."
},
{
"speaker": "",
"content": "Moving to the segments. In Chicken, given the strong start in the first half of the year, we continue to believe that there are more tailwinds than headwinds. We are raising our AOI guidance range to be between $700 million and $900 million. Prepared Foods also had a solid first half. In this segment, we are tightening our AOI outlook to be between $850 million and $950 million, indicating a weaker second half of the year, which reflects typical seasonality. In Beef, the first half of fiscal 2024 has progressed in line with our expectations. However, uncertainties remain, including the progression of the cattle cycle, and we now expect our full year AOI to be between a loss of $400 million and a loss of $100 million. In Pork, we've seen solid first half performance and are raising our guidance to be between $50 million and $150 million."
},
{
"speaker": "",
"content": "To add some color to the shape of the rest of the year, uncertainties remain around consumer strength and behavior, the progression of the cattle cycle and key commodity costs. When we factor in these variables with Pork and Prepared Foods seasonality, there are reasons to believe that Q3 could be weaker than Q4. To round out the key P&L items, we anticipate interest expense to be roughly $400 million and our tax rate to now be approximately 24%."
},
{
"speaker": "",
"content": "Turning to CapEx. We're maintaining tight controls on spending in line with profitability and cash flow, and we are narrowing our CapEx range to be between $1.2 billion and $1.4 billion this year. And finally, on free cash flow, we're committed to managing working capital and CapEx and we're even more confident now that we can fully fund our dividend this year through our free cash flow generation."
},
{
"speaker": "",
"content": "Now I'll turn the call back over to Donnie to wrap up before we move to Q&A."
},
{
"speaker": "Donnie King",
"content": "Thanks, John. Before we get to your questions, I'd like to thank our 139,000 team members, who worked tirelessly to feed the world like family and fulfill our mission to bring high-quality food to every table in the world. It is the strength of our team that secures our position as a world-class food company and a recognized leader in protein. Together, we delivered a solid first half, we still have more work to do and believe we have the strategy in place to continue our progress and deliver long-term shareholder value."
},
{
"speaker": "",
"content": "Now I'll turn the call back over to Sean for Q&A instructions."
},
{
"speaker": "Sean Cornett",
"content": "Thanks, Donnie. We will now move to your questions. Please recall our cautions on forward-looking statements and non-GAAP measures apply to both our prepared remarks and the following Q&A. Operator, please provide the Q&A instruction."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] The first question today comes from Peter Galbo with Bank of America."
},
{
"speaker": "Peter Galbo",
"content": "Donnie, maybe just to start, you typically gave, I think, kind of an update on the state of the business and things have improved to your -- sequentially at least pretty dramatically. I guess just curious a little bit on 2 things. One, kind of are you happy now with kind of the state of the portfolio and the state of plant closures and asset rationalization? And then secondly, just trying to understand the commentary around Q3 weaker than Q4 seasonally in light of what you've been saying that, that would run kind of counter to what has been the case seasonally for the past, I don't know, 5 or 6 years. So maybe if you can just unpack those 2 areas would be helpful."
},
{
"speaker": "Donnie King",
"content": "Thanks, Peter, and I appreciate everyone for being on this morning. Your first part of your question is essentially am I satisfied? I'm encouraged, I would -- I'd stop short of saying satisfied in terms of the results. I'm proud of the results that we delivered in Q2, and we're seeing the benefits of our diverse portfolio across proteins, channels, categories and eating occasions, where we saw Chicken and Pork are offsetting the headwinds in Beef. In our Q2, our momentum continues to strengthen on all of our businesses, and they're running better today than they were last year."
},
{
"speaker": "",
"content": "We've come a long way from where we were a year ago, and my thanks to all of our team members for continued improvement in execution. We're executing against the priorities we laid out for fiscal '24. We are controlling the controllables. We're optimizing our network. We remain focused on operational excellence. We've taken bold actions to drive performance and to build financial strength. We're delivering meaningful results compared to the first half of last year in profitability, cash flow, CapEx in line with historical rates. Our performance has given us confidence to raise our guidance, while acknowledging uncertainties remain, and we have much work to do."
},
{
"speaker": "",
"content": "In terms of your specific question around Prepared, let me make a few comments, and then I'll pass it over to Melanie to add some detail. Our results were in line with our expectations. Our brands are strong and our share remains healthy. Persistent inflation is weighing on our bifurcated consumer. Our strategy is to meet the consumer where they are with offerings at various price points."
},
{
"speaker": "",
"content": "In terms of more details, let me flip it over to Melanie to add a little color to your questions."
},
{
"speaker": "Melanie Boulden",
"content": "So Peter, I think you were asking specifically about our projections for Q3 as well as the rest of the full year. And so I'll just talk specifically about Prepared Foods and let any of the other leaders chime in. So the first half of the year, Prepared Foods delivered $500 million in AOI and you also know that profit delivery in the second half of the year has historically been lower than the first half, and we expect this year to be the same. So therefore, the midpoint of our second half guidance is $400 million. And I also want to point out that historically, Q3 has performed better than Q4, but we're seeing higher commodity costs in Q3, so we expect a pretty even split between the 2 quarters."
},
{
"speaker": "Peter Galbo",
"content": "Great. Melanie, that's very helpful. Yes, we've gotten certainly a number of questions on that. So thank you for the context. And then Donnie, maybe just as a follow-up. Look, we've had a number of companies this quarter, both in the CPG industry and in restaurants. Just kind of comment on the state of the consumer and low-income consumer. I know that was in some of your prepared remarks, but curious if you could dive a little bit deeper on just your view on food service and some of the channels that you service there. Just any commentary around quick service, casual dining and noncommercial would be helpful."
},
{
"speaker": "Donnie King",
"content": "Melanie, why don't you answer that?"
},
{
"speaker": "Melanie Boulden",
"content": "Yes, happy to. So Peter, in both retail and foodservice, as you know, the consumer is under pressure, especially the lower income households. And in retail, we're seeing roughly 20% cumulative inflation over the last 3 years. Now the inflation impact, coupled with historically low savings rate has created a more cautious price-sensitive consumer. And we're also seeing a cautious consumer prioritized essential staples over discretionary categories. Now that said, we're advantaged, in that our protein categories enjoy lower levels of elasticity compared to the broader consumer landscape. And in retail, we're experiencing -- well, I should say, but in retail, we are experiencing a little slippage to private label with lower income households. However, our share remains strong with growth in bacon, snacking and sausage."
},
{
"speaker": "",
"content": "Now in foodservice, where you specifically noted, we continue to deliver solid performance. but we are seeing shifts from fine dining into QSR. We're also seeing QSR slippage to more meals being consumed at home. But for Tyson, we're advantaged as we serve both in home and away-from-home consumers. The key point, I guess I'd like you to take away from all of this is that we've intentionally built the portfolio diversified across strong brands spanning multiple protein offerings and value tiers, and our scale allows consumers to find our products in multiple places throughout retail and foodservice channels. And this allows us to deliver on our goal of meeting our consumers where they're at, across a variety of value spectrum."
},
{
"speaker": "Operator",
"content": "The next question comes from Ben Theurer with Barclays."
},
{
"speaker": "Benjamin Theurer",
"content": "Congrats on those very outstanding results. Just wanted to dig a little bit into the dynamics in Chicken that you've seen and kind of unpack a little bit the volume performance on the production side. Can you help us to kind of frame it a little bit more? Is it lower head? Is it lower weight? Is it a combination of it? What have you done differently in terms of like adjusting your operations to kind of have those sales down, but at the same time, with a very nice profit spread. And that would be my first question and a quick follow-up."
},
{
"speaker": "Donnie King",
"content": "I think I caught all the questions. Let me start out here was -- if I heard correctly, it was a kind of a supply question and then let me talk about that, and I will flip it to Wes to add some very specific details. But in terms of chicken supply, if you look at the publicly available data, USDA has projected chicken supply increased about 1% in 2024. But if you look at the data underneath it, there are some things that you need to get from this. This is a livability and hatchability story for the industry. If you look, pull it and [ hen ] mortality continues to be elevated. Broiler mortality continues to be elevated. Hatchability continues to be 3% to 5% below historical rates."
},
{
"speaker": "",
"content": "So the net of all that is this. There will be fewer live pounds delivered to the processing plant than forecast. So if I look at that, I believe the supply will be lower than 1% projected by USDA. The other thing I would say with that is this is not a short-term fix. If you remember, we have a genetics company as well. And we've seen some of this activity as well. So this is -- can be a little bit of a longer-term issue. So you ask -- you didn't ask, but I would tell you, at least from our perspective, genetic selection over the last several years have been skewed towards broader characteristics like yield and feed conversion. There has been some impact -- the cumulative impact from no antibiotics ever across the supply chain."
},
{
"speaker": "",
"content": "And there's some, I won't say, new disease, but the disease persists, creating mortality in the broiler. There's a new one -- or new to me called Avian metapneumonia virus that's out there. Laryngotracheitis, or LT, is out there today, and there are other things. But I think the supply could be -- will be less than 1% based on the data points I'm looking at and from flat to 0.5% or something along that order."
},
{
"speaker": "",
"content": "Let me flip it to Wes and let him talk about our supply and see if that answers your question."
},
{
"speaker": "Wes Morris",
"content": "Yes, Ben, we certainly see the USDA numbers projecting up 1%, but we're seeing the egg sets up, but slaughter pounds relatively flat. Now the good news is I'm very proud of our live performance. We hashed [ 82 34 ] in the quarter, livability is up 50 points year-over-year. And so looking at our live performance and then our S&OP process, our supply-demand group, we're in a good position for the back half of the year to stay balanced, to take care of our customers, and I'm very pleased with our live and supply-demand planning group."
},
{
"speaker": "",
"content": "Specifically to Q2 volume, our volume is solid. It's consistent with Q1 and our expectations. Just as a reminder, 2023 is a challenging comparison period. Our pricing is solid. Just as a reminder, we lag a quarter to a quarter plus. And then the other dynamic unique to us is we have quite a few grain-based models that pull pricing down, but it does stabilize our margin."
},
{
"speaker": "Benjamin Theurer",
"content": "Okay. Perfect. And then just a quick follow-up on Beef in terms of like what you're seeing on the industry. Have you seen any signs of heifer retention to just what you like getting on the ground to get a better feel on how bad it is still going to get until it might get better? A little bit of the premium maybe into '25."
},
{
"speaker": "Brady Stewart",
"content": "Sure, Ben. This is Brady. And thanks for the question. And first of all, I guess, really at a high level, we haven't seen anything relative to any of the industry numbers that have been published that really indicate that true meaningful heifer retention has begun. And so at this point, we can potentially anticipate retention beginning in the fall, but there's some caveats to that. And certainly, as we shift from an El Nino weather pattern to a La Nina, the pasture conditions are extremely important to heifer retention. And there's a potential we could see some drier conditions as well persist. We'll continue to monitor that along with additional metrics around heifer retention and the percentage of heifer that move into slaughter."
},
{
"speaker": "",
"content": "And then lastly, one of the promising signs would be we have seen a meaningful decline of the number of cows that are going to slaughter, down double digits from '22 and '23, both and so really, we find ourselves what looks like in the midst of a transition pattern, and we'll continue to monitor to understand the timing of that as we move forward."
},
{
"speaker": "Operator",
"content": "The next question comes from Tom Palmer with Citi."
},
{
"speaker": "Thomas Palmer",
"content": "Maybe start off on the Chicken side, at least relative to consensus estimates, the guidance boost would seem to indicate more than just upside in the quarter. So maybe talk on the components that are driving that increased outlook for the second half of the year? I mean it does seem, obviously, like feed is favorable. It seems like the pricing environment it's getting better. And then you've had positive commentary on productivity. So just any help on kind of how much those items are helping, if there are other items to consider? And any quantification, of course, would be appreciated."
},
{
"speaker": "Donnie King",
"content": "Sure. Let me start off, and I will let Wes add a little color to this as well. But one of the things I got to point out is that the focus on the fundamentals that Wes and our Chicken team have had over the past year actually is quite impressive, and that's a result of some of this. I would point out this that there have been some market tailwinds that as far as Chicken is concerned. But of the $325 million that were better year-over-year, more than half of that came from execution type things, such as the footprint and network as well as some of the other tougher decisions that we made."
},
{
"speaker": "",
"content": "And with that, Wes, why don't you cover some of the more specifics around the program."
},
{
"speaker": "Wes Morris",
"content": "Yes, sure. We're certainly focused on controlling the controllables, and Donnie talked about live operational performance, which includes our network changes. And then probably the biggest change is making sure that we match our supply and demand. We've talked about the lives being better. Our plant performance and network optimization is right on target. Our capacity utilization continues to improve sequentially. We've improved our order fill rate while actually lowering our working capital over $400 million, driven almost exclusively by inventory. Demand solid and '23 is not a very good comp."
},
{
"speaker": "",
"content": "Let me add a little more color to valuing up and our path forward. And so we have our new start-up plant in Danville. It is currently single shifted, and I expect due to demand will be double shifted by the beginning of '25. And so we are running a fundamentally stronger Chicken business. We've got strong [ BU ] leadership in place and strong future growth plans. So specific to your question, Q1, Q3 are typically our strongest quarters. So good balance front half and back half, grains have moderated, but are still higher than pre-COVID levels. We continue to watch the total protein availability. Obviously, spring and summer are better growing conditions so that should increase some volumes in the industry."
},
{
"speaker": "",
"content": "We're also paying real close attention to the consumer behavior and how that may shift our mix. But we will be doing quite a bit of investing in the back half of the year, and our value-added business, where we have a #1 share in both retail and foodservice. And as I said earlier, we're ramping up Danville well ahead of schedule. If I could, I'd like to just reiterate something that to make it really clear in our Chicken business. Our strategy is very simple. It's live performance, excellence in live performance, it's operational execution and matching supply and demand. It's that simple."
},
{
"speaker": "Thomas Palmer",
"content": "Right And then maybe a quicker one on Pork. Just with the costs falling, are you seeing any signs that the industry in terms of hog supply making better profits and might start ramping up supply at all or still a bit too early?"
},
{
"speaker": "Brady Stewart",
"content": "Thanks for the question, Tom. Certainly, the compression we've seen on some of the feed stuff has helped move some numbers back to profitability within the industry from a Pork production standpoint, which is certainly good news for our producer partners as well. What we've seen consistently for the last year, which is of importance is we've seen genetic improvement across the entire industry, leading to additional pigs per liter. And when you compound that with the fact that we've seen over the last 10 years, probably the best year relative to true industry herd health. We're seeing ample supply as we move forward as well."
},
{
"speaker": "",
"content": "So I'd be speculating if we commented on any potential expansion. But certainly, the environment is set up in a much better position versus last year. But let me be clear, when we look at our business, we really focused on the controllables and have seen good improvements from our Pork business through the first half of the year relative to operational excellence, relative to yields within our assets and relative to our mix management conversions as well. That's really coupled with the fact that we have plenty of runway ahead of us to continue to improve and get better, and that's the expectation as we move forward."
},
{
"speaker": "Operator",
"content": "The next question comes from Adam Samuelson with Goldman Sachs."
},
{
"speaker": "Adam Samuelson",
"content": "Maybe continuing on the discussion on controlling the controllables. Donnie, in response to the last question, you talked about kind of improvements in live operations, operational efficiency, kind of matching supply demand. I would just love to get your view on where the company is today and certainly notably improved versus where you were 12, 18 months ago. But where how much -- where can you get it to? How much kind of cost reduction on a per pound or millions of EBIT dollars, do you think is still kind of attainable, excluding changes in the external market environment in the Chicken business?"
},
{
"speaker": "Donnie King",
"content": "Sure. Let me -- Chicken specifically, but let me start with the -- across the portfolio, just managing working capital and CapEx, driving cash flow and really in support of the dividend. That's still a priority for us and part of the controlling the controllables, optimizing the footprint and network, still a huge priority for us. Restoring Chicken performance is right there at the top and also strengthening our Prepared Foods business, really important to us."
},
{
"speaker": "",
"content": "And then managing Beef through the cattle cycle. The unknown around that is, once we do see heifer retention, obviously, you were not going to be processing those animals. So what does that do? And we still got that coming our way and then continue to drive efficiencies in ports. As you stated, versus last year, every business is performing better. We had -- we raised the guidance primarily this quarter based on strong chicken performance, but let me acknowledge that there are still some uncertainties out there relative to the consumer and their strength and behavior, and that's still out there. I mentioned the cattle cycle already. Key commodity markets, what is -- there are tailwinds today, but what do they look like beyond our horizon."
},
{
"speaker": "",
"content": "Pork and Prepared Foods seasonally -- could be seasonally weaker, will be seasonally weaker and then Q3 could be, I say could be weaker than Q4 driven by Prepared and Pork. Chicken. Chicken is -- we're seeing better execution in our Chicken business, and we've seen some time better capacity utilization than we've seen in some time. We're very optimistic in terms of where we are. And we've gone slow in our Chicken business. We've built this thing from the ground up, and we're excited about the momentum that we're seeing relative to that."
},
{
"speaker": "",
"content": "Wes, do you think about Chicken specifically that I haven't said?"
},
{
"speaker": "Wes Morris",
"content": "Yes, I think I'd say it this way, Adam. In the long term, Tyson is the market leader in the industry, and I would fully expect us to deliver best-in-class results over time regardless of the market conditions, but we still got work to do."
},
{
"speaker": "John Tyson",
"content": "And Adam, I think -- this is John, just with one final clarifying point. You had a specific question around, can you quantify the operational performance opportunity? I would just say that -- we've got a range of guidance out there. I think that reflects the balance take and the midpoint of that is probably a reasonable place to be for the total company. But we've left things open a little bit on the top side and the high end of all the estimates of the various segments would reflect, at least what we believe to be achievable in our fiscal from an operational improvement opportunity. So I think that's about as much detail as we're intending to provide here. But safe to say, I think we see a lot of opportunities around the portfolio. The guidance reflects what we can get in '24, and we're optimistic about '25 and beyond, too."
},
{
"speaker": "Adam Samuelson",
"content": "Okay. No, that's all very helpful color. And if I could just ask a follow-up on Beef and taking, Brady, some of your comments about kind of uncertainty on if heifer retention has actually begun in earnest across the industry, but if it did, that would further reduce slaughter utilization for a period, while those cattle don't come to market. Again, under the spirit of controlling the controllables, if we actually are entering heifer retention cycle and herd rebuild cycle, can you help quantify the magnitude of controllables and beef that you actually have to mitigate kind of what would be a further drop in volume and throughput that I mean the business is already operating at a loss today. Presumably, that would be a meaningful incremental challenge. So could -- is there a path for the Beef business to make money through the worst of the heifer retention period?"
},
{
"speaker": "Brady Stewart",
"content": "Thanks for the follow-up question there. And we've been pretty consistent with our message over the last few quarters, whereas there is absolutely a variety of expected outcomes here and how we move through relative to supply and pounds. One of the good signs we've seen is we have seen additional weight for carcass. And so that has provided some dilutive effect relative to cost structure, which is one of the concerns as you move through lower supplies, how that translates itself into potentially higher grading cattle is of interest as well, and we'll be monitoring that. But as we looked at the cycle and the potential outcomes of the cycle, we created a strategy that was completely focused on understanding a range of outcomes and how we can provide deliverables within those outcomes as well."
},
{
"speaker": "",
"content": "And I'd just say we really appreciate and we like the strategy that we have developed, regardless of the range of outcomes on the supply side. We like the progress we have made year-to-date relative to controlling the controllables, which for us is operational excellence and efficiency within our assets, managing our mix and delivering to our customer, and we like the runway in front of us relative to improvements that we can continue to make as we move through what is going to be a range of outcomes through the cycle as well."
},
{
"speaker": "Operator",
"content": "Our next question comes from Heather Jones with Heather Jones Research."
},
{
"speaker": "Heather Jones",
"content": "Congratulations on the quarter. Yes. I had a couple of questions. One on Chicken and one on Beef. And I just want to start on Chicken. I wanted to go back to the volume question. So I understand that Q2 was a more difficult compare than Q1, but it was a pretty substantial volume decline. And you always close the facility, but I think I remember those were going to be consolidated into other plants. So just wondering, is this production decline going to continue going forward? And was it lower outside meat purchases or lower internal production? Just wonder if you could help us how to think about the rest of the year going into '25."
},
{
"speaker": "Donnie King",
"content": "Sure, Heather. Let me start out and just maybe remind us of last year. In '23, at least the first half of '23 is not a real good comparator. If you look at Q1 of last year, we absolutely missed the demand signal in Q1 of last year, and that carried on into Q2 of last year. And so if you look at volume in Q2 of last year, versus Q2 of this year, you're going to see that it is down and -- but last year was really overstated. Volume growth was, in fact, there, but there was also issues with profitable sales as it relates to Q1 and Q2 last year. So we're beyond that, we've cleaned all of that up, and we're moving forward. We're running a much better business today in our Chicken business."
},
{
"speaker": "",
"content": "And Wes, do you want to speak to the volumes?"
},
{
"speaker": "Wes Morris",
"content": "Yes, Heather, thank you for your question and asking for clarity. Our volume is in line with our expectations. We are well positioned in supply-demand balance. And we have strong growth plans put in place, and you'll start to see that in the second half."
},
{
"speaker": "Heather Jones",
"content": "Okay. And then a follow-up on Beef. More recently, beef demand seems to have been more challenged, and I don't know if it's related to the HPAI or what. But anyway, I just wonder if you could give us a sense of how your margins are tracking relative to where they were in Q2."
},
{
"speaker": "Brady Stewart",
"content": "Yes, Heather, thanks for the question. I would say relative to demand, we've seen a fantastic demand on both the Chicken side and the Pork side relative to retail promotional activity as well. While we've seen fantastic demand being driven by that retail and promotional activity, Beef really has not received much promotional activity at all. And so where in the past, as we move into the summer months, you've seen that activity. We'll be watching for that as we move into Q3 to see if we see additional promos, where retail specifically going to drive the consumer relative to any of the proteins. Luckily for us, we're in good shape on the Pork side, good shape on the Chicken side in terms of meeting that customer in those channels as well."
},
{
"speaker": "Donnie King",
"content": "So just to maybe cleanup for clarity, I think you may have misspoken on. It is Pork and Chicken, where we are seeing the future activity right now."
},
{
"speaker": "Brady Stewart",
"content": "That's correct."
},
{
"speaker": "Heather Jones",
"content": "And so have you seen any -- I know you narrowed your guidance and you took down the up the high end for Beef. I'm just wondering has there been any deterioration in margins relative to Q2, given that you haven't gotten the future activity you normally would have gotten at this time of the year for Beef?"
},
{
"speaker": "Brady Stewart",
"content": "The Beef -- Beef promotion, that's been -- that's really been a calendar '24 story. And again, we'll continue to monitor that as we move through the remainder of the quarter, but we won't provide any additional guidance on Q3 other than what we've provided already."
},
{
"speaker": "Operator",
"content": "The next question comes from Ben Bienvenu with Stephens."
},
{
"speaker": "Ben Bienvenu",
"content": "So you noted that in the Chicken business, fairly equal contribution in the first half of the fiscal year of the improvement to what we saw last year between operational improvements and market improvements. As you look to the balance of the year, 3Q, 4Q, is it similarly equally split? Or should we see a diminished operational improvement contribution and more of the improvement is predicated on the market having strengthened?"
},
{
"speaker": "Donnie King",
"content": "Well, let me say this in short, Ben, and then Wes can give you the details. As I mentioned in my opening statements, we have made great progress, but I would be -- I would also make sure that you understand that we believe there's still a lot of work to do. Good progress, but much work to do. And so you can define that financially, if you'd like, but we're not where we need to be yet in our Chicken business."
},
{
"speaker": "",
"content": "But Wes?"
},
{
"speaker": "Wes Morris",
"content": "Yes, Ben, I'd say we certainly got more tailwinds than headwinds, and it's really a function of the volatility of the grain market, what ultimately happens in the supply and chicken markets and then the consumer mindset. And then as I've said a couple of times, we do have some go-forward investments in our value-added business in the back half of the year."
},
{
"speaker": "Ben Bienvenu",
"content": "Okay. Very good. My second question is related to total company. And in particular, in years past, you all have gone through the exercise of articulating what you think kind of normalized earnings power is for the business and you've provided some clarity by segment. Not asking today what that earnings power is, but maybe when you think you all might be at a place where you can provide that level of clarity at the total enterprise and across the segments, given all the changes that you've made and the operational improvements that you've made progress against?"
},
{
"speaker": "John Tyson",
"content": "Ben, this is John Randall. Let me try to answer that question. So short version, yes. We're not making any adjustments to long-term outlook on normalized ranges today. We plan to do that maybe as we go through the balance of this year and start to look to '25 and kind of give some color around that potentially. But let me take the opportunity just to talk about the shape of the total -- of the rest of the year for the total company and build on some things that have already been said today."
},
{
"speaker": "",
"content": "So I just want to point out that from a total range standpoint, guidance has come above from midpoint to midpoint $350 million. We think that is reflective of the results year-to-date and some of our optimism for the balance of the year. And there's also a range of outcomes in there. And I think that we've -- despite some of the potential signals we see in Chicken around supply and demand, I think there's more tailwinds and headwinds there. I think going to our prepared segment, although we are experiencing some of the consumer behaviors that we've heard so many other companies talk about. I think we feel really good about our portfolio. And we've gotten questions about food away from home, food at home. We're in a pretty good position to win no matter where consumers are shopping."
},
{
"speaker": "",
"content": "And I think that you kind of heard us say, hey, Q3 could be softer than Q4. I think I want to just put a point on that, that we see the rest of the year as being fairly balanced, but just with all of the various factors at play and some seasonality in Pork, especially there could be a tweak there, but don't want anyone to overread into that. We don't mean to get so overly precise. There's a lot of factors at play, and I would just emphasize that we're confident about the balance of the year and the midpoint to the guidance we've given."
},
{
"speaker": "Operator",
"content": "The next question comes from Alexia Howard with Bernstein."
},
{
"speaker": "Alexia Howard",
"content": "So can I start with Chicken? I seem to remember that the [ ColdSnap ] in January hit production operations somewhat this quarter. Are you able to quantify any of that? How much it hit volumes and profitability for the segment overall?"
},
{
"speaker": "John Tyson",
"content": "Alexia, this is John again. I would say that we typically plan for a little bit of that weather in the quarter. When we talked to you in February, we were pretty early on and had experienced some significant event just at that point, kind of one month in. I would say overall, though, the impacts in the quarter were not so significant that it had a disproportionate impact on earnings. So I think nothing to read into there."
},
{
"speaker": "Alexia Howard",
"content": "Okay. And then 2 quick things. How much longer do you expect the start-up costs in Prepared Foods to remain a headwind? When does that go away? And then finally, do you have a forecast for where you expect your leverage to end up by fiscal year-end?"
},
{
"speaker": "Melanie Boulden",
"content": "Alex, this is Melanie. And in terms of our start-up costs, we may experience a little bit bleeding over into Q3, but we think the majority of them have hit in Q2."
},
{
"speaker": "John Tyson",
"content": "And to your second question, Alexia, on leverage, not placing a specific number where we expect to exit the year. But safe to say, we're definitely trending towards lower leverage and 2x or below is the long-term target. But that's as much as we can give right now."
},
{
"speaker": "Operator",
"content": "The next question comes from Andrew Strelzik with BMO."
},
{
"speaker": "Andrew Strelzik",
"content": "I wanted to go back to the Beef segment outlook. And you've mentioned some uncertainty and ranges of outcomes. I guess I'm just curious what is the environment that would get you to the top end of the Beef profit range versus the bottom end? Is it primarily around whether or not, we get heifer retention and herding rebuilding efforts in the fall, and that's kind of the biggest piece of it or the demand side, I guess, what are the range of outcomes that would get you to the top or bottom end of the range?"
},
{
"speaker": "Brady Stewart",
"content": "Thanks for the question, Andrew. And specifically, we talk a lot about beef demand. We talk a lot about beef cutout pricing as well. But also, we need to factor in the fact that drop as a significant amount of value that falls within the beef supply chain and also our largest cost is relative to live cattle costs as well. And so when you really balance the 2 revenue streams, the cutout pricing and the drop pricing and you take that into account with live cattle and where potentially we could see some live cattle pricing going, that really creates the range of outcomes. It's trying to balance those 3, the 2 revenue and the 1 supply cost perspective when we look at particular guidance and the range of outcomes."
},
{
"speaker": "",
"content": "But again, we still have plenty to control within Tyson. And we really focus on making sure that we balance the grade of cattle with the demands of the consumer as we move through the cycle as well. We're continuing to see improvements relative to efficiencies and yields. And really, we'll just continue to look at value streams that we can continue to generate to help offset some of these headwinds we have from a margin perspective."
},
{
"speaker": "Andrew Strelzik",
"content": "Okay. Okay. That's helpful. And then my second question is on the CapEx outlook. And I know last quarter, when it was reduced, you were kind of matching CapEx and the operating profit outlook. And so I guess I'm curious just how we should think about CapEx on a go-forward basis as the profit environment is better, since that hasn't really kept up and maybe there's timing dynamics and you've already mentioned controlling that tightly. But just as the profit dynamics get better, how should we think about the rate at which you might add back to CapEx? Where are the priorities where you might want to add back? Just any color around that on the go forward would be great."
},
{
"speaker": "John Tyson",
"content": "This is John. Let me take that question. So you are right in that we had talked in the past about being responsive to the operating environment and managing cash flows. I would tell you that, first off, we feel good about our free cash flow projection for the year in terms of being in excess of covering our dividend, so just pointing that out. But I would also tell you that the tighter range on our CapEx today, $1.2 billion to $1.4 billion that's really reflective of us determining what are the needs for the business and where are there opportunities for good investment. What I want you to take away from that is we're not turning on and off this big. It's kind of based on our outlook on profitability, but rather trying to return to a normalized level of spend."
},
{
"speaker": "",
"content": "And you asked where would be the best opportunities for investment. I think the short answer is that our prepared portfolio and components of our chicken portfolio, where we see the best opportunity for the growing our value-added business, is where we want to continue to invest. And then, of course, we have our ongoing maintenance and repair that's needed. So I think that will probably paint a good picture for you on how we think about capital allocation."
},
{
"speaker": "Operator",
"content": "The next question comes from Michael Lavery with Piper Sandler."
},
{
"speaker": "Michael Lavery",
"content": "You had mentioned that you still have some work to do in chicken and you've touched on that a few ways, but can you just be clear how that does or doesn't apply to your footprint there? Is the supply-demand balance pretty well set? Or is that another piece of the equation that could evolve as well?"
},
{
"speaker": "John Tyson",
"content": "Yes. Thanks for this question. So let me answer it in two ways. I think, first off, on the network moves that we've made up until this point. We anticipate that we have either recovered all or should recover nearly all of that -- all of the volume in chicken and nearly all of the volume related to our pork moves and the other moves. So I think I just want to be clear that when we talk about that rationalization, we're talking about being more efficient, taking cost out and losing none of the business. So I think that, that is a point we're emphasizing."
},
{
"speaker": "",
"content": "The other part of your question was about chicken specifically, and I think that we even talked last year or a couple of quarters ago about the overall capacity utilization. Safe to say, we still got some headroom in our current footprint and would expect to grow with demand in the more profitable parts of our business. And so I think have a positive outlook based on all of the network moves."
},
{
"speaker": "Donnie King",
"content": "If I might add one more thing relative to chicken. The back half of the year for chicken, if you look, grains have moderated, the demand for chicken is very strong, and we've built a fundamentally stronger Chicken business. So we're excited about that. We're executing better, and demand is certainly working in our favor."
},
{
"speaker": "Michael Lavery",
"content": "Okay. That's helpful. And just on international. You've touched on it a couple of times earlier in the prepared remarks. Just how should we think about its margin runway? And what does it take for that to get a ramp-up in profitability?"
},
{
"speaker": "Donnie King",
"content": "Well, thanks for the question on international. And I think it's important to remind this came up a little bit in the CapEx question. But I think we should remember over the last 2-plus years, we've built 12 processing plants around the world. That was part of the driver as it relates to the capital spend, and we're beyond that, and we're moving into filling up those capacities. But we're also lapping -- if you look at the International, we're lapping a ramp-up cost for the 7 facilities outside the United States, and our execution should continue to improve. Our focus short term is operational excellence and capacity utilization as it relates to our International business."
},
{
"speaker": "",
"content": "Amy, would you like to speak?"
},
{
"speaker": "Amy Tu",
"content": "Thanks for the question, Michael. As Donnie said, we are absolutely focused on delivering the results that is expected of us. So we're focusing on driving operational efficiencies across our plants. We are focused on improving our conversion costs. We're identifying available and open -- available capacity, reviewing our SKUs and delivering the more profitable mix of products, and we're also tightening our spending. So all of these actions are beginning to -- we're beginning to see the results and improve gross margins and AOI delivery."
},
{
"speaker": "Operator",
"content": "This concludes our question-and-answer session. I would like to turn the conference back over to the company for any closing remarks."
},
{
"speaker": "Donnie King",
"content": "Thanks for your continued interest in Tyson Foods. We look forward to speaking with you again soon."
},
{
"speaker": "Operator",
"content": "The conference has now concluded. Thank you for attending today's presentation. You may now disconnect."
}
] |
tsn | 2,024 | 1 | [
{
"speaker": "Operator",
"content": "Good morning, and welcome to the Tyson Foods First Quarter 2024 Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] Please note, this event is being recorded. I would now like to turn the conference over to Sean Cornett, Vice President, Investor Relations. Please go ahead."
},
{
"speaker": "Sean Cornett",
"content": "Good morning, and welcome to Tyson Foods' fiscal first quarter 2024 earnings conference call. On today's call, Tyson's President and Chief Executive Officer, Donnie King, and Chief Financial Officer, John R. Tyson, will provide some prepared remarks followed by Q&A. Additionally, joining us today are Brady Stewart, Group President, Beef and Pork and Chief Supply Chain Officer; Melanie Boulden, Group President, Prepared Foods and Chief Growth Officer; Wes Morris, Group President, Poultry; and Amy Tu, President, International. We have also provided a supplemental presentation, which may be referenced on today's call and is available on Tyson's Investor Relations website and via the link in our webcast. During today's call, we will make forward-looking statements regarding our expectations for the future. These forward-looking statements made during this call are provided pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements include all comments reflecting our expectations, assumptions, or beliefs about future events or performance that's not related solely to historical periods. These forward-looking statements are subject to risks, uncertainties and assumptions, which may cause actual results to differ materially from our current projections. Please refer to our forward-looking statements disclaimers on Slide 2 as well as our SEC filings for additional information concerning risk factors that could cause our actual results to differ materially from our projections. We assume no obligation to update any forward-looking statements. Please note that references to earnings per share, operating income and operating margin in our remarks are on an adjusted basis, unless otherwise noted. For reconciliations of these non-GAAP measures to their corresponding GAAP measures, please refer to our earnings press release. Now, I'll turn the call over to Donnie."
},
{
"speaker": "Donnie King",
"content": "Thanks, Sean, and thank you to everyone for joining us this morning. As you may have seen in our press release this morning, fiscal 2024 is off to a good start with solid performance in Q1 giving us confidence in our full-year outlook. The momentum we established in the back half of last year continued in Q1, highlighted by a $175 million improvement in adjusted operating income, a 130 basis points of AOI margin expansion and near doubling of adjusted EPS, all on a sequential basis. As we begin fiscal '24, we're witnessing the benefits of our core multi-protein portfolio. Chicken and Pork are offsetting Beef headwinds, while Prepared Foods continues to generate strong profit dollars and margins. While we can't control the macro environment, our focus on what we can control has been evident in Q1. Our performance reflects a commitment to operational excellence, we are more agile, collaborative, and disciplined business than a year ago, and we have a long runway of opportunities in front of us. I'm proud of our team members' continued efforts to enhance operational performance and want to thank all of them for their high level of engagement and their part in delivering our results in this quarter. We're controlling what we can to drive cash flow as well. Our disciplined approach to CapEx and working capital helped generate strong cash flow in the quarter. Prudent cash deployment is part of our strategy to build financial strength and will position us well when market dynamics turn in our favor. You've seen us take bold actions to improve performance, and everything remains on the table to drive operational excellence and address inefficiencies. Our plan is working, and we're seeing tangible benefits of our efforts as evidenced by improvements in Chicken and Pork. While I'm pleased by the performance in Q1, we still have more work ahead of us, and we're cautiously optimistic and laser-focused on achieving what we set out to do this year. Our brands resonate with consumers, and we're maintaining strong market share despite comparing to our record position last year and some overall category consumption softness in Q1. We will continue to support our brands through innovation, marketing, and strong customer partnerships while meeting consumers where they are. I remain highly confident in our long-term strategy based on a broad portfolio of core proteins and strong brands and I'm optimistic about our future. We're leaving no stone unturned to drive long-term value for our shareholders. Now, let's delve into an update on share position of our branded portfolio. Our Q1 pound share in our core business lines, which include product lines from our iconic brands, Tyson, Jimmy Dean, Hillshire Farm, State Fair, Aidells, and Ball Park, remains at historically high levels despite a modest decline compared to record share in Q1 last year. In fact, our core business lines have grown pound share by more than 400 basis points since Q1 of 2019. While inflation is easing, consumers are still facing high prices compared to two years ago. However, they are still willing to purchase brands they know and trust, and this is reflected in our share. We're also focused on customer elasticity and balancing with our own cost. We believe our approach is working. The value proposition of our iconic brands resonate strongly with consumers. Over the past year, nearly three out of four US households purchased a Tyson core business line product, and this penetration rate is growing. What gets me even more excited is that our product line with the highest penetration rate is only in about a third of households, leaving us plenty of room for continued growth over the long run. Moving on to segment performance, starting with Prepared Foods. Our foodservice volumes continue gaining traction as we strive to grow this business with a focus on customer diversification and margin accretive channels. Operational efficiencies and lower raw material costs drove strong adjusted operating profits and margins. Our Branded Foods business remains a strategic growth pillar, and we are committed to supporting and growing our brands through innovation, price pack architecture, high ROI marketing support and strong customer partnerships. This is critically important in an economic environment where consumers remain more discerning with their purchasing decisions. In Chicken, the momentum established in the second half of fiscal '23 continued in Q1 with a third consecutive quarter of over $100 million in sequential AOI increase. Operational improvements, including the bold actions we've taken along with improvements in live operations, yield, labor efficiency, and customer service, as well as improving market conditions, were the primary drivers in Q1. In Beef, limited cattle supply led to spread compression as we expected. Roughly half the loss in Q1 was related to an inventory valuation adjustment, which was primarily driven by highly volatile cattle futures. While spreads are expected to remain tight, our goal remains to be best-in-class operators so that we can manage the business as efficiently as possible. We have identified incremental opportunities to improve our execution and help offset some of the challenges from the current cattle cycle. Turning to Pork, better supply drove lower hog cost leading to improving spreads. Our team's focus on operational execution allowed us to capture the benefits of these favorable market dynamics, which resulted in improved profits both on a year-over-year and sequential basis. Before I hand it over to John for a financial review, let's reiterate our priorities for the year. First, we're committed to improving our financial strength and driving cash flow to support our dividend, as demonstrated in Q1. Over the past year, we announced the closure of six of our older, less-efficient plants in chicken and two of our smaller beef case-ready value-added facilities. We're already seeing the benefits of these actions and we'll continue to evaluate opportunities to drive efficiency across our segments. In Chicken, our focus on enhancing our competitiveness continues. In Prepared Foods, we want to build growth momentum behind capacity additions coming online, increase our brand household penetration, and diversify and grow our foodservice business. In Beef, we acknowledge the challenges and will be prepared for multiple outcomes during the current cattle cycle. In Pork, we're gaining momentum in operational execution and are excited for continued improvements. With that, I'll turn the call over to John to discuss our financial results and outlook."
},
{
"speaker": "John R. Tyson",
"content": "Thanks, Donnie. I'll start with an overview of our total company results before moving on to our individual segments. Sales in Q1 grew slightly year-over-year as an increase in Beef revenue was nearly offset by a decrease in Chicken. The decline in adjusted operating profit was driven by lower profitability in Beef, which was partially offset by growth in Chicken and Pork. It's important to note that AOI improved significantly on a sequential basis despite the modest decline versus last year. Adjusted EPS nearly doubled compared to last quarter, highlighting the ongoing improvement in our operational performance. Now, let's review our segment results starting with Prepared Foods. In Prepared Foods, Q1 revenue was flat year-over-year. Volume growth was led by benefits from the Williams acquisition and continued recovery in our foodservice business. Lower pricing primarily reflects the mix impact of the lower contribution from retail. AOI in Q1 was also in-line with last year. Lower raw material costs and operational efficiencies were offset by increased brand support expenses, start-up costs associated with new capacity additions and mix. AOI dollars and margin both increased significantly on a sequential basis due to strong operational performance and great seasonal execution by the team. Moving on to Chicken. Sales in Q1 declined 5.4% year-over-year, primarily driven by the impact of lower commodity protein prices. Volume declined 1.5% due to lower production, which was partially offset by continued sell-through of finished goods inventory. Despite the decline in sales versus last year, AOI more than doubled in Q1, primarily driven by the benefits of our strategic actions and other operational efficiencies. These include lower plant spend, improved yield and better live performance. While input costs were a clear tailwind, these were largely offset by the impact of lower pricing. As Donnie mentioned, this is the third consecutive quarter of more than $100 million of AOI improvement as we were able to pull forward the benefits of closures of inefficient plants in improvements in our live operations. Now moving to Beef. In Beef, revenue increased 6.4% year-over-year in Q1, with lower head throughput more than offset by higher prices per pound. While revenue increased, AOI decreased versus last year, primarily reflecting compressed spreads, as was expected. As Donnie mentioned, in Q1, nearly half of the operating loss was driven by an unfavorable inventory valuation adjustment, which was primarily due to the rapid and significant decline in cattle futures. Moving to Pork, Q1 revenue was down modestly as volume growth was offset by lower pricing. However, AOI increased year-over-year, benefiting primarily from improved spreads driven by lower hog cost as well as better execution. And finally, a brief comment on our International business. AOI improved as we begin to lap some of the start-up cost of our newer facilities and continue to focus on improving execution despite a decline in sales, driven by macroeconomic challenges. Shifting to our financial position and capital allocation. Our commitment to building financial strength, investing in our business and returning cash to shareholders, primarily via our dividend, remains unwavering. While market conditions remain challenging, we are laser-focused on disciplined management and deployment our capital resources to drive cash flow. Q1 showcased robust operating cash flow of $1.3 billion, above our expectations, and working capital was a solid source of cash as we continued to manage inventory levels. We were also disciplined with CapEx, which came in at just over $350 million in the quarter, below last year's exit rate. During the quarter, we returned $171 million to shareholders via dividends. Our net leverage declined sequentially, coming below 4 times, driven by our improved profitability and strong cash generation. We ended Q1 with more than $3.7 billion of liquidity. Our balance sheet management approach remains unchanged. We are committed to building financial strength and maintaining our investment-grade credit rating, and returning net leverage to at or below 2 times net debt to EBITDA. We remain committed to maintaining a disciplined yet opportunistic capital allocation strategy, ensuring that we deploy resources to maximize long-term shareholder value. Now, let's take a look at our updated outlook for fiscal 2024. Given the solid results in Q1, we have confidence that our financial performance in 2024 will improve versus last year. However, as it's still early in the new fiscal year and uncertainties remain, especially in our Beef segment, we have made only modest changes to our outlook. Our focus for fiscal 2024 remains to manage the business for profit and cash dollar generation, reflected in our guidance presented in dollar terms rather than margin percentages. With that in mind, we are reiterating our overall sales guidance to be roughly flat year-over-year. Moving to each of the segments. Prepared Foods had a solid start in a seasonally strong period. For the remainder of the year, we expect strong volume results as we continue our momentum in foodservice and see the benefits of our capacity additions. We remain focused on operational efficiencies while we support our brands and anticipate continued start-up costs. Taking all this into account, we're maintaining our AOI guidance to be in the range of $800 million to $1 billion. In Chicken, our operational turnaround is progressing as anticipated. For the remainder of the year, we expect to return to normal seasonality where Q2 is typically a weaker quarter. Given the strong start in Q1 and that we believe that there were more tailwinds than headwinds, we are tightening our AOI guidance range to be between $500 million and $700 million. In Beef, spreads are compressing as expected. However, uncertainty remains around how the cattle cycle will progress. Therefore, we are maintaining our full-year guidance at a loss of $400 million to breakeven. In Pork, on the back of our strong Q1 results, we're now raising our guidance to be between breakeven and $100 million. For the total company AOI, we're maintaining our guidance of between $1 billion and $1.5 billion, reflecting the portfolio nature of our segments. To round out the key P&L items, we anticipate interest expense to be roughly $400 million, and a tax rate to now be between 23% and 24%. Turning to CapEx, we're maintaining tight controls on spending in-line with profitability and cash flow, and we expect CapEx to remain between $1 billion and $1.5 billion this year. Finally, on free cash flow, we're committed to managing working capital and CapEx, and we're even more confident now than we were last quarter that we will generate positive free cash flow for the year. To further help model the shape of the rest of the year, we anticipate more typical seasonality across our business. As a reminder, Q2 is seasonally our weakest quarter for AOI and cash flow, driven by Beef and Chicken. As you may be aware, this January has already been impacted by severe winter weather disrupting operations. And again, we expect start-up costs in Prepared Foods to impact Q2 as well. So, in summary, 2024 is off to a promising start and we're cautiously optimistic on our prospects for the remainder of the year as well as for the long term. Tyson is a leader in the global protein industry. We have strong brands, a broad portfolio of products and a great team, all of which uniquely position us to win in the market. With that, I'll turn the call back over to Sean for Q&A instructions."
},
{
"speaker": "Sean Cornett",
"content": "Thanks, John. We will now move on to your questions. Please recall that our cautions on forward-looking statements and non-GAAP measures apply both to our prepared remarks and the following Q&A. Operator, please provide the Q&A instructions."
},
{
"speaker": "Operator",
"content": "We will now begin the question-and-answer session. [Operator Instructions] The first question comes from Peter Galbo with Bank of America. Please go ahead."
},
{
"speaker": "Peter Galbo",
"content": "Hey, guys. Good morning. Thanks for taking the question."
},
{
"speaker": "Donnie King",
"content": "Hi, Peter. Good morning."
},
{
"speaker": "John R. Tyson",
"content": "Good morning, Peter."
},
{
"speaker": "Peter Galbo",
"content": "Donnie, I was just wondering if you could give kind of maybe a brief state of the union, I know you gave some in your prepared remarks, but across the segments. And then maybe specifically, if you could start on Prepared Foods, where unlike a lot of CPG peers, you're showing actual volume growth. Some of that may be acquired, but just some of the dynamics around foodservice there seem to be a pretty important driver. So, if you can unpack that for us would be great."
},
{
"speaker": "Donnie King",
"content": "Sure. Thanks, Peter. I'll start off and maybe I'll have others to weigh in. Let me start off just kind of State of the Union. We had a solid first quarter and we continue to build on the momentum of the back half of 2023. We are seeing the benefits of our portfolio where Chicken and Pork improvements are offsetting challenges in Beef and where our Prepared Foods continues to deliver strong results. We continue to restore performance in our Chicken business. As I said earlier, this was our third consecutive quarter of $100 million of AOI improvement. And this -- our Chicken business remains a top priority of mine. We're managing Beef through the volatility and spread tightening of the cycle. We're making great progress in driving out the inefficiency all across the supply chain in Pork. Prepared Foods is performing to plan. While we have seen softness in the retail channel, our brands have performed well. Core brand share remains near-record levels and we're regaining share in our foodservice business, and I'll talk more about that in a moment. We're cautiously optimistic about FY '24. We have considered our better-than-expected results in this quarter. We've considered our initiatives to improve performance, while also still accounting for the ongoing macro uncertainty. As John said in his opening statement, Q2 is seasonally weaker and our Q2 started off -- has started off with several significant weather events. But, having said all that, taken together, it's still early in the year and we don't want to get ahead of ourselves. We have a lots of work ahead of us, and we're leaving no stone unturned. We're focused on CapEx and working capital to drive cash flow and support our dividend. We are controlling the controllables and taking necessary action, including right-sizing and modernizing our footprint and network design to drive efficiencies. We are pleased with the quarter and believe we're taking the right steps. We are excited about our future and are focused on creating value for our shareholders. Specifically -- or a little bit more specifically in terms of Prepared Foods, to your question, Peter, we had -- in the quarter, we had strong top- and bottom-line performance in the quarter, with meaningful sequential improvement versus Q4 of '23. If you look at the makeup of the volume, it was driven by a balanced portfolio between retail and foodservice. We're regaining some share lost in the middle of the pandemic that we couldn't support and we also had the acquisition from a volume standpoint of Williams sausage. Our branded core business line remained a key focus, and we have a competitive advantage with volume share near-record levels and 400 basis points above Q1 '19. Let me stop with that. Melanie, anything you would add to what I've said?"
},
{
"speaker": "Melanie Boulden",
"content": "Yeah. Donnie, I think you did a great job I'm hitting the highlights. The only thing I'll add for you Peter is, as Donnie said, our foodservice performance was strong, and I believe you asked about this question. Our growth this quarter was up 3% and that was due to customer expansion. Look, as this channel is rebounding, it continues to be an important part of our portfolio that we are focused on because we want to be where our consumers are at. And so, we're diversifying our customer base, we're building digital capabilities to drive demand, and we are focused on profitable growth."
},
{
"speaker": "Peter Galbo",
"content": "Great. Thanks for all that. And then just maybe quickly as a follow-up on Beef, Donnie. Look, the cattle inventory report out last week seems like maybe we're nearing a bottom or seeing potentially some improvement. But just, what's the conversation like with ranchers at this point? Like what's it going to take to get them to actually start the heifer retention process? Because I think that remains kind of the biggest linchpin in the whole chain and it doesn't seem like we have a lot of clarity there yet. Thanks very much."
},
{
"speaker": "Donnie King",
"content": "Sure. I mean, I'll tell you we look at the same information that I'm sure you've seen and we saw the cattle on feed report that you referenced. Unfortunately, Peter, the data doesn't indicate that heifer retention is taking place and that's obviously one of the signposts we're looking for. In the quarter, we continue to see volatility and spread tightening. We expected that. As we think about our outlook, we continue to project high cattle supplies for the balance of 2024 and even beyond. And let me pause. Brady, do you want to add anything to that?"
},
{
"speaker": "Brady Stewart",
"content": "Yeah. Thanks, Donnie. And Peter, that's a great question and one that we continually are studying. I think when you unpack that cattle on feed report, there's a few comments that obviously are lending itself to the numbers that we're seeing, and part of it's relative to some slower turnover that we've seen. We've seen placements for cattle on feed from some of the drought areas as well from a geographical perspective. And as you indicated, which is the spotlight of the conversation is, we have not seen significant heifer retention to-date and continue to see those heifers move into the cattle on feed report. So, continuing to focus on a few factors relative to heifer retention, obviously, how these interest rates that we see today relative to the difference or the delta today versus some of the cycles in the pack -- in the past is a highlight for us to continue to watch. And then, we'll continue to evaluate and understand how weather conditions are changed and lend themselves into a more favorable heifer retention strategy for these ranchers."
},
{
"speaker": "Peter Galbo",
"content": "Thanks very much."
},
{
"speaker": "Donnie King",
"content": "Thanks, Peter."
},
{
"speaker": "Operator",
"content": "The next question comes from Adam Samuelson with Goldman Sachs. Please go ahead."
},
{
"speaker": "Adam Samuelson",
"content": "Yes, thank you. Good morning, everyone."
},
{
"speaker": "Donnie King",
"content": "Good morning, Adam."
},
{
"speaker": "Adam Samuelson",
"content": "Good morning. So, maybe coming back to Chicken, and John, you gave some color in your prepared remarks, but hoping to expand on a little bit on just the profit drivers in the business in the quarter. There was $170 million of feed tailwind year-on-year, some offset with price. But can you walk through the year-on-year profit bridge in Chicken a little bit more closely? And I guess, apart from seasonality in the fiscal first quarter -- fiscal second quarter, excuse me, the first quarter would imply kind of tracking to at or above the high end of the segment profit guidance for the year. So, just want to make sure we're understanding kind of some of the moving pieces you're looking at for the balance of fiscal '24."
},
{
"speaker": "John R. Tyson",
"content": "Yeah, Adam, thanks for the question. And maybe let me give a few point that will help you shape our '24 outlook compared to '23. I think the first thing to point out is we talked about the network moves, operational performance improvement, we started to realize that, and the adjustment in our guidance range of taking the bottom end up by $100 million, roughly equivalent in-line with where we were ahead of expectations for the balance of the year -- or excuse me, where we were compared to expectations. Then, when I move through the balance of the year, I know one question is sometimes on investors' mind is, \"Hey, where is your return on sales guidance? How does that peaking, or not peaking?\" We've heard some questions about that. We're not going to return on sales guidance, but there's reasons to believe that our quarter three and quarter four could be around where we delivered the result in Q1, but frankly, it's probably premature to make any strong assertions around that. And then again, Q2, we had weather impacts across all of our segments. Chicken was not immune to that. And so, that's kind of the overall picture that we can give today based on the shape of the year. A couple of other things we're saying, we did talk about a couple of hundred million dollars in improvements on some previous earnings calls, thinking about the benefits we've realized from the network moves. We believe that we have achieved that. We have one facility still going core in Indiana. And when we close out that process, then we'll be nearly finished there. And then, there are some tailwinds from a market standpoint. I think last quarter Donnie was the one who said more tailwinds than headwinds. I think that sentiment prevails. As you know it's not just grain prices, but it is kind of the interplay between that and what chicken markets are doing and what's going on from a supply-demand standpoint to influence things. So, I think overall the $500 million to $700 million range, for a lot of those reasons, is our best estimate today of where we think the year will be. And, yeah, hopefully that gives you a little extra color. Wes, maybe you got something to add in there for Adam."
},
{
"speaker": "Wes Morris",
"content": "Yeah, I had a couple of comments, Adam. We expect to realize our strategic change funding throughout the year. And specifically to your question on year-over-year, both grains and markets were both lower. So, we stayed focused on improving our fundamentals year-over-year, did have a little tailwind, but it's mostly the material change we made in our fundamentals. We improved our live performance, specifically hatch and livability. We have a very disciplined S&OP process that got really tight in Q1, and our sales are not only sold out position, but our forecast accuracy has allowed us to do a better job filling orders with material less working capital."
},
{
"speaker": "Adam Samuelson",
"content": "That's very helpful color. And then just as a follow-up, especially in Chicken and Prepared Foods. Just wondering if you have any views on changes in consumer behavior and how consumer demand elasticity has been evolving as you kind of enter -- as the calendar flipped and how you're thinking about the state of the US consumer over the balance of calendar '24."
},
{
"speaker": "Melanie Boulden",
"content": "Thanks, Adam. So, I'll start first to talk about how we're looking at it from a Prepared Foods perspective and our Branded portfolio. So generally, we're seeing elasticities returning to pre-COVID levels. And as you know, we seek to balance both price and volume growth to maximize the value of our Branded portfolio. But at the end of the day, we do understand the financial uncertainty that our consumers are faced with as inflation remains elevated, which is why we continue to leverage our strong revenue growth management capabilities in support of our brands, and we're prioritizing their health and their profitability when determining our pricing strategy. And additionally, across the board for any of our Branded business, we remain focused on understanding our category dynamics, assessing our competition and, of course, meeting our consumer needs when making pricing decisions."
},
{
"speaker": "Wes Morris",
"content": "Yes, Adam, I'd just add that we're seeing really good dark meat demand. We've seen a reemergence of our wing demand, and we're seeing a slight shift towards foodservice."
},
{
"speaker": "Adam Samuelson",
"content": "All right. That's all really helpful. I'll pass it on. Thank you."
},
{
"speaker": "Donnie King",
"content": "Thanks, Adam."
},
{
"speaker": "Operator",
"content": "The next question comes from Ken Goldman with JPMorgan. Please go ahead."
},
{
"speaker": "Ken Goldman",
"content": "Hi, thanks so much. I wanted to ask a little bit about competition on the Prepared Food side. Are there any of your more important categories that you're starting to feel maybe a little incremental pressure in terms of competition, whether it's on the pricing side or however you want to frame it? And I guess, how comfortable are you with your price gaps versus these competitors today just in a general sense?"
},
{
"speaker": "Donnie King",
"content": "So, in terms of competition, I mean, regardless of the business, I mean there's -- we have some very strong competitors in every space that we play. And so, I'll leave that there. But I'll give Melanie the opportunity to talk about more specifics in categories. For example, I would just simply say that we saw a strong performance in breakfast sausage and cocktails, and we had some headwinds in our lunch meat and our frozen protein breakfast area. Melanie, do you want to add to that?"
},
{
"speaker": "Melanie Boulden",
"content": "Yeah. I would just say, Ken, at the end of the day, this is a challenging consumer environment, and boy, competition is stepping up. We're not only seeing competition step up from branded players, but also private label is a factor. And I think overall, we're doing very well and holding our position. But at the end of the day, we are just focused on our own retail business, in particular, and making sure that we're doing what we have to drive consumption, to address any price gaps and make sure that we are maintaining our leadership position in -- which, as you know, in eight of our 10 categories. So right now, we are focused on making sure that we grow through high ROI merchandising with a strong feature and display at shelf. We're increasing our MAP investment to continue to grow our household penetration. We've got strong innovation on shelf now and also coming, which is going to offer strong engagement with consumers. And very importantly, to address pricing, we're making sure that we're enhancing our price pack architecture offering so we can ensure that we are maximizing our distribution footprint. And we think all these steps together, we're starting to see actions in the marketplace and are confident in our full-year outlook."
},
{
"speaker": "Ken Goldman",
"content": "Thank you for that. And then, a follow-up is on Chicken. As we look at some of the export data, and I realize some of the monthly data is a couple of months in arrears usually. But the export data in general in terms of pounds for chicken, they've been a little bit weaker as 2023 anyway, progressed. And yet as we start into 2024, at least according to Urner Barry, leg quarter prices have done pretty well, which might be not what one might expect at first glance is seeing the trade number. So, just curious for a little bit of your thoughts on how to think about like demand for leg quarters, export demand in general. Any color there would be helpful. Thank you."
},
{
"speaker": "Wes Morris",
"content": "Yeah, I'll take that, Ken. Thanks. We've seen a lot of disruption in the [part] (ph) export side. Specific to leg quarters, freezer stocks are at a really low level and demand seems to be robust enough to clear it at very attractive prices."
},
{
"speaker": "Ken Goldman",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "The next question comes from Ben Bienvenu with Stephens Inc. Please go ahead."
},
{
"speaker": "Ben Bienvenu",
"content": "Hi. Thanks. Good morning."
},
{
"speaker": "Donnie King",
"content": "Good morning, Ben."
},
{
"speaker": "Ben Bienvenu",
"content": "I want to ask -- I know, Chicken has gotten a lot of focus, congrats on the quarterly results. John, I wanted to drill down on the 2Q commentary that you provided, recognizing it sounds like there's some operational headwinds and disruptions from weather early in the year. What I'm curious on is if fundamental -- commodity fundamentals continue to improve and grain prices stay low, supply/demand comes into better balance, is that enough positive to offset the temporal operational dynamics that we saw in the second quarter?"
},
{
"speaker": "John R. Tyson",
"content": "I think there are reasons to believe why some of that could offset it. But I think it would be -- I think, to quantify exactly what that offset is, we're not really ready to do that. But let's zoom out and talk about the broader year, because I think I just want to hone in on some factors that are at play about why we remain cautious on the Chicken outlook. And it has to do with what's going on in the total protein markets. Beef continues to be volatile. I think we've had predictions about where beef prices and beef markets were going to go, some have held through, some have not. There is projections for more pork to be on the market this year. We've already talked about the consumer today. So, I just want to make sure that we land the message today while there -- we're cautiously optimistic about chicken, there remains a lot of uncertainty and a lot of time left in the year. So, Ben, I think I addressed at least parts of your question. Hopefully, that's helpful."
},
{
"speaker": "Ben Bienvenu",
"content": "That's great. Sorry."
},
{
"speaker": "Donnie King",
"content": "If I could add one thing or a couple of things to that as it relates to Chicken. Those operational improvements that all of us have talked about in Chicken, those continue. And those fundamentals, while we are improved, there's still a lot of work left to do there. And we got a really good team working against those things. But keep that in mind as you are looking at Q2 and the balance of the year as well."
},
{
"speaker": "Ben Bienvenu",
"content": "Okay. Very good. Thinking about the cash flow statement, John Randal, you guys came into fiscal '24, bringing down your CapEx budget materially. You've sustained the range again this quarter. Is there yet still room to tighten that budget as we move through the year, or do you think that number is more set in stone with potentially improvements coming into 2025?"
},
{
"speaker": "John R. Tyson",
"content": "That's a great question. I think there's probably room to tighten it a little bit, but let me kind of talk about the total picture. When we gave guidance in the first quarter, we talked about striving to be free cash flow positive that we would pay attention to our ability to manage the business and working capital as well as our operational results, and that would influence our thinking in terms of the total spend. If you just extrapolate where we are in Q1, that would take you towards a higher end of that $1.5 billion range. But that's really just a product of lot of good projects in flight that we have, our efforts to slow down from the spin that was projected in north of $2 billion in recent years. And I would just say we're not trending to that higher end because, \"Hey, we've made some adjustment in our opening up the capital floodgates again,\" we remain very committed to getting that spend down to the midpoint of our range or below as we move through the balance of this year and next year. So that's what I want you to take away from a CapEx guidance standpoint."
},
{
"speaker": "Ben Bienvenu",
"content": "Great. Thanks so much."
},
{
"speaker": "Donnie King",
"content": "Thanks, Ben."
},
{
"speaker": "Operator",
"content": "The next question comes from Andrew Strelzik with BMO. Please go ahead."
},
{
"speaker": "Andrew Strelzik",
"content": "Hey, good morning. Thanks for taking the questions. My first one is actually on the Pork segment and the outlook there. If I look at the performance in the quarter, and it seems like some solid performance is probably continuing into the second quarter. It doesn't seem like there's much baked into the back part of the year. So I guess, how are you thinking about pork margins from here evolving through the year and kind of the puts and takes as we get into the back part of the year?"
},
{
"speaker": "Donnie King",
"content": "Let me start off, and then I will flip it to Brady to talk about Pork. Hog supply drove lower hog costs, leading to improved spreads. We're seeing a number of benefits of better execution in Pork, and we have assembled a really, really strong team in our Pork business led by Kyle Narron. He and his team have really taken out inefficiencies from procurement all the way to the customer, consumer, and very proud of that work. But I would also tell you there's still room for more. And you will probably continue to hear that from us is there's -- every time -- excuse me, every time we turn over a rock, we find something else, but where our moat is one of continual improvement. And Brady, any big nuggets that I have not touched on?"
},
{
"speaker": "Brady Stewart",
"content": "No. Thanks, Donnie. And Q1, obviously, is seasonally the strongest quarter of the year. And we'd expect to see some typical seasonality as we move through specifically the latter part of this year as well. The team understands it's their responsibility to control the controllables. And as Donnie indicated, done a really good job of being able to take advantage of some of the spreads we have seen in Q1 and certainly expect those improvements to continue through the course of the year as well. Really seeing some increased operational efficiencies, and the team has done a great job increasing the true business performance through the data and analytics platforms that they've stood up that allow us for better decision-making and really adaptation of some of these market trends in the current conditions."
},
{
"speaker": "Andrew Strelzik",
"content": "Okay. Great. That's helpful. And then, on the Beef side, I guess, when I look at the typical seasonality and I look at kind of the performance in the first quarter and then the commentary around the second quarter, it seems like you would need to have pretty solid improvement in the back part of the year, not to be kind of towards the lower end of that range. I know there's seasonality involved there as well. I guess I'm just curious, can you talk about maybe what would get you to the high and low end of that range? I understand certainly that there's a lot of uncertainty as we move through the year. And then, maybe can you clarify also when we think about the second quarter, are you thinking about sequentially lower off the number that you reported adjusted operating income in the first quarter, or is that kind of once you back out the inventory adjustment? Thanks."
},
{
"speaker": "Brady Stewart",
"content": "Well, thanks for the question. And as you pointed out there, I think it's really important to emphasize what both John and Donnie indicated in the opening remarks, which was, in Q1, we saw that rapid decline in cattle futures and that was the driver for that inventory valuation adjustment, that was roughly $56 million in the first quarter. And really, as we look at the first quarter, obviously, we saw some headwinds relative to some decreased value in the drop. We saw the spread compression. And obviously, with lower supply, not only in Q1, but as we move through the rest of the year, we see that lower opportunity for cost dilution of our overhead structure relative to these volumes. But let me be really clear, we see a path to improvement as well. And from an operational excellence perspective, how we manage the business today versus the past in a different economic cycle is very important. Focus on efficiency, yield and really balancing supply and demand, not only by a cut-by-cut basis and through our grinds complex, but also in terms of yield and efficiency is going to be paramount and important to the team, and they're dialed in on that as well. We've made changes that certainly provide us opportunity in the future as well as we mentioned last quarter. We've right-sized our Beef value-added business really to match our customer needs and what we're seeing from a supply perspective as we move through this. And again, as I've mentioned before, we have a well-capitalized asset base, and believe we're really able to manage through a variety of headwinds and market conditions that we expect to see as we move through this cattle cycle."
},
{
"speaker": "Andrew Strelzik",
"content": "Great. Thank you very much."
},
{
"speaker": "Donnie King",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "The next question comes from Ben Theurer with Bank of America -- excuse me, with Barclays. Please go ahead."
},
{
"speaker": "Ben Theurer",
"content": "Hi, good morning, Donnie, John. Thanks for taking my question."
},
{
"speaker": "Donnie King",
"content": "Good morning."
},
{
"speaker": "Ben Theurer",
"content": "So, just wanted to kind of understand a little bit some of the dynamics as it relates to the export business, because if I remember right, that used to be some sort of a headwind also in Beef. So, if we look into the details on sales into the international channels, particularly Beef, which kind of contrary to the rest of it, was actually even down in the sales. Could you elaborate a little bit on the dynamics in the export markets as it relates to Beef in particular, but also if you could just mention briefly what you're seeing on exports for Chicken and Pork? That would be my first question. Thank you."
},
{
"speaker": "Brady Stewart",
"content": "Sure. Well, thank you for the question. And I think it's really important to understand, we've really been working within historically high rates from a beef product or cut-out perspective. And when we talk about the arbitrage opportunity between a domestic sale and an export sale, really puts the domestic beef business and industry at a disadvantage right now. We're seeing large supplies from some of our competing countries that are in the southern hemisphere. And they're really on the opposite side of the cycle from we are -- from where we are. And so that's really led to increased opportunity for some of those competing countries and a decreased opportunity for us here in the U.S. However, we have seen strong domestic beef demand has led the -- held these cut-out values at a historically high level as well."
},
{
"speaker": "Wes Morris",
"content": "Yeah. And Ben, this is Wes. I'll touch briefly on Chicken. As I said earlier, parts have been interrupted due to [indiscernible]. And on leg quarters, we're seeing frozen inventory in the US at almost record lows. Our inventory continues to be in check, and the pricing has been very good going forward."
},
{
"speaker": "Ben Theurer",
"content": "Okay. Perfect. Thank you very much. And then just quickly following up as it relates to the Prepared Foods business. Can you quantify what the Williams sausage volume contribution was? Because I didn't find that. I know it was positive, but if you could quantify that, that would be helpful."
},
{
"speaker": "Brady Stewart",
"content": "Yeah. We haven't broken that out, but it's -- we haven't broken that out specifically, Ben."
},
{
"speaker": "Ben Theurer",
"content": "Okay. That's okay. Thank you."
},
{
"speaker": "Operator",
"content": "The next question comes from Tom Palmer with Citi. Please go ahead."
},
{
"speaker": "Tom Palmer",
"content": "Good morning, and thanks for the question. Maybe I could ask on feed costs. Just how locked in is your exposure this year? And then, when you look at the downward moves over the past few months, does this benefit your current fiscal year? Or if it continues, is this more of a 2025 flow-through? Because it does seem like there's some incremental favorability."
},
{
"speaker": "Wes Morris",
"content": "Yeah, Tom, this is Wes. I'll touch on that. We have a very diverse commodity risk management group. We also have different pricing mechanisms with customers in which some of the grains flow-through through pricing. I would tell you it's moderate and in the back half of the year."
},
{
"speaker": "Tom Palmer",
"content": "Okay. Thank you. And then, I wanted to follow up on the Prepared Food side, maybe going back to Peter Galbo's question just on the new customer wins. Are there particular products that you're seeing these wins greatest in or particular channels within foodservice? Thanks."
},
{
"speaker": "Donnie King",
"content": "Melanie?"
},
{
"speaker": "Melanie Boulden",
"content": "So Tom, your question was -- I just want to make sure I'm clear. Are we -- are there particular products where you are seeing more success? Can you just repeat your question for me?"
},
{
"speaker": "Tom Palmer",
"content": "Yes. Sorry. Exactly. Just you've noted some -- your growth was driven by some new customer wins. And I was just curious what products were really driving that for you right now within Prepared Foods. Thanks."
},
{
"speaker": "Melanie Boulden",
"content": "Yeah. So, I'd say that when I was talking about the customer expansion, we are making great strides in that area on the foodservice side of the business. And then, I would say, on the retail side of the business, we're seeing strong growth in distribution with our existing customers behind our core business lines, but we're also seeing excitement behind some of our -- a lot of our new innovation. And in particular, I want to highlight our Jimmy Dean Maple Griddle Cake that we launched last year to success, and we are planning in a couple of months to launch an extension of that product item. Does that help, Tom?"
},
{
"speaker": "Tom Palmer",
"content": "Yes. Thank you."
},
{
"speaker": "Donnie King",
"content": "Tom, let me add a little more color as it relates to foodservice there. As a reminder to everyone, in the middle of the pandemic, we had some operational issues being able to produce enough product for our customers, and we essentially had to give up some business. And we've been, since the pandemic, trying to go and regain that. But we have a nice diversification between what are the traditionally quick-service restaurants and as well as broad line distribution."
},
{
"speaker": "Tom Palmer",
"content": "Okay. Thank you."
},
{
"speaker": "Operator",
"content": "The next question comes from Michael Lavery with Piper Sandler. Please go ahead."
},
{
"speaker": "Michael Lavery",
"content": "Thank you. Good morning."
},
{
"speaker": "Donnie King",
"content": "Good morning."
},
{
"speaker": "Michael Lavery",
"content": "I want to come back to Chicken and just trying to understand, obviously, the lift in the quarter was cost and margin driven. But when you point to the strategic actions and those benefits, can you help us understand maybe how to think of them kind of longer term? And would this put you at the higher end or above kind of a 5% to 7% margin range? I know you're not wanting to think about margins as how you guide for the year. You gave a little bit of breadcrumbs for the second half. That's all real helpful. But maybe just looking a little further out, is business structurally different enough that under normalized conditions, you would rethink what it's capable of, what its earnings power is longer term?"
},
{
"speaker": "Donnie King",
"content": "So, let me start. This is Donnie. Let me start with a couple of points, and then I think John probably has a couple to add. But in terms of being prepared to give guidance, we're not prepared to do that today and talk about that. But what I can tell you is what we're doing as a company. We talked about the third consecutive quarter of over $100 million of AOI improvement. In the midst of that, what I can also tell you is market that's for grain or the meat side, those were largely offsetting one another. So, the improvements are coming from operational improvements, operational excellence both in plants and in live production and really driving out waste from the business. But we also, as we said earlier, we're realizing the benefits from plant closures that in terms of modernizing and right-sizing our footprint. So, we're seeing all of those. But this plan doesn't really is -- I mean, we've modeled the markets as they are today for the balance of the year, but this is all about operational excellence, and being more competitive and being better at what we do, at the same time driving up raw material to a more value-added and branded within the Chicken segment. John?"
},
{
"speaker": "John R. Tyson",
"content": "Yeah, Don, it's a nice summary. I think, again, without touching on what the long-term outlook is like, the things I would point out about how the strategic moves we made have a sustaining impact in our business is a couple of things. First, we're just taking cost out of the system while still keeping the same amount of volume with our customers. Over the long run, that means not putting capital into older and more tired assets, rather investing in those assets where we think we could achieve our targeted ROIC number. And then, I think the other thing, too, is we have really, in the last year, refocused our growth to be demand backed and to be in those subcategory within the Chicken segment, where we see favorable trends from a growth and margin standpoint. So, I think with that over the long run, we project to be competing and performing as a best-in-class chicken company from a margin standpoint, and that's how we realize that. I think the other big move that we made, we've seen it in our live performance results this year is the switch from NAE to NAIHM and that provides us for a lot more consistency in order to meet customer demand and expectations from a live standpoint."
},
{
"speaker": "Michael Lavery",
"content": "Okay. That's helpful. Great. And just a follow-up on Prepared Foods. I understand it's obviously always competitive, and you touched on some of those dynamics. But can you give a sense on promotional levels? Would you say they're normalized again? Do you see increasing activity there? You called out some of the mix headwinds was priced otherwise flat? Or I guess maybe could you dissect the price and mix pieces of that, and just a sense of how the environment looks from a promotional perspective? Is it getting more intense, or does it seem to have stabilized? What's your sense of how that looks?"
},
{
"speaker": "Melanie Boulden",
"content": "Yeah. So, this is Melanie. I would say that promotional activity is continuing -- we are continuing to see intense promotional activity. In terms of how we are operating, we have our highest-performing our highest-ROI merchandising initiatives in place to drive our feature and display and choice at shelf, and we are seeing it working. But to your point, competitive activity in this area is strong and we're just focused on controlling our controllables. And in addition to our promotional activity, we're focused on, as I said before, increasing our MAP investment to engage consumers. Again, we've got strong innovation in place, and we're enhancing -- when you asked about price, we're making sure that we enhance our price pack architecture structure to address competitive pricing as well."
},
{
"speaker": "Michael Lavery",
"content": "Okay, great. Thanks so much."
},
{
"speaker": "Donnie King",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "The next question comes from Alexia Howard with Bernstein. Please go ahead."
},
{
"speaker": "Alexia Howard",
"content": "Good morning, everyone."
},
{
"speaker": "Donnie King",
"content": "Good morning."
},
{
"speaker": "John R. Tyson",
"content": "Good morning, Alexia."
},
{
"speaker": "Alexia Howard",
"content": "Okay. So two ones. Firstly, on the financial side. Your leverage has obviously come down, but it sounds as though weather -- there'll be more sequential improvement in operating income next quarter in CBD given the weather issues. Do you expect leverage to continue to come down from here, or could next week -- next quarter be the high point?"
},
{
"speaker": "John R. Tyson",
"content": "Yeah. Thanks, Alexia. So, I think two questions in there. The first off is just independent of weather -- I want to make sure we're tracking. Independent of weather, we expect our Q2 to typically be one of the softer quarters from an operating income standpoint. And so then that's exacerbated by weather a little bit. In the long run, we are projecting for leverage to continue to come down. That's driven by a couple of things. One, we're getting more efficient with working capital. We've talked about some inventory clearing in our -- around our segments. Exactly kind of where things happen in the first half of the year, we can say that we would expect to end our fiscal 2024 in a better net leverage position from a ratio standpoint than last year. That's evident also in our pull down on CapEx and what we projected, which is to be a better year from an operating income and EBITDA standpoint than '23. So that's -- we're trending in the right direction, aggressively pursuing that at or around 2 times net leverage ratio. And we would project that we'll get to do that, continue to invest in our business and also support our dividend from a capital allocation standpoint."
},
{
"speaker": "Alexia Howard",
"content": "Thank you. And then just as a follow-up, sticking with Prepared Foods, it sounds as though this mix shift into foodservice is obviously a good thing overall, but it is pushing the pricing down and potentially there might be a negative mix shift with margins. Are you able to clarify whether that price pressure will continue in future quarters? And are you able to talk about the margin differential between branded retail and foodservice and private label, which I assume is lower?"
},
{
"speaker": "Donnie King",
"content": "Okay. Alexia, this is Don. There are a lot of questions in there. Here's what I can tell you relative to foodservice. And keep this in mind, we've talked about it today because you have seen some volume improvement relative to foodservice. I would remind you that we had given up some business in the middle of pandemic, and the nature of those contracts can be quite lengthy. And we're starting to get back in when those open up and get some volume. We have maintained in Prepared Foods the capacity which produces those products. So, if you think about it from that perspective, this overhead in these assets have been a drag on our business to some degree. We've gotten new volume to put into those assets. So that's one piece of it. We're probably not going to talk about the differential in the margin structure between foodservice and retail. But it's important that we regain that volume in foodservice. But our retail -- our iconic brands in retail continuing to support those and grow those and innovate and do merchandising like Melanie has talked about before, those are all still critical -- mission critical for us."
},
{
"speaker": "Melanie Boulden",
"content": "Yeah. And the only thing, Alexia, I would like to add, because I think Donnie did a nice job of highlighting more of the top-line, but also as we think about our business and our performance, one of the reasons that we were able to deliver a solid quarter and what we plan on continuing to do is focus on our controllables, the things we can control, especially from an operational efficiency standpoint. So, we're really focused on improving our service levels, maximizing our asset utilization by driving down our overhead and increasing our yield and labor efficiencies. And importantly, we're driving automation to improve our supply chain execution. So, from a top-line perspective, yes, your question was about mix, but I just wanted to reiterate that we're also working all levers of the P&L to ensure that we drive strong bottom-line as well."
},
{
"speaker": "Alexia Howard",
"content": "Great. Thank you very much. I'll pass it on."
},
{
"speaker": "Operator",
"content": "This concludes our question-and-answer session. I would like to turn the conference back over to Donnie King for any closing remarks."
},
{
"speaker": "John R. Tyson",
"content": "Before Donnie wraps us up, I just want to make sure we land one final point related to our outlook for 2024. And we've had a lot of great discussion this morning about our various segments. We obviously moved the range on Chicken and on Pork. But I just want to highlight our reaffirmation of the total company guidance from $1 billion to $1.5 billion based on a lot of various macro factors and the interplay between all of our segments. I think we have reasons to believe while we could achieve a range of outcomes in that window, the midpoint plus or minus, we designed it that way for a reason, and it feels like a way to think about the total look. And then obviously, as we move through Q2 and through the balance of the year, we'll give any revisions as necessary. But cautiously optimistic, promising start to the year, but still a lot of factors at play around total protein availability, consumer sentiment and the other unpredictable factors that would get us to where we are. So, Donnie, I think with that, I hand it over to you."
},
{
"speaker": "Donnie King",
"content": "Okay. I want to say -- once again, say thank you to all 139,000 of our team members. We're here today and have a good story to tell because of those 139,000 team members who contribute to us each and every day. Their efforts are what makes and what drives this business forward. Our strategy is working. We have the right leadership team in place to deliver, and we're poised to drive long-term opportunity and shareholder value. We've taken some steps in the right direction, but we have a lot of work to do. Thanks for your continued interest in Tyson Foods, and we look forward to speaking with you again soon."
},
{
"speaker": "Operator",
"content": "The conference has now concluded. Thank you for attending today's presentation. You may now disconnect."
}
] |
tt | 2,024 | 4 | [
{
"speaker": "Operator",
"content": "Good morning, and welcome to the Trane Technologies Fourth Quarter 2024 Earnings Conference Call. My name is Regina, and I will be your operator for the call. The call will begin in a few moments with the speaker remarks and the Q&A session. [Operator Instructions] I will now turn the call over to Zac Nagle, Vice President of Investor Relations. Please go ahead."
},
{
"speaker": "Zac Nagle",
"content": "Thanks, operator. Good morning, and thank you for joining us for Trane Technologies fourth quarter 2024 earnings conference call. This call is being webcast on our website at tranetechnologies.com, where you'll find the accompanying presentation. We're also recording and archiving this call on our website. Please go to Slide 2. Statements made in today's call that are not historical facts are considered forward-looking statements and are made pursuant to the Safe Harbor provisions of federal securities law. Please see our SEC filings for a description of some of the factors that may cause actual results to differ materially from anticipated results. This presentation also includes non-GAAP measures, which are explained in the financial tables attached to our news release. Joining me on today's call are Dave Regnery, Chair and CEO; and Chris Kuehn, Executive Vice President and CFO. With that, I'll turn the call over to Dave. Dave?"
},
{
"speaker": "Dave Regnery",
"content": "Thanks, Zac, and, everyone, for joining today's call. Please turn to Slide 3. I'd like to begin with a few minutes on our purpose-driven strategy, which enables our differentiated financial results over time. At Trane Technologies, we continuously innovate for a sustainable world. And our innovation is driving significant customer demand. We are the partner of choice to ensure optimal performance while reducing energy use and emissions. Our customers know that our solutions are green for green, good for the planet, and good for the bottom line. Our relentless investment in innovation powers our flywheel of market outperformance and strong free cash flow. With this momentum, our proven business operating system and our uplifting culture, we are well positioned to deliver a leading growth profile and differentiated shareholder value into the future. Please turn to Slide 4. We expect to deliver top-quartile financial performance over the long term, consistently and reliably for our shareholders. This is core to our culture and central to how we set our targets and execute our strategy across our global portfolio. 2024 was a standout year for the company. I'm proud of how our global teams exceeded our targets, top to bottom. We closely track top quartile performance against our core peer group and believe our performance will rank in the top quartile on organic revenue growth, up 12% as well as adjusted EPS growth up 24%. We also delivered free cash flow of $2.8 billion or 109% free cash flow conversion, enabling us to make key strategic M&A investments while raising our dividend and returning significant cash to shareholders through share repurchases. Please turn to Slide 5. Relentless investment in innovation, growth, people, culture and our business operating system have yielded clear benefits over time, demonstrated by our strong track record. Since 2020, we've delivered a revenue compound annual growth rate of 12%, expanded our adjusted EBITDA margins by 400 basis points and delivered free cash flow conversion of 108%, while deploying approximately $12 billion of capital. We believe that consistent business reinvestment is key to our long-term success. For over a decade, we've added a high level of incremental investments each year in high-ROI projects. This has resulted in a world-class direct sales force channel and service organization. It has also enabled us to develop cutting-edge solutions for the most pressing customer challenges, driving strong demand. We have all the essential ingredients to execute our strategy and continue driving differentiated returns for our shareholders over the long term. Please turn to Slide 6. We delivered robust financial results in the fourth quarter, extending our strong track record of execution and industry-leading revenue and EPS growth. Our global team achieved 10% organic revenue growth, 110 basis points of adjusted EBITDA margin expansion, and 20% adjusted EPS growth. Organic bookings for full year 2024 were strong, up 11% with a book-to-bill ratio of 102% on top of 12% organic revenue growth. This contributed to a highly elevated backlog of $6.75 billion entering 2025. We saw a strong performance across our segments, led by our Commercial HVAC businesses. Fourth quarter Americas and EMEA organic Commercial HVAC bookings were both strong, each up more than 30% on a three-year stack. Fourth quarter organic revenues were exceptional, with Americas Commercial HVAC up mid-50% on a three-year stack and EMEA Commercial HVAC up more than 60% over the same period. Our teams are excelling in complex bespoke applied projects, which are key to the multi-year CapEx cycle, especially in high-growth verticals. For instance, three-year stack organic revenue growth in applied systems for our Americas and EMEA Commercial HVAC businesses is up over 120% and 90%, respectively. Applied systems offer a durable service tail of eight times to 10 times the initial equipment cost over their lifespan, meaning our strong growth in applied solutions presents tremendous service opportunities with higher margins that are largely still ahead of us. Looking beyond the continued strength in Commercial HVAC, we see several tailwinds in 2025. We believe residential markets have largely normalized and are returning to our long-term framework of GDP plus growth. The Americas transport refrigeration markets are expected to bottom in the first half of 2025, paving the way for a second-half recovery and strong growth in 2026 and 2027. In addition, the challenges associated with our actions in the second half of 2024 to tighten credit policies in China are improving ahead of our initial expectations. Given our consistent performance over time, we are confident in our ability to deliver strong results in 2025. We are initiating a strong guide for the year, which Chris will cover in more detail in a few minutes. Please turn to Slide 7. Demand for our innovative solutions was broad-based across our segments in the fourth quarter. In our Americas segment, Commercial HVAC bookings were up high-single-digits. Revenues were up mid-teens in both equipment and services. Residential revenues were up low-teens, consistent with the second and third quarters. Transport refrigeration bookings were down high 20s after being up high 20s in the third quarter, reflecting the inherent lumpiness associated with the timing of large customer orders in this business. Revenues were down low-teens, outperforming end markets, which were down more than 20% in the quarter. In EMEA, Commercial HVAC bookings were up mid-single-digits in the quarter versus a tough prior year comp. Two-year stack bookings were up 20%. Revenue was also strong, up low-teens. Our transport business performed in line with our expectations with revenues down low single digits. In Asia Pacific, our team demonstrated resilience, achieving strong sequential improvement. Bookings in the region were up 8% and revenues were up 1%. Strength in the rest of Asia more than compensated for the softness in China, where bookings were down low-single-digits and revenues declined by low-teens. Now, I'd like to turn the call over to Chris. Chris?"
},
{
"speaker": "Chris Kuehn",
"content": "Thanks, Dave. Please turn to Slide 8. This slide provides a snapshot of our fourth-quarter performance, showcasing strong execution across the board. Organic revenues were up 10%, adjusted EBITDA margin increased by 110 basis points and adjusted EPS rose by 20%. At the enterprise level, we achieved robust organic revenue growth in both equipment and services, up high single-digits and low-teens respectively. Our high-performance flywheel continues to yield results with relentless investments in innovation driving top-line growth, margin expansion, and EPS growth. Please turn to Slide 9. At the enterprise level, we achieved robust volume growth, positive price realization, and productivity gains that offset inflation and high levels of business reinvestment. In the Americas, we delivered 9 points of volume growth and 2 points of price. Strong performance in commercial HVAC and residential was partially offset by softer transport results. Adjusted EBITDA margin expanded by 140 basis points, driven by volume growth, productivity, and price realization. In EMEA we delivered 6 points of volume growth and 1 point of price with strong commercial HVAC performance. Adjusted EBITDA margin expanded by 20 basis points, driven by volume growth, productivity, and price realization. In Asia Pacific, we delivered 1 point of price and volume was flat. EBITDA margin expansion was driven by price realization and strong productivity, more than offsetting inflation and business reinvestment. Now I'd like to turn the call back over to Dave. Dave?"
},
{
"speaker": "Dave Regnery",
"content": "Thanks, Chris. Please turn to Slide 10. This slide outlines the key dynamics shaping our market outlook and guidance for 2025. In the Americas, we anticipate continued strong execution and broad-based strength in core markets with particular momentum in high-growth verticals. Our world-class direct sales force and leading innovation are powerful competitive advantages that enable us to optimize opportunities and drive market outperformance. We expect residential markets to return to a GDP-plus framework in 2025, following a modest pre-buy of around $75 million to $100 million in Q3 and Q4 of 2024. Most of this pre-buy is expected to impact the first quarter of 2025. For the full year, we see mid-single-digit growth in the residential business with a tailwind from the low GWP mix. Turning to transport, we expect relative flat markets in 2025, plus or minus low single digits. The market should bottom in Q1, down about 25% year-over-year, then rebound in the second half aligning with freight market recovery forecasts. While the exact timing and speed are uncertain, ACT predicts a sharp recovery in both 2026 and 2027, up mid-teens each year. We've continued to invest heavily during the market downturn and we are well-positioned to outperform as the market comes back. In EMEA, we expect continued strength in commercial HVAC in 2025, driven by strong execution in core markets and tailwinds from thermal management systems, services, and key growth verticals. EMEA transport markets are expected to be flat to up low-single digits in 2025 and we expect to outperform. In Asia, we anticipate a flattish market for the year due to a soft macro backdrop and our tightened credit policies impacting the first half of 2025. We expect muted performance in China to be offset by growth in the rest of Asia. Now, I'd like to turn the call back over to Chris. Chris?"
},
{
"speaker": "Chris Kuehn",
"content": "Thanks, Dave. Please turn to Slide 11. Our 2025 guidance reflects the market dynamics outlined on the prior slide and our optimism about our ability to outperform. It also incorporates our value creation flywheel, emphasizing continued investment in innovation, market outgrowth, healthy leverage, and strong free cash flow. We are initiating 2025 guidance with 7% to 8% organic revenue growth and adjusted earnings per share of $12.70 to $12.90, representing approximately 13% to 15% EPS growth. This includes about 100 basis points of negative FX and roughly 50 basis points of growth from M&A impacting revenue, which together are expected to negatively impact earnings by about $0.20 for the year. We are targeting organic leverage of 25% or higher, consistent with our long-term goals. We anticipate another year of 100% or greater free cash flow conversion in 2025. Looking at the first quarter of 2025, we expect approximately 6% to 7% organic revenue growth, driven by continued strength in commercial HVAC. We expect adjusted EPS in the first quarter to be between $2.15 and $2.20 with a midpoint of $2.17. This midpoint represents about 17% of our full year guidance ahead of our three-year and five-year historical averages of approximately 15% to 16%. Overall, we believe our Q1 guidance is strong and an achievable start to the year. For additional details related to our guidance, please refer to Slide 18. Please go to Slide 12. We remain committed to our balanced capital allocation strategy focused on deploying excess cash to maximize shareholder returns. First, we strengthened our core business through relentless reinvestment. Second, we maintain a strong balance sheet to ensure flexibility as markets evolve. Third, we expect to deploy 100% of excess cash over time. Our approach includes strategic M&A to enhance long-term returns and share repurchases when the stock trades below intrinsic value. Please turn to Slide 13. In 2024, we deployed or committed approximately $2.5 billion through our balanced capital allocation strategy with approximately $800 million to dividends, $470 million to M&A, and $1.3 billion to share repurchases. We made several strategic bolt-on acquisitions, enhancing our AI and digital building management capabilities, expanding specialized refrigerated transport, and making multiple channel investments. Our M&A pipeline remains active and we will continue to be disciplined in our approach. In addition, with $6.2 billion remaining under repurchase authorizations, we have strong flexibility as our shares trade below our calculated intrinsic value. For 2025, we expect to deploy between $2.5 billion and $3 billion in capital. Our strong free cash flow, liquidity, balance sheet, and significant share repurchase authorization provide excellent capital allocation optionality moving forward. Now I'd like to turn the call back over to Dave. Dave?"
},
{
"speaker": "Dave Regnery",
"content": "Thanks, Chris. Please turn to Slide 15. We've already covered our transport market expectations in the Americas and EMEA on Slide 10. So I'll keep my comments brief. While the Americas transport refrigeration markets have been more volatile in recent years compared to the five years preceding the 2020 pandemic, the long-term outlook remains strong. ACT forecasts show an average of 44,000 trailer units per year over a 15-year period. For 2026 and 2027, ACT projects mid-teens growth. The future looks bright and we're excited about the opportunities ahead. Please turn to Slide 16. In summary, we are well-positioned to deliver leading performance and differentiated shareholder returns in 2025 and beyond. Our uplifting and engaging culture, combined with our leading innovation and proven business operating system continue to set us apart. I'm proud of our team's consistent track record of growth, including our standout performance in 2024. And I truly believe our brightest days are still ahead. And now we'd be happy to take your questions. Operator?"
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Our first question comes from the line of Chris Snyder with Morgan Stanley. Please go ahead."
},
{
"speaker": "Chris Snyder",
"content": "Thank you for the question. I wanted to ask on service with Q4 up low-teens again. I think America was in the mid-teens in Q4. And service has now grown at a double-digit rate for the last three to four years. And Dave, I know you typically talk about high single-digit service growth. I'm just wanted to get a sense for the outlook here and what's baked into this 2025 guide on service, which I know in the past, you've said hasn't usually lags equipment by a couple of years. Thank you."
},
{
"speaker": "Dave Regnery",
"content": "Hi, Chris, how are you doing? Thanks for the question. Yes, I'm so proud of our service business. Just the growth rates that we've seen there. Chris makes me use a seven-year CAGR on that. So that's where the high single digits comes from and it's very high, high single digits. But look, we were up mid-teens or low-teens, I'm sorry, in the fourth quarter low-teens for the full year. Our service business now from a dollar basis is $6.5 billion. And just tremendous growth that we're seeing there. And if you think about our backlog, right, which is predominantly on commercial HVAC, predominantly applied, that's really where our service business was designed around our applied solutions. And the more complex those solutions become, the more propensity for the OEM to do the service work. So - but we'll keep our guide at the high-single-digits, but think about $6.5 billion that's growing at a close to 10% rate per year in the last couple of years have been in that double-digit range. As you said, it's a very resilient business. And I can tell you that we're operating very well there as part of our operating system, the cadence that we have there, and we're really hitting on all cylinders right now."
},
{
"speaker": "Chris Snyder",
"content": "No, really, really appreciate that. And then maybe turning over to the commercial HVAC equipment. Orders this quarter, high singles a bit better than last quarter, low singles, comp seems to be the same. I know there's always a lot of focus on data center, but you guys do, obviously, I think you talked to 13 or 14 commercial verticals. So was that improvement - is that just project lumpiness? Or when you look across those verticals, do you see positive rates have changed across some of them? Thank you."
},
{
"speaker": "Dave Regnery",
"content": "Chris, great question. Look, our order grade for Commercial HVAC in the Americas was up high single digits. On a two-year stack, it's over 20%. On a three-year stack, it's over 30%. So we continue to see tremendous growth in our Commercial HVAC business. As far as the verticals, yes, we track 14 different verticals and we're seeing growth, yes, we're seeing growth in data centers. It's been a strong vertical for us in the past. It's going to be a strong vertical for us in the future. But we're seeing broad-based growth. And if you think about it, I mean, the revenue for the Americas for the year was up over 20% and we had growth in 13 of the 14 verticals. The only vertical that did not show growth was Life Science and it's been challenged all year, but we're very optimistic about the future there. So think about that. We're showing broad-based growth and you would expect that from Trane Technologies with the broad-based portfolio of products and services that we have. We didn't design our portfolio of products to serve a particular vertical. We designed it to serve the market, and that's exactly what we're doing. And if you take that with our direct sales force with deep domain expertise knowledge at both a technical level and then within a vertical level, you could understand why we're being able to have this broad-based growth. So we're very excited about what we're seeing in Commercial HVAC. The team is performing very well. And the pipeline too is very, very strong. So we obviously - we report orders, but the pipeline is what the team is working on and that remains very, very robust."
},
{
"speaker": "Chris Kuehn",
"content": "Chris, I would add - think about our applied solutions, which impact many of those 14 verticals. Revenues in applied are up over 120% in the Americas, Commercial HVAC business over the last three years. In the EMEA business, it's up more than 90%. And that is building an installed base that then drive services that think of that as a few years after the installed base, the service revenues start to apply post-warranty period. That's largely in front of us. So it's a very durable tail, as Dave described, and really excited that, again, applied serves multiple verticals."
},
{
"speaker": "Chris Snyder",
"content": "Thank you guys. Really, really appreciate that."
},
{
"speaker": "Dave Regnery",
"content": "Thanks, Chris."
},
{
"speaker": "Chris Kuehn",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Julian Mitchell with Barclays. Please go ahead."
},
{
"speaker": "Julian Mitchell",
"content": "Hi. Good morning. Maybe just a first question around the sort of organic sales guide through the year. So I think a lot of investors would have expected maybe a slow start to the year and then an acceleration because of resi HVAC recovering from the pre-buy headwind and TK picking up a bit. But your organic growth guide looks very steady through the year, just a point less in Q1. So trying to understand - does that reflect not a big headwind from resi HVAC and TK in Q1? Or does it just reflect some conservatism when we're thinking about the second half and the Commercial HVAC sales growth?"
},
{
"speaker": "Chris Kuehn",
"content": "Yes. Hi, Julian, it's Chris. I'll start. Yes, think about the first quarter, and I'll start with residential, right? Dave called out the pre-buy estimate that we had around $75 million to $100 million. We expect that should largely impact the first quarter. It may extend beyond that, but right now, we're thinking that should largely impact the first quarter. Probably means residential is flat to slightly down in the first quarter. Transport markets, as you described, I mean, we're seeing them bottom out in the first half of the year, probably a bit under-challenged here in the first quarter. But we're seeing continued strength in the Commercial HVAC businesses. So think of them as up high-single-digit could be 10% growth here even in the start of the first quarter. But it's really why we have a range of 6% to 7% organic revenue growth for the first quarter. We think the guide is in the right range. We've got opportunities and multiple ways to get there. But you're right. I mean transport residential, it may have a start that could be a little bit down in the beginning of the year, but a lot of strength coming through Commercial HVAC. And then we have multiple opportunities as we execute to the guide on the full year, as we said was 7% to 8% organic revenue growth, a lot of confidence in our guide for the first quarter and for the full year."
},
{
"speaker": "Julian Mitchell",
"content": "Thanks very much. And then just my follow-up would be around the price sort of volume outlook within the organic sales guide. So I think fourth-quarter price was sort of 1 to 2 points across the company, higher than that in the Americas. When we're thinking about the year ahead, is it sort of a similar 1- to 2-point price tailwind in the sales mix? And any sort of concerns about customers, for example, in the resi channels pushing back on price increases?"
},
{
"speaker": "Chris Kuehn",
"content": "Yes. For the fourth quarter, price was a little bit above 2 points. It really has been coming down over the last couple of years and now at a - for the full year in 2024, it was a little bit above 2 points as well. And the Americas would be really the driver there, a little bit above 2 points in the Americas. And Julian, for 2025, we'd expect pricing to contribute about a point to maybe 1.5 points on the full-year revenue growth outlook. So on 7% to 8%, we get 5.5% to 6% or 6.5% around volume and then 1 to 1.5 points coming from price. It's less of the carryover from 2024 pricing that would impact '25, just given the low nature of the contribution in '24. It's really around the new price increases that we put in place for 2025. On residential, you mentioned that just to be clear on the transition to the lower refrigerants, the 454B refrigerant for us. We're going to report that price increase, which is high single digits for that portfolio. We're going to report that in volume, so that would not be part of price. But think of that as on 65% of the portfolio and then about 75% of the year, three quarters of the year really being impacted by that transition for the A2L refrigerants. So hopefully that gives you a sense. We're probably in that 1 point to 1.5-point price range for the year."
},
{
"speaker": "Julian Mitchell",
"content": "That's great. Thank you."
},
{
"speaker": "Dave Regnery",
"content": "Thanks, Julian."
},
{
"speaker": "Chris Kuehn",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Andy Kaplowitz with Citi. Please go ahead."
},
{
"speaker": "Andrew Kaplowitz",
"content": "Hi, good morning, everyone."
},
{
"speaker": "Dave Regnery",
"content": "Hi, Andy, how you doing?"
},
{
"speaker": "Andrew Kaplowitz",
"content": "Good, how are you? Dave, Chris, I wanted to ask Chris' question in a slightly different way. I know you have the 14 verticals. But are data center project bookings set to lead growth, for instance, in '25 versus '24? And it seems like education-related bookings are holding up well. There's been some consternation about that. And just on the comps issue, like comps in North America seem like they continue to get a little more difficult. Can you still grow Commercial HVAC bookings in North America even against difficult comps?"
},
{
"speaker": "Dave Regnery",
"content": "Yes. A lot there, Andy. But look, our - we saw a growth in, like I said, at almost all verticals. So, yes, data centers were strong, but we had a lot of other verticals that were very, very strong. And you hit on one, education. Education has been strong, certainly, ESSER funding was a tailwind there, but even in the fourth quarter, where ESSER funding is now at least from an order standpoint behind us, we still saw growth in fourth-quarter bookings. And I would tell you the pipeline there in education is very, very robust. So look, as far as the - do we think there's opportunities that comps get hard? Look, we still believe there's tremendous opportunities here for growth in all verticals, right? If you think about the megatrends around decarbonization and energy efficiency, they're - they continue to intensify. If you think about reshoring activity in the United States, that continues to intensify. If you think about the multi-year CapEx cycle with mega projects, that continues to have momentum. So we're very bullish on our commercial HVAC business. I would tell you that the portfolio of products and the innovation that we have there, I know I said in my prepared remarks, we are green for green. When you have a solution that's very sustainable for the planet and has a great payback for the customer, it's the greatest place to be. And that's what we have at Trane Technology. So, I'm very bullish about the future."
},
{
"speaker": "Andrew Kaplowitz",
"content": "Very helpful, Dave. And then just focusing on margin. APAC margin was obviously surprisingly strong in Q4. Maybe just comment on the durability of those margins in '25? And then I think your incremental margin dropped a little in Americas and EMEA in Q4. Is that just, you mentioned transport mix, is that really what it is, but you also talked about investments quite a bit. Could you quantify how much they were and what you're thinking for '25?"
},
{
"speaker": "Chris Kuehn",
"content": "Yes, Andy, I'll start. I'll soon start with Asia. We expected sequential improvements in Asia in the fourth quarter versus the third quarter and our team in Asia just has even outperformed those expectations. It's still going to take some time to continue to normalize in China the tightened credit policy. So that will probably extend into the first half of 2025. But their decisions were the right decisions you're seeing that come through on sequential improvement versus what we saw in the third quarter. Margins, look, that team has just been outstanding in terms of managing their productivity, their investments, and ultimately still investing in the business. So let's see where margins go for going forward. There's certainly leading margins across the regions and it gives us a lot of confidence that EMEA and Americas can continue to grow their margins into the future as well given, just to recall, our Asia business is largely Commercial HVAC that they're selling into the region. For the other markets, very strong results in terms of margin expansion. We're driving all of those businesses for 25% or better leverage into 2025. We like that framework. The last couple of years, we've - actually, we've taken the lid off of investments. We're making sure that we can drive strong leverage and also accelerating as many investments as we can, and that's really across all three of our regions. Otherwise, I think that hopefully answers the question. We have a lot of confidence that we're going to be able to grow the margins and really the leverage with the investments we're making."
},
{
"speaker": "Dave Regnery",
"content": "Yes, I'll just add that, look. I'm super proud of the team in Asia. I know Asia, it's only 8% of our revenue, 50% of that's China, 50% is outside the rest of Asia. But I mean just great performance. I mean, the rest of Asia had 10% growth and had order growth in the high teens. So very strong performance there. And as Chris commented, the team in China just executed very well, implementing our new credit policy and the credit tightening is the right reason and I was very - the right prudent thing to do. And I was very clear on the third quarter if we don't have an order, we're not going to - we don't have a down payment, we're not going to take the order. And in the fourth quarter, we made some adjustments to our backlog to make sure that everything in the backlog had down payments in it. So that team is just executing at a very high level."
},
{
"speaker": "Andrew Kaplowitz",
"content": "Appreciate the color, guys."
},
{
"speaker": "Dave Regnery",
"content": "Sure."
},
{
"speaker": "Chris Kuehn",
"content": "You're welcome."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Amit Mehrotra with UBS. Please go ahead."
},
{
"speaker": "Amit Mehrotra",
"content": "Thanks. Good morning, guys. Dave, can you talk about the margin, just coming back to the service conversation at the front of the call. Just trying to understand the margin opportunity in the service business over time. I know there's a lot of investments in technology to make technicians more efficient, maybe predictive maintenance. But hoping you could just speak to the runway there just given obviously, it's a third of the business and the installed base is growing quite rapidly and a few years from now, it could be quite larger. So if you can talk about that?"
},
{
"speaker": "Chris Kuehn",
"content": "Hi, Amit, it's Chris. I'll start. Yes, look, we like the margins in the service business. It's higher margins when you think about what we're delivering to customers and making sure that their products are running efficiently. As Dave has described in the past, the service business is rapidly evolving from running to go fix something that's not working effectively to now making sure that the equipment is always optimized, right. It may be running, you may think it's up, it's operating well, but the fact is it may be operating inefficiently and therefore, that's a really nice opportunity for us. So it gives us a lot of confidence that we should be driving organic leverage 25%, or better. And a reminder, services is a third of the enterprise revenues. It remains a third of the enterprise revenues. And you're right, the investments that we've been making across our portfolio also include investments in our service portfolio. So think about service technicians, think about front-end tools, digital in terms of diagnostics, it's an area that again, that's a great area to take the lid off and keep investing in that part of our portfolio."
},
{
"speaker": "Dave Regnery",
"content": "Yes, Amit, one of the things that we announced in the quarter two was the closure of an acquisition, BrainBox AI, and that's really going to help our service business as well in the future. So if you think about today, we have 42,000 roughly connected buildings. We have well over 2 million connected assets. We're getting a lot of data at the building level and at the asset level and we'll call that structured data. What AI does is, it augments that with unstructured data. And when you combine that, that's really where you're able to make buildings operate more efficiently. So our service teams will be a big part of that in the future. And I know you've probably heard me speak in the past about demand side management. Look, we've done hundreds of thousands of energy audits and we know that about 30% of the energy consumed after the meter is being wasted. And our goal is to help decarbonize that built environment and to get everything back to where the way it was designed to operate. And if we can save that 30%, there's so much opportunity there well into the future."
},
{
"speaker": "Amit Mehrotra",
"content": "And then just related to that because obviously, paybacks are so compelling today, which is what's driving a lot of the growth. But there is this expectation that power prices will continue to go up over the next several years. I guess the BrainBox acquisition probably allows the equipment to run even more efficiently. Can you just talk about how you think the payback map evolves over the next few years? Because there's, the question you routinely get is how long is it sustainable, but if paybacks can actually improve, I wonder if this growth can actually reaccelerate."
},
{
"speaker": "Dave Regnery",
"content": "Well, I think you're spot on. I don't think anyone is projecting that the cost of energy is - or at least electricity is going to go down in the future, right. So you think of the paybacks, it's actually going to become more punitive if you're not running the system the way it was designed. So the paybacks will actually increase. So we're - we think there's a tremendous opportunity in demand side management and we're executing to that strategy. BrainBox can be a big part of us. It's a small business today, but we've been really good at taking these technologies, in this case, the technologies on the software side, and scaling it within our channels. So we're really excited about the growth that we're going to see in the future from it."
},
{
"speaker": "Amit Mehrotra",
"content": "Thanks a lot. Appreciate it."
},
{
"speaker": "Dave Regnery",
"content": "Sure. Thanks, Amit."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Scott Davis with Melius Research. Please go ahead."
},
{
"speaker": "Scott Davis",
"content": "Hi, good morning, guys."
},
{
"speaker": "Dave Regnery",
"content": "Hi, Scott, how are you doing?"
},
{
"speaker": "Chris Kuehn",
"content": "Good morning."
},
{
"speaker": "Scott Davis",
"content": "Good, good. Congrats on a very strong year. Guys, I wanted to go back, I mean, you talked a lot about energy audits, and just makes a ton of sense. It seems like that's kind of what drives the sales cycle. Do you measure internally the number of energy audits that you do kind of each quarter? And is there such a thing as kind of thinking about that as I'll just call it like front log that energy audits are up x percent this quarter and that gives you some additional confidence on the backlog or - on the front log, backlog?"
},
{
"speaker": "Dave Regnery",
"content": "Yes. It's a great question, Scott. But obviously, we have a lot built into our operating system around our energy management's audits that we do. So, I won't disclose too much there, but absolutely, we track a lot of different metrics, okay, and a lot of them are leading metrics and that would be one of them, but we track a lot of others as well. At the end of the day, it's when you're connected to an asset, you're going to make sure the asset is performing the way it was designed and it's not wasting precious energy. And when you get - when you show that to customers and they start to understand it, it becomes very compelling. And now with the addition of not only the structured or machine learning data that we've been able to derive in the past, this unstructured data that we bring into the equation with BrainBox, it really we're able to drive results that we didn't think were possible three or four years ago."
},
{
"speaker": "Scott Davis",
"content": "Dave, can you use AI now to do a digital twin meaningfully faster than you could in the past? Are we there? Are we at that point yet?"
},
{
"speaker": "Dave Regnery",
"content": "Yes, we do. We do a lot of work with digital twins. I'm not sure if you saw it when you went to 55 Water Street because I think we demonstrated one there. The speed is always getting better and the tools that we're using, obviously, we're using all the tools that we have available to us and AI is one of those tools. So it's certainly, there's other tools as well that have really sped up that process. But it's when you can see it visually and you see the digital twin and then you see the before and after, it's very, very compelling for the customer to understand the impact that we're able to have by constantly monitoring the equipment and constantly making sure it's at the peak performance levels."
},
{
"speaker": "Scott Davis",
"content": "Okay. Best of luck this year, guys. Appreciate it."
},
{
"speaker": "Dave Regnery",
"content": "Thanks, Scott. Appreciate it."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Joe Ritchie with Goldman Sachs. Please go ahead."
},
{
"speaker": "Joe Ritchie",
"content": "Hi, guys. Good morning."
},
{
"speaker": "Dave Regnery",
"content": "Hi, Joe, how are you?"
},
{
"speaker": "Joe Ritchie",
"content": "Doing great. Thanks, Dave. So look for better or for worse, your stock at times tends to trade with the sentiments surrounding AI, CapEx and data centers. I guess just maybe as you kind of - as you think through like the trajectory of your data center business from here, maybe just give us some color on how you think that you expect that to progress? And then also just on your commercial HVAC backlog, is, are you still well above normal on that backlog in terms of how long cycle it is? Or is it starting to normalize?"
},
{
"speaker": "Dave Regnery",
"content": "Yes. Why don't I start with the backlog, then I'll get to the data center question. Look, our book-to-bill in 2024 was over 1%, it was 102% and our backlog year-over-year was relatively flat. It's down a little bit. What everyone needs to understand is we had a couple of adjustments that occurred within the backlog, right? There's really three. One is currency worked against us all year. Two is, I've been very clear in Asia, specifically in China, that if we don't have a down payment, we're not including something in our backlog. So we adjusted that out of our backlog. And then the third is the normalization of our transport businesses, which have been under pressure all year. That accounts for about $0.5 billion of backlog adjustments that we took in the year. So if you think about it, our backlog would actually be up year-over-year versus what we're reporting right now. That said, our backlog is very, very elevated, which gives us a lot of visibility into 2025, and that's why Chris and I could speak with so much confidence about the guide that we're putting forward. It gives us great visibility. And the other thing that we track a lot of is the pipelines and these are orders before they become orders, that activity remains very, very robust. As far as data centers go, look, data centers have been a strong vertical for us for decades and they'll be a strong vertical for us well into the future. As far as the news about new competitor coming out of China and the impact that will have, we'll see, I can't comment on that. I could just comment on what we're seeing right now. And we're seeing a lot of growth in data centers and we're seeing a lot of pipeline activity in data centers. I had the opportunity to listen to the earnings call from Meta last night. And if you listen to them, they would say that they're building out their infrastructure and that's part of a competitive advantage that they have. So it doesn't appear as though they're going to be slowing anything down. But we'll wait and see, but everyone needs to understand that we are much more than just data centers. Data centers are strong. They've been strong in the past. We're really good in that vertical. But we're really good in 13 other verticals that we track very, very closely."
},
{
"speaker": "Joe Ritchie",
"content": "Super helpful. And bless you to whoever sneezes in the background. The quick question follow-up there is just maybe just a tariff question. Any comments on, like how you see this playing out and any thoughts and your potential exposure there?"
},
{
"speaker": "Dave Regnery",
"content": "Yes. I mean, good question, Joe. Look, we - for decades now, we've had a manufacturing strategy of in-region for-region. So you think about - in the Americas, we have a plant in Mexico. We have over 20 plants in the United States. We have plants throughout Europe. We have plants throughout Asia, some in China, some outside of China. So look, we've - in the past, we've dealt with tariffs. Should they happen, we'll react. Do I think they could impact our supply chain? For sure, there's a little bit of flexibility there, but they will have an impact. But I think we've been able - part of our operating system is we understand our cost inputs. And if we see something change, we're going to react and we're going to act very quickly to make sure that we stay margin-neutral over time."
},
{
"speaker": "Joe Ritchie",
"content": "Thanks, guys."
},
{
"speaker": "Dave Regnery",
"content": "Thanks, Joe."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Steve Tusa with JPMorgan. Please go ahead."
},
{
"speaker": "Steve Tusa",
"content": "Hi, good morning."
},
{
"speaker": "Dave Regnery",
"content": "Hi, Steve. How are you?"
},
{
"speaker": "Steve Tusa",
"content": "Good. Always interesting times. So I guess just on this resi guide, roughly, I don't know, 4%-ish on the mix benefit, which you'll call volume a 1.5%, maybe 2% headwind from pre-buy, this is all annual. So what are you thinking about like the market on like a volume basis this year, just like from an underlying demand and replacement events perspective, if you will?"
},
{
"speaker": "Chris Kuehn",
"content": "Yes, Steve, it's Chris. Yes, you're right, there's three elements that really come into the guide of around mid-single-digit revenue growth for residential. The first one would be that mix tailwind from the A2L refrigerant change, right? You can think of that as maybe around 4 points high single-digit price on 65% of the portfolio multiplied by, say, three-quarters of the year impact gets you to around 4 points. The view around a GDP-plus framework would be the second element. Think of that as maybe 3 to 4 points of growth from returning to GDP, IRA tailwinds, right, that money is at the state level and it's really starting to be deployed. That could be a tailwind for 2025. And then items around consumer confidence, tax cuts, those are all things that could be beneficial to the - to a GDP-plus framework for the year. And then the third element would be the pre-buy dynamic, which is probably around 3 percentage points of a headwind. So altogether, you get into that 4% to 5%-ish range on growth, which is our guide for the year around residential. But to be fair, if it turned out that things were softer in the markets and it wasn't necessarily growth, but it was flattish, and really the impact to our enterprise revenues would be less than a point. It would be 70 basis points or 80 basis points and we really feel comfortable we've got that and it's manageable within our guidance for the year."
},
{
"speaker": "Steve Tusa",
"content": "Yes. That makes sense. And what do you guys see in Light Commercial? What's your expectation for the year on Light Commercial?"
},
{
"speaker": "Chris Kuehn",
"content": "Yes. That's - we certainly think applied markets are going to grow faster than the unitary markets will for 2025. We'll see where it plays out. The best thing about Trane Technologies is we've got the broadest portfolio of products. And unitary versus applied, it's not harder and harder to kind of figure out what the need for the customer is. We're looking at a solution and many of those solutions will involve multiple products to ultimately deliver the energy savings that they need. So let's see, but, probably more growth in applied for 2025 than unitary."
},
{
"speaker": "Steve Tusa",
"content": "Okay. And then, sorry, one last thing, given services is such a topic. Dave, you said like 8 to 10 times, I think the multiplier on services. That just seems like a big number for an asset that has like, I don't know, a 30-year useful life that basically people are spending that much money every like three years to service. Is that really like the - considered an annuity or is that more like every five years, they do like a major refurb or something like that? Like how visible is that revenue? Because it just seems like a really big number for a building guy or an equipment owner to spend relative to his initial buy."
},
{
"speaker": "Dave Regnery",
"content": "Yes. Just understand 8 to 10 over the life of the asset, right? So the asset is going to add 30 years and the asset cost $1 million, think of it at $8 million in service over that time period. But yes, I mean there is the maintenance that happens. And then obviously, at some point in the useful life, you tend to do our renewals for it where you'll change out controls or make it run more efficiently just because technology continues to advance. So we're very comfortable with that number. We've done a lot of analysis on that with the installed base. So I'm very comfortable with the 8 to 10 times over the life of the asset."
},
{
"speaker": "Steve Tusa",
"content": "Okay. Great. Thanks a lot."
},
{
"speaker": "Dave Regnery",
"content": "Thanks."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Jeffrey Sprague with Vertical Research. Please go ahead."
},
{
"speaker": "Jeffrey Sprague",
"content": "Hi, thanks. Good morning, everyone."
},
{
"speaker": "Dave Regnery",
"content": "Hi, Jeff."
},
{
"speaker": "Chris Kuehn",
"content": "How's Connecticut, Jeff."
},
{
"speaker": "Jeffrey Sprague",
"content": "It's a little chilly. It's warmed up recently, but, we're not needing any HVAC in the, well, we don't need any VAC. We need some H, that's what we need."
},
{
"speaker": "Dave Regnery",
"content": "You need a heat pump, Jeff, but go ahead."
},
{
"speaker": "Jeffrey Sprague",
"content": "Yes. So hi, a lot of ground covered, a little maybe a couple of nits from me. Just first on backlog. I think you include everything in backlog regardless of how far out it reaches. Maybe you could just give a little color on kind of the backlog staging, what's deliverable in '25, and how far out it does reach?"
},
{
"speaker": "Chris Kuehn",
"content": "Yes, Jeff, it's Chris. I'll start. So $6.75 billion of backlog at the end of 2024. Again, the majority of that, call it, 90% is going to be driven by Commercial HVAC globally. And then of that, it's going to be majority applied systems. That backlog, the majority of it will revenue in 2025. So that's actually fairly consistent with how we've seen the backlog in terms of the growth over the last few years that the majority will turn in 2025. There'll be a small amount that will push out into 2026 and that's really at the customer demand. But the majority of that backlog will turn within 12 months."
},
{
"speaker": "Dave Regnery",
"content": "And I mean - and Jeff, remember, we don't have services in the backlog."
},
{
"speaker": "Jeffrey Sprague",
"content": "Right. And yes, majority doesn't mean 55%, it means 80%, or 90% or something like that, it sounds like. And then --"
},
{
"speaker": "Dave Regnery",
"content": "Yes. It's not a tick above 51, or 50, but no absolutely, right."
},
{
"speaker": "Jeffrey Sprague",
"content": "Yes. And could you just also just really in the weeds on resi, how sort of - how did the two-step channel perform in the quarter versus your internal channels as we kind of think about all the pre-buy generations we went through here?"
},
{
"speaker": "Dave Regnery",
"content": "The pre-buy obviously happened in the two steps or with our IWDs, Independent Wholesale Distributors. Think of that pre-buy that $75 million to $100 million, Jeff, as between Q3 and Q4, all right. We don't think it was all in Q4. It's hard to tell, but because we're estimating, but we think probably about 50% was in Q3, 50% of it was in Q4. But we also think, as Chris said earlier that the majority of that will be impacted in the first quarter. Some of it will probably go into the second quarter, but we can give you guys an update on that when we get to that point."
},
{
"speaker": "Jeffrey Sprague",
"content": "Great. I'll leave it there. Good luck this year. Thanks."
},
{
"speaker": "Dave Regnery",
"content": "Thanks."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Nigel Coe with Wolfe Research. Please go ahead."
},
{
"speaker": "Nigel Coe",
"content": "Thanks. Good morning. Lots of questions on services. So here's another one. So I probably should know this, but what is the mix between predictive connected type services versus, I guess, transactional services where there's a phone call from a customer, where there's parts involved, et cetera? So just wondering what that mix is. And does it matter, I mean, is there a growth differential? Is there a margin differential between connected versus transactional?"
},
{
"speaker": "Dave Regnery",
"content": "Yes, it really doesn't matter, but we haven't disclosed that Nigel, like for a lot of different reasons, but we're strong in both. I mean, obviously, we want to encourage our customers to have agreements because we make sure that the assets we do more maintenance than to make sure that the assets are performing. But obviously, we're going to respond if we get just a cold call saying, hey, my system is down, can you help me? And then what we'll do is, if that happens, the goal is to make sure that we try to sign that customer up for a more comprehensive service agreement over time."
},
{
"speaker": "Nigel Coe",
"content": "Okay. And is there a margin differential between whether the contract is more transactional?"
},
{
"speaker": "Dave Regnery",
"content": "Yes. I'll say no, but there might be one if it's a cold call, okay, depending on what's going on. We try not to because someone is in a dire need charge them more, that's usually not a long-term way to grow a business. So we try to be competitive in both just because we want the customer for life."
},
{
"speaker": "Nigel Coe",
"content": "Okay. And then a question on BrainBox. I can't believe I said that, but BrainBox AI. It seems like it's quite a chunky deal. It looks like $300 million, or so EV. So just wondering if you could just give any details on the size, growth profile, how you can like really kind of really expand this business. And then annuity accounting question for Chris, I think. When - this sounds like a very sort of intangible heavy business. So just curious if the intangible amortization is coming down when we think about that step-down in the trade normalization from 15 years ago."
},
{
"speaker": "Chris Kuehn",
"content": "Yes, Nigel, I'll start with BrainBox. So less than $300 million from a purchase price, we had another meaningful acquisition that we closed on in the first week of January like we did with BrainBox, actually over in Europe acquiring one of our independent channels there, very similar to a strategy that we have in the U.S. so, but, yes less than that from an EV perspective and not dissimilar to Nuvolo in 2024 with early-stage technology company has a lot of amortization expense. We're expecting that to happen in 2025 for BrainBox. It's part of the guide in terms of the FX headwind and the amortization from the newly-acquired business will have about a $0.20 negative impact on earnings and we've got that incorporated in our guide. But you're right, that's kind of the accounting rules around the acquisition. On the accounting rules, going back to Trane, you're right, we start stepping down on the train amortization in 2025. It's around $25 million or $30 million of lower amortization expense, that's really being offset fully with the investments we've made over the last few years in CapEx and the rising depreciation that comes from that. We've also had a few acquisitions that have some higher amortization as well. So in 2025, the net impact of that benefit from the Trane amortization is really offset and zero. Let's see this in 2026. It's a bigger step-down in '26 on Trane amortization. We'll update you then for next year. But for 2025, it's really a neutral impact."
},
{
"speaker": "Dave Regnery",
"content": "Yes. And as far as the growth rates go, Nigel, look, we're pretty excited about it. It's small today, but we like these technology companies that we could scale. We have 42,000 buildings, right. So there's 42,000 potential customers that we already have the data on. We're going to start running algorithms against it to understand what the influence could be with being structured and unstructured data to get. So this is going to be excited, and like I said, it's going to be a nice tail for our service business earlier."
},
{
"speaker": "Nigel Coe",
"content": "Great. Thanks, guys."
},
{
"speaker": "Chris Kuehn",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Deane Dray with RBC Capital Markets. Please go ahead."
},
{
"speaker": "Deane Dray",
"content": "Thank you. Good morning, everyone."
},
{
"speaker": "Dave Regnery",
"content": "Hi, Deane, how are you?"
},
{
"speaker": "Chris Kuehn",
"content": "Good morning."
},
{
"speaker": "Deane Dray",
"content": "Doing, real well. Thank you. Maybe just circle back on the pre-buy. It seems like it was relatively uneventful, at least in terms of how you were positioned. But just - if you just step back, anything that surprised you in terms of the demand, the timing and there's always this nuance about competitive positioning, who cuts over first, but kind of just the post mortem, was there anything that you'd call out in terms of what you were expecting, or what didn't play out?"
},
{
"speaker": "Dave Regnery",
"content": "Not really, Deane. I mean we've said for a long time we thought it would be a modest pre-buy it was. The team did a nice job of executing the changeover to the A2L refrigerant. We're fully operational on 454B product now. We have the capability of running mixed model lines in our factories, so we can support the aftermarket for 410, which will be needed. But not a lot. I mean, it was pretty much as we predicted. The only thing I would say maybe a little bit different is we probably had more of the pre-buy in Q3 than we anticipated. I didn't realize it was a kind of a pre-buy until we got into Q4. So that would have been the only maybe oddity, but it makes sense though, too, why would you wait till the fourth quarter if you were going to do a pre-buy and you might not have products. So we probably saw more in Q3 than I anticipated. But again, we're talking about relatively small numbers that really don't have a big impact on results."
},
{
"speaker": "Deane Dray",
"content": "Good to hear. And I also like hearing that you say 410 is going to be around for a while because I will be a user of that, so."
},
{
"speaker": "Dave Regnery",
"content": "So we'll help it out. Well, if you have a Trane part, you probably won't need it to have it worked on for a while, but if you ever do."
},
{
"speaker": "Deane Dray",
"content": "Good. It may happen to be one of your units. So that's good to hear. And then just second question, just circling back on China and that whole tightening the credit. It seems to have played out exactly the way you said you would be getting the down payments and maybe some progress payments. But did you - when I hear about tightening credit, that also makes me think that you actually turned down some customers, or maybe shying away from particular verticals. So has there been any selectivity going on maybe related to this credit sensitivity?"
},
{
"speaker": "Dave Regnery",
"content": "Yes. I mean, at the end of the day, we're just - we're looking we say we call it tightening credit. What we're doing there is we're requiring down payments, right. We're requiring a down payment when the order comes in and we're requiring an additional down payment before the order will ship. So it's not specific to any one vertical or any one channel, that's just the rules of the game that we're operating with. And the team is doing a nice job of educating our customers as to the why. And we made nice progress in the fourth quarter compared to the third quarter. We have some work in front of us in the first half of 2025, but this is the --this is our new way of doing business in China."
},
{
"speaker": "Deane Dray",
"content": "Great. I appreciate that color. Thank you."
},
{
"speaker": "Dave Regnery",
"content": "Sure."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Tommy Moll with Stephens. Please go ahead."
},
{
"speaker": "Tommy Moll",
"content": "Good morning, and thank you for taking my questions."
},
{
"speaker": "Dave Regnery",
"content": "Hi, Tommy, how are you?"
},
{
"speaker": "Tommy Moll",
"content": "Doing fine. Thank you. Chris, you called out early in the call that if we look at the first quarter earnings contribution as a fraction of the full-year outlook you've provided. It's a bit higher than the average. I've thought about it differently just given the transport and resi headwinds in the first quarter. So is there something we're missing that changes as you go into Qs Q2, Q3, Q4? Or is it perhaps some conservatism just about what's longer-dated here? Just help us triangulate there. Thank you."
},
{
"speaker": "Chris Kuehn",
"content": "Yes. We wanted to call out, Tommy, that EPS as a percent of the full-year guide is around 17%. It's normally 15% to 16%. So we are starting the first quarter a little bit ahead of that three-year and five-year average, which we just wanted to make sure everyone understood. It's a strong guide for the first quarter and we have a lot of confidence in it. As you work throughout the year though, the transport markets are going to be expected to be down in the first half. There's expected recovery starting in the second half of the year, roughly flattish, maybe plus or minus low-single-digits for the full year, but growth in the second half. And really what's exciting is the growth expectations for 2026 and 2027 in the transport markets in the Americas. So we'll see how the year plays out. But, yes, there's more of a headwind in the first half of the year from transport. Residential, in the first quarter, a little bit more of a headwind from that pre-buy, right? We think that will largely impact the first quarter. It may drip into the second quarter or beyond. We'll update as we go throughout the year, but that will really normalize, let's say, by the second half of the year and we'll see where growth is based on market conditions and then the tailwind we're getting from the A2L pricing. So those are the two that would stand out to me. Maybe the third would be Asia. Again that new business in China and our team again executing very well there, that could be a little more headwind in the first half of the year, much easier comps as you get into the second half of the year in Asia. So I think those three would probably really be the dynamics I'd call out now."
},
{
"speaker": "Tommy Moll",
"content": "Thank you, Chris. And then as a follow-up, I wanted to ask about the comment made on some recent investments in channel. I just want to ask if there's anything more you can share there. Dave, I think you mentioned one investment in Europe. But if there's anything you want to call out in terms of a strategy update there, please do. Or if this is same as before and just some opportunistic transactions, let us know that. Thanks."
},
{
"speaker": "Dave Regnery",
"content": "Yes. Look, we've been buying up our independence in our Commercial HVAC business for a long time. And these are great businesses. They've had great leaders and just it's opportunistic for us to buy them off. So nothing has changed there with our strategy. There's not a lot of them left, unfortunately, because they're great acquisitions and they become accretive very, very quickly, like almost instantaneously. But that's just more - it's just more of the same and we just had one this time, it was actually in Belgium over in Europe."
},
{
"speaker": "Chris Kuehn",
"content": "Yes. For January. So think of it as we've been 95% plus direct and it's these last few percentage points of those independent channels that when they're ready, we're ready to kind of fully bring them into the Trane business."
},
{
"speaker": "Tommy Moll",
"content": "Thank you both. I'll turn it back."
},
{
"speaker": "Dave Regnery",
"content": "Sure. Thanks, Tom."
},
{
"speaker": "Operator",
"content": "And that will conclude our question-and-answer session. And I will now turn the conference back over to Zac Nagle for closing remarks."
},
{
"speaker": "Zac Nagle",
"content": "Thanks, operator. I'd like to thank everyone for joining today's call. As usual, we'll be available to answer any questions you may have in the coming days and frankly in the coming weeks. We'll also be on the road in the next couple of months attending conferences and other things. And so, we hope to see you in person very soon. So hope everyone has a great day. Thank you."
},
{
"speaker": "Operator",
"content": "This will conclude today's call. Thank you all for joining. You may now disconnect."
}
] |
tt | 2,024 | 3 | [
{
"speaker": "Operator",
"content": "Good morning. Welcome to the Trane Technologies Q3 2024 Earnings Conference Call. My name is Julianne, and I will be your operator for the call. The call will begin in a few moments with the speaker remarks and the Q&A session. At this time, all participants are in a listen-only mode. After the speakers' remarks, we will have a question-and-answer session. [Operator Instructions] Thank you. I will now turn the call over to Zac Nagle, Vice President of Investor Relations."
},
{
"speaker": "Zac Nagle",
"content": "Thanks, operator. Good morning, and thank you for joining us for Trane Technologies' third quarter 2024 earnings conference call. This call is being webcast on our website at tranetechnologies.com where you'll find the accompanying presentation. We are also recording and archiving this call on our website. Please go to Slide 2. Statements made in today's call that are not historical facts are considered forward-looking statements and are made pursuant to the safe harbor provisions of federal securities law. Please see our SEC filings for a description of some of the factors that may cause our actual results to differ materially from anticipated results. This presentation also includes non-GAAP measures, which are explained in the financial tables attached to our news release. Joining me on today's call are Dave Regnery, Chair and CEO; and Chris Kuehn, Executive Vice President and CFO. With that, I'll turn the call over to Dave. Dave?"
},
{
"speaker": "Dave Regnery",
"content": "Thanks, Zac, and everyone, for joining today's call. Please turn to Slide #3. I'd like to begin with a few minutes on our purpose-driven strategy, which enables our differentiated financial results over time. Climate change is occurring much faster than anticipated, affecting people and communities around the world, as we saw here in North Carolina just a few weeks ago. Urgent and transformative action is needed to reduce emissions and limit global warming. That's where Trane Technologies comes in. Through our innovation, we are helping our customers reduce energy and emissions. When you consider that in a typical building, approximately 30% of the energy after the meter is wasted, it's a massive opportunity. And for our customers, it's grain for grain, good for the planet and good for the bottom line. With our relentless innovation, consistent execution and uplifting culture, we are positioned to deliver a leading growth profile and differentiated financial results over the long term and build a more sustainable future. Please turn to Slide #4. We delivered strong performance in the third quarter, extending our track record of leading revenue and EPS growth among industrials. Our global team delivered 11% organic revenue growth, adjusted EBITDA margin expansion of 120 basis points and adjusted EPS growth of 21%. Enterprise organic bookings were very strong at $5.2 billion, the second quarter highest in the company's history, up 5% in the quarter and up 13% on a two-year stack. To put this into perspective, bookings were only about $120 million or 2% below our highest bookings quarter in Q2 of this year. Organic bookings in Americas commercial HVAC this quarter were also the second highest in company's history, up low-single-digits and up mid-teens on a two-year stack. Q3 bookings were only $100 million below the highest bookings quarter in Q1 of 2024. Net absolute bookings remained very strong. Given the tremendous growth we've seen over the past four years and the variation in order timing, comps will likely continue to be somewhat lumpy. While absolute bookings are expected to remain very strong, backlog also remains very strong at $7.2 billion, up from $6.9 billion at year-end 2023, and we expect to exit 2024 with highly elevated backlog. We encourage investors to look at absolute bookings, revenues and backlog, along with growth rates in order to gain a clear picture of our strength. Robust performance continues to be led by our Americas commercial HVAC business, where revenue growth has been exceptionally strong and consistent. Revenues for each of the first three quarters of 2024 are up 50% plus on a three-year stack, inclusive of both equipment and services. And we expect the fourth quarter revenue to be up 50% on a three-year stack as well. We are building a strong track record of market outperformance, particularly as increasing project complexity plays to our unique strengths in innovation and direct sales and service. Case in point, organic bookings and revenue for our Applied Solutions in the Americas are both up well over 100% over the past four years. Our installed base is expanding rapidly, adding an estimated eight to 10 multiple of higher-margin services revenue over the life of the equipment. Our strong performance throughout 2024 has enabled us to accelerate incremental investments, while delivering full year leverage above our long-term framework of 25% plus. We've stepped up the pace of investments in the second half of 2024, further strengthening our position for 2025 and beyond. Given our strong performance and positive outlook, we are raising our full year organic revenue and adjusted EPS guidance. Chris will cover our guidance update in more detail later in the presentation. Please go to Slide #5. In our Americas segment, commercial HVAC has delivered exceptional bookings and revenues throughout the year, as I've highlighted on the prior slide, with broad-based strength across vertical markets. Revenue was very strong, up nearly 20% in the quarter, with equipment and services up nearly 25% and mid-teens, respectively. In residential, the team delivered very strong results with bookings up high-20%s and revenues up low-teens. Turning to transport, the business performed as expected. Bookings were strong, up high-20%s. Revenues were down high-single-digits, consistent with our guide. In EMEA, commercial HVAC strength continues to be driven by demand for our innovation, with bookings up mid-single-digits in the quarter and up high-teens on a two-year stack. Revenue was also strong, up low-teens. Our transport business performed in line with our expectations, with bookings up mid-teens and revenues flat. Turning to Asia, results were mixed between China and the rest of Asia. Starting with the rest of Asia, bookings and revenues were solid, up low-single-digits and up mid-single-digits, respectively. China had a challenging quarter, which I'll discuss in more detail on Slide 8. Now, I'd like to turn the call over to Chris. Chris?"
},
{
"speaker": "Chris Kuehn",
"content": "Thanks, Dave. Please turn to Slide #6. This slide provides a snapshot of our performance in the third quarter and highlights continued strong execution top to bottom. Organic revenues were up 11%, adjusted EBITDA margin was up 120 basis points, and adjusted EPS was up 21%. At an enterprise level, we delivered strong organic revenue growth in both equipment and services, up double-digits and low-teens, respectively. Our high-performance flywheel continues to pay dividends with relentless investments in innovation, driving strong top-line growth, margin expansion and EPS growth. Please turn to Slide #7. At the enterprise level, we delivered robust volume growth with strong incrementals, positive price realization and productivity that more than offset inflation, and continued high levels of business reinvestment. In our Americas segment, we delivered about 12 points of volume and 3 points of price. Strong volume growth in our commercial HVAC and residential businesses was partially offset by muted performance in our transport business. Adjusted operating margin expansion of 130 basis points was driven by volume growth, productivity and price realization, more than offsetting inflation and high levels of business reinvestment. In our EMEA segment, we delivered about 7 points of volume and 1 point of price with strong volume in our commercial HVAC business. Adjusted operating margin expansion of 140 basis points was driven by volume growth, productivity and price realization, more than offsetting inflation and high levels of business reinvestment. In our Asia Pacific segment, volumes declined by approximately 22 points. The team was able to deleverage within gross margin rates. Now, I'd like to turn the call back over to Dave. Dave?"
},
{
"speaker": "Dave Regnery",
"content": "Thanks, Chris. Please turn to Slide #8. Our outlook is largely unchanged as we move closer to the end of the year with America's commercial HVAC and residential a bit stronger and Asia Pacific more muted. We've talked about the strength of our Americas commercial HVAC business at length, so I won't go into a lot more detail. We expect the strength to continue in the fourth quarter with three-year stacked revenue growth of approximately 50%, consistent with our performance each quarter this year. Our residential business delivered stronger-than-expected growth in the third quarter, driven by the factors highlighted on the slide. We continue to expect a modest pre-buy of 410A in 2024, primarily impacting Q1 of 2025. We've raised our full year 2024 revenue growth outlook to up high-single-digits, up from mid-single-digits prior. In our Americas transport business, ACT continues to forecast the 2024 transport markets to be down mid-teens, and we expect to outperform. Looking to 2025, ACT has moderated their trailer growth expectations to up low-single-digits. This includes a weak first half and a stronger second half, and we largely agree with that view. We've been investing heavily in our transport business. And as the markets recover, we expect to emerge well-positioned to outperform. Overall, the changes to our outlook in the Americas segment are favorable, and we reflected this in our raised guidance for the year. Turning to EMEA, the business performed as expected, and there's no change to our outlook. Asia represents about 8% of our overall revenue mix with about 50% in China and 50% in the rest of Asia. The rest of Asia performed in line with our expectations in the third quarter, and we expect continued modest growth in Q4 as well. Our China commercial HVAC business came in below our expectations in the third quarter, primarily related to two factors: First, the non-residential markets in China deteriorated meaningfully since the June timeframe, and bookings and revenues were negatively impacted as a result. Second, we made the prudent decision to tighten our credit policies in China, primarily related to downpayments and progress payments. Despite the significant revenue decline in China, the team maintained deleverage within gross margin rates. While China will remain a dynamic environment, we expect some improvements in the fourth quarter as our customers and sales teams navigate the market and policy changes. We have an outstanding team in China that has delivered leading results for many years, and I remain confident in our team's ability to outperform over the long term. Now, I'd like to turn the call back over to Chris. Chris?"
},
{
"speaker": "Chris Kuehn",
"content": "Thanks, Dave. Please turn to Slide #9. We continue to target top-quartile performance on organic revenue and adjusted EPS growth for the full year and believe we're on track to achieve those objectives. Given our continued strong performance, positive outlook and exceptional backlog, we're raising our organic revenue guidance to approximately 11% from our prior guide of 10%. We're also raising our full year adjusted earnings per share guidance by $0.30 to approximately $11.10, up from $10.80 prior. We're well positioned to deliver our fourth consecutive year of adjusted earnings per share growth of 20% or greater. Between our strong year-to-date revenue performance and the addition of two small acquisitions that we made in the third quarter, we expect M&A to contribute approximately 50 basis points to 100 basis points to revenue in 2024, which we expect to result in about 3 points of negative impact on reported versus organic leverage for the year. We also expect a more moderate negative impact from FX for the year at less than 1 point, effectively offsetting the positive revenue impact of M&A. Net organic and reported revenue guidance is the same at approximately 11%. We expect full year organic leverage of approximately 30%, up from our prior guidance of 25% more. We continue to expect free cash flow conversion to adjusted net earnings of 100% or greater. Absolute free cash flow is expected to be higher, reflecting our higher adjusted earnings guidance. For the fourth quarter, we expect organic revenue growth of approximately 7% and adjusted EPS of approximately $2.50. Embedded in this guidance is a step-up in investments and higher incentive-based compensation, reflecting strong performance in 2024. Please see Page 18 for additional details related to our guidance that may be helpful for modeling purposes. Please go to Slide #10. We remain committed to our balanced capital allocation strategy, focused on consistently deploying excess cash to opportunities with the highest returns for shareholders. First, we continue to strengthen our core business through relentless business reinvestment. Second, we're committed to maintaining a strong balance sheet that provides us with continued optionality as our markets evolve. And third, we expect to consistently deploy 100% of excess cash over time. Our balanced approach includes strategic M&A that further improves long-term shareholder returns, and share repurchases as the stock trades below our calculated intrinsic value. Please turn to Slide #11. Year-to-date through October, we've deployed or committed approximately $2 billion in cash, with about $800 million to dividends, $230 million to M&A and about $1 billion to share repurchases. We have $1.5 billion remaining under the current share repurchase authorization, providing us with strong optionality as our shares remain attractive, trading below our calculated intrinsic value. We continue to have an active M&A pipeline, with potential value-accretive opportunities to further improve long-term shareholder returns. Our outlook for 2024 cash deployment remains unchanged at approximately $2.5 billion. Our strong free cash flow, liquidity, balance sheet and significant share repurchase authorization gives us excellent capital allocation optionality moving forward. Now, I'd like to turn the call back over to Dave. Dave?"
},
{
"speaker": "Dave Regnery",
"content": "Thanks, Chris. Please go to Slide #13. We discussed the transport markets in our outlook discussion on Slide #8, so I won't cover them again here. However, we've continued to provide this slide with additional details for your convenience. Please turn to Slide #14. We operate our transport business for the long term. And while we will continue to manage through a down cycle in 2024, this is a great business with a bright future. ACT projects a modest trailer market rebound in 2025, mid-teens growth in 2026 and 2027, and continued strong markets in 2028 and 2029. We're directionally aligned with these projections. We have a diversified transport business globally and opportunities to grow across the portfolio. With leading innovation, strong execution through our business operating system and a world-class dealer network, we're well positioned to outperform in any market environment. Turning to Slide #15. We expect to provide 2025 guidance on our fourth quarter earnings call. However, given our strong bookings, backlog and growing pipeline of opportunities, visibility into 2025 has steadily increased. We thought it would be constructive to provide our early views on 2025 as another year of healthy growth. Our commercial HVAC businesses are executing well. Our world-class direct sales and service teams are a clear competitive advantage, enabling us to quickly pivot across vertical markets to capture growth opportunities. We have the broadest and most innovative portfolio in the industry, and we're relentlessly reinvesting in our business for growth. As we look at market opportunities, we're in the early innings of a strong multiyear CapEx cycle. We're also in early innings on the journey to decarbonize hundreds of billions of square feet across the built environment. Increasing complexity of these project opportunities plays to our unique strengths, and we're seeing this in our bookings, backlog and pipeline of projects. Net, we see another strong year ahead for commercial HVAC in the Americas and in EMEA. In Asia and more specifically, China, which is more than 90% commercial HVAC, the macro is more dynamic. However, with China at roughly 4% of our portfolio, we expect strength in the Americas and EMEA to more than offset a challenging backdrop for the region. Turning to residential. We've moved through a period of normalization in 2023 and 2024, and we believe we're returning to a GDP-plus framework. While we expect a moderate amount of prebuy in 2024, we expect this to largely impact revenues in the first quarter of 2025. Pricing differentials from the A2L transition should also act as a tailwind as we move through 2025. Turning to our Americas transport business, which is about 7% of our revenues, ACT is projecting modest growth, largely in the second half of 2025. Net, 2025 will be a modest tailwind for the enterprise. We continue to lead with innovation, which yields healthy pricing opportunities, and our business operating system is prime to stay ahead of inflationary pressures. Underpinning our enterprise growth is our resilient services business. Services comprised about a third of our enterprise revenues and has averaged high single-digit growth over the past seven years. We see opportunities for continued growth in services across our portfolio. In particular, we expect strong performance in our commercial HVAC businesses with our large and growing installed base. With increased focus on decarbonization, we're seeing increased demand for digital performance optimization and demand side management, where our energy services business shines. All in, we're excited about the opportunities for strong growth again in 2025. Please go to Slide #16. In summary, we are well positioned to deliver leading performance and differentiated shareholder returns in 2024 and beyond. We recently received the results of our annual employee engagement survey, and engagement was at a record level, and in the top quartile compared to external companies. I experienced that engagement firsthand when I see our team members engage with customers around the world. That engaging culture, combined with our leading innovation and proven business operating system continues to set us apart. I'm proud of our team's consistent track record and believe our brightest days are ahead. And now, we'd be happy to take your questions. Operator?"
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Our first question will come from Scott Davis from Melius Research. Please go ahead. Your line is open."
},
{
"speaker": "Scott Davis",
"content": "Hey, good morning, Dave, and Chris and Zac."
},
{
"speaker": "Dave Regnery",
"content": "How you doing, Scott?"
},
{
"speaker": "Scott Davis",
"content": "I'm great. The numbers are good. I'm just trying to figure out a little bit of, perhaps, you can help with some context around data center specifically, just since it's so topical right now. Just anything you can give us, whether it's growth, orders, materiality to your algorithm? I'm just trying to get my arms around how important that is for you guys for the next year."
},
{
"speaker": "Dave Regnery",
"content": "Sure. Good question, Scott. Look, Scott, we've been strong in data centers for decades now, okay? So, this has always been a very strong vertical for us. And I think we were kind of early adopters in the data center. We had a dedicated team that just focused on data centers, which has really allowed us to continue to remain very strong in that vertical. If you look at data centers, the growth projection that's projected, I mean, if you take the middle there, and there's a lot of numbers out there, you're going to see the data center vertical is going to be growing at the mid-teens for the foreseeable future. And you should expect that Trane Technologies will continue to be very, very strong in this vertical as we have been for a long time. So, it's important that when you think of data centers, they're probably the most complex systems that we build, okay? We like working directly with the data center customers. We like thinking about it at a system level, okay? You'll hear a lot about different components within the system. We look at the entire system and really help the customers think through optionality that exists for their particular needs based on what they're going to be using in that data center for. And it does depend on what they're going to be using it for. Chris, I don't know if you want to add anything."
},
{
"speaker": "Chris Kuehn",
"content": "Yeah. What I would add, Scott, is year-to-date in our Americas commercial HVAC business, data centers have provided a lot of growth to bookings, but when you remove data centers from those bookings, the rest of the verticals, in aggregate, are also up very strong. So, we like the broad-based focus of our direct sales force. Data centers is one strong vertical, but as we highlighted in our release, there's a number of verticals that have been strong for us this year, almost nearly all of them year-to-date showing strength."
},
{
"speaker": "Scott Davis",
"content": "Okay. That's helpful. And I wish you'd size it for us, but I understand if you don't want to do that, it's totally fine. Just moving to China, guys. Is that market mature enough at this point where we can start to see it, perhaps moving to more retrofit and services and being a little bit more stable longer term? I understand the down 45%, projects can disappear pretty quickly over there. But it's been a couple of decades now that you guys have been pretty strong and have a pretty big installed base there. So, is that something that you see that kind of becoming a more mature market going forward?"
},
{
"speaker": "Dave Regnery",
"content": "Yeah. I mean, we have a service business in China, as you're aware, it's not at the same level that you would see here in the Americas, but it's growing. Look, specifically in China, I know I've read a lot of the pre-reports here. Let me just be very specific. Look, our business in China, I think we all understand what's happening in the markets in China, and we were obviously impacted by that. The second is that we thought it was very prudent for us to tighten our credit policies and specifically around downpayments and progress payments. So for example, if a customer wants to give us an order and they don't give us a downpayment with that, we will not accept the order. If we have a product that's complete and ready to ship to the customer, and the customer doesn't provide the proper downpayment -- or progress payments, we will not ship that product to the customer. So look, long term, we know this is the right decision to make. We have a great team in China. It's performed exceptionally well for a long period of time. And I have 100% confidence that we'll continue to outperform the market there. Our teams are just going to be working through this in the fourth quarter and these changes. And look, it's the right decision to make for that particular region at this particular time."
},
{
"speaker": "Scott Davis",
"content": "Okay. Makes sense. I'll pass it on. Best of luck, guys."
},
{
"speaker": "Chris Kuehn",
"content": "Thank you."
},
{
"speaker": "Dave Regnery",
"content": "Thanks, Scott. See in December."
},
{
"speaker": "Operator",
"content": "Our next question comes from Chris Snyder from Morgan Stanley. Please go ahead. Your line is open."
},
{
"speaker": "Chris Snyder",
"content": "Thank you. I wanted to ask on services, which continues to be really strong, up low-teens again here in Q3. Can you just maybe talk a little bit about the mechanics of the service business? What is the lag between when you sell the equipment to when it starts generating service revenue? Anything you could talk about on service margins? And then, it seems like a lot of the reinvestment the company is making is in that service side. So, just what are you spending on to better position the company to capture more of that revenue?"
},
{
"speaker": "Dave Regnery",
"content": "Sure. I'll start and I'll let Chris answer some of the margin questions. But look, we love our service business. It's a third of the company. And it's very, very resilient, okay, over the last seven years, it's -- compound annual growth rate is high-single-digits. So, it's a very, very competitive weapon that we have within Trane Technologies. And we continue to, as you've noted, invest heavily in it. Look, as far as the timing as to when a product gets installed, specifically on the applied side to when service starts, it varies, okay, depending on what the warranty is on a particular product. A lot of customers will have extended warranties. That's why I say it varies. And obviously, that would vary around the world. But think of it year two, year three, it starts to ramp up. And by the way, even if it's under extended warranty, we're going to be doing PM work on these products in many cases. The applied systems are so much more sophisticated today than they were just four or five years ago. And the customers are really demanding that the OEMs do the service on these systems to make sure that they're always performing the way they're designed. And Chris, you and I spoke a lot about connected solutions in the past. And I would tell you that, that's going to be so fundamental to how we continue to drive our service business in the future. I think you could certainly understand that our installed base is increasing. That's the -- that will continue to drive growth. But the connected solutions and making sure that the asset is always performing the way it was designed and consuming energy at that level is so important. Today and a little bit certainly into the future, an HVAC asset isn't performing not only if it's not cooling properly, not only if it's not heating properly, not only if it's not ventilating properly, but if it's using too much energy. And if you think about that, that's where the opportunity is. And we have done hundreds of energy audits in buildings, and we know that I'll be conservative here and say that 30% of the energy after the meter is being wasted. However, if you are connected to an asset, you could always ensure that it's performing the way it was designed and that's going to continue to be a significant tailwind for our service business well into the future. So, Chris, I don't know if you want to talk about margins?"
},
{
"speaker": "Chris Kuehn",
"content": "Yeah. I'd add with the applied growth over the past four years, Chris, over 100%, that obviously bodes well as we think about that installed base maturing. And as Dave said, two to three years out, starts to build a little bit of a ramp on the services revenues. The services business, I'll call it, higher margins in the average. So, we like that business for that reason as well. And it's a perfect example of where we've accelerated investments over the last few years, but even more so into the second half of this year. Dave talked about digital connected solutions. That's absolutely one way we're making investments, but think about it as capacity as well. I'm not going to focus on factories or plant capacity. I'm going to focus on people. And when you think about sales and service, adding employees from covering verticals to adding service technicians to support our customers with that higher installed base. That's one area where we're really continuing to inflect up in investments. And then, the tools to support the sales and service team. So, sales support tools, whether it'd be customer relationship tools, order intake tools, billing, collections, you name it, it's all part of what Dave and I coming out of the second quarter, said we're going to accelerate the speed of some of these investments just give us even further confidence on growth over the next couple of years. But it's such a strong business and we're going to keep investing in it."
},
{
"speaker": "Dave Regnery",
"content": "Yeah. One other point, Chris, that I always tell people that some of our service technicians are our best sales associates. As you think about it, our service techs are with our customers every day, and they're building that trusted advisor relationship with our customers. They often see opportunities that the customer can make improvements in their own facilities. So, they do a fantastic job for us, but the service business is a strong part of Trane Technologies today and think of it being even stronger tomorrow."
},
{
"speaker": "Chris Snyder",
"content": "Really, really appreciate all of that. Maybe just following up on data center service specifically. If we kind of think about that two- to three-year lag, it would imply that a lot of the growth we've seen in -- certainly in orders, and even, I guess, revenue on the data center side over the last 12, 18 months hasn't really found its way into service yet. Can you just maybe talk about service [Technical Difficulty] different in data center elsewhere? And I just asked because, obviously, these are customers that are very sophisticated, uptime is everything. Energy efficiencies even more important there than it is elsewhere. So, any just color on how the data center service model differs would be helpful. Thank you."
},
{
"speaker": "Dave Regnery",
"content": "As I said earlier, think of it as the more sophisticated the product, the greater the appetite is for the OEM to do the service. And data centers tend to be some of the most sophisticated systems that we deploy. So, we're very strong in the data centers there and service. And by the way, I know that the growth over the last several years has been fantastic in data centers. But remember, data centers have been around for a long time, and we've been very strong in this vertical for -- since the beginning. So we have -- even though we've seen tremendous growth, we also have a big installed base in data centers that we're servicing today."
},
{
"speaker": "Chris Snyder",
"content": "Thank you."
},
{
"speaker": "Dave Regnery",
"content": "Sure, Chris."
},
{
"speaker": "Operator",
"content": "Our next question comes from Julian Mitchell from Barclays. Please go ahead. Your line is open."
},
{
"speaker": "Julian Mitchell",
"content": "Hi, good morning. Maybe I just wanted to start with Slide 15. You talk -- gave us some very useful pointers on next year. Just when we're thinking about kind of -- any color you could give us as to how to think about organic operating leverage? This year is guided at 30% now. Trying to think about sort of that for next year. Anything you're calling out in terms of, say, mix? It looks like you get a mixed tailwind, perhaps, within resi from the A2L transition. There may be some high operating leverage as transport markets turn around more in the second half. I guess I want sort of rolling all that together, should we expect kind of strong operating leverage in '25? Any reason not to?"
},
{
"speaker": "Chris Kuehn",
"content": "Hey, Julian, it's Chris. I'll start. We'll provide a bit more detail around 2025 in our earnings call for the fourth quarter, but we really do like that long-term algorithm of 25% or better operating leverage and making sure we have the ability to fund investments in the business. We would be targeting 2025 for top quartile financial performance. We're going to look at that in the top line. We look at that on the bottom line and cash conversion as well. One thing so far this year, we've had excellent free cash flow conversion. The average over the last four years is, I think, 108%. And so we're going to be targeting top line, bottom line and really strong cash conversion going into 2025. So, we would expect commercial HVAC to be -- remain strong. The backlog visibility gives us a lot of confidence around that. We just talked about services and the high-single-digit growth we've seen over the last seven years gives us a lot of confidence that should continue. And I think about Americas transport, it's probably not a headwind, it could be a modest tailwind going into next year, just given the expectation of around refrigerated trailers in the Americas being up low-single-digits, more second half of the year than first half. So, we think we got some nice tailwinds going into next year, but on the leverage, we like the 25% or greater algorithm and keep those investments coming."
},
{
"speaker": "Julian Mitchell",
"content": "Thanks very much, Chris. And then maybe my second question just around the US resi HVAC market, which I don't think has been touched on in the questions so far. Maybe just help us understand, I think, Dave, you mentioned a slight increase to your revenue assumption for that business this year. Was that tied to sort of share gain or some behavior by distributors in general? Any color on that? And it sounds like you're pretty confident of decent revenue growth in 2025 again despite the prebuy. I just wondered if you could flesh that out, please, at all."
},
{
"speaker": "Dave Regnery",
"content": "Yes, sure. Well, Julian, first of all, nice job on CNBC the other day. I saw you did a fantastic job. So, nice to see. Look, on resi, look, let's just go back. We started the year and we were thinking that resi was going to be plus or minus low-single-digits. And then, at the end of the first quarter, we kind of said, look, the EPA clarification around the refrigerant transition, that was a nice help. We thought that inventory had normalized in the channel, so that was a help. And then, we had a very warm cooling season, right? So I think it was a very hot summer and that certainly drove growth as well. As far as share goes, I'm sure -- yeah, we're saying we've had nice gains, but I've heard everyone say they have nice gains. So, I'm not sure where that will come out, but we're very confident and we're happy with the share that we have in that space and the progress that, that team has been able to make. Look, our team is really executing at a high level in residential right now. We've made some investments there in our manufacturing that are really paying dividends. And I could not be more proud of what that team has been able to execute to. So, we're very happy with what we're seeing in residential. As far as 2025 goes, look, I've been saying for a long time that I believe our resi business is a GDP plus business. And I think that's the framework that we're working through that we'll get back to in 2025. The prebuy, look, I don't think there's going to be a significant prebuy. I've been saying that since January. There will be something. We'll clarify that as we get through the fourth quarter. But look, resi business is operating on all cylinders right now, and we expect it to continue into the future."
},
{
"speaker": "Julian Mitchell",
"content": "Great. Thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from Andy Kaplowitz from Citi. Please go ahead. Your line is open."
},
{
"speaker": "Andy Kaplowitz",
"content": "Hey, good morning, everyone."
},
{
"speaker": "Dave Regnery",
"content": "Good morning, Andy."
},
{
"speaker": "Chris Kuehn",
"content": "Hey, Andy, how you doing?"
},
{
"speaker": "Andy Kaplowitz",
"content": "Good. How are you? Dave, look, I know you already talked about data centers a little bit, but interestingly, in your presentation, you mentioned other verticals. You've mentioned before education, healthcare, but you also mentioned office. Maybe you can elaborate on what you're seeing there. And then, given we're at the tail end as you're spending for K-12, what could that mean for education-related HVAC spend in 2025?"
},
{
"speaker": "Dave Regnery",
"content": "Andy, look, first of all, thanks for noticing office on the page. We haven't talked about office in a long time. And although it may sound counterintuitive because you still have vacancy rates that are quite high, but we had a very strong quarter in office. Actually, year-to-date office is up from an order rate perspective. And if you think about it, you go kind of a click lower, you could sit there and say, well, we're doing a really good job in Class A buildings. And we're also really helping our customers navigate through how they get tenants back into their space. And I know you had the opportunity to visit us in New York, and you got to see it firsthand, right? Having this direct sales force with deep domain expertise as to what's happening in a particular city is critical, right? We know what the carrots are, what the sticks are and, more importantly, how to navigate that so that we could help the customer make the right decisions so they can get tenants back into their space. So, it's just -- I can't speak enough about our direct sales force. I can't speak enough about how they pivot to where the opportunities are and how. It's not just about data centers that's growing. For us, it's really almost all of our verticals. I was doing the study or I had the team do a study, and I was looking from year-to-date from order rates, and I'll speak about commercial HVAC, we track 14 different verticals, 13 of them were positive by a lot, and office was one of those. So, it just shows you the broad-based strength that we have and the ability of our teams to really navigate to where the opportunities are. So, I could not be happier with seeing office on the page, and the team continues to execute at a high level there."
},
{
"speaker": "Andy Kaplowitz",
"content": "Great. And let me just ask you about China in the context of -- you obviously had somewhat high decremental margins there. Some of that is the choices you've made. Do you -- again, you've been in China for a long time. You moved to direct sales and everything was good once you did that. Do you see this as a more structural issue, or is it really just cyclical? And if it is either way, can you take more cost out of that business, or how should we think about that to offset higher decrementals?"
},
{
"speaker": "Dave Regnery",
"content": "Yeah. I mean, well, first of all, the team performed quite well. Even though the revenues were down, they were, within gross margins, on a deleverage standpoint. So, that was good to see. Look, we're going to just work through this in China. We have a great team there, and we have a great business, and we've been overperforming in China for a long time. We've made a decision to change our credit policy, specifically around downpayments and progress payments. Long term, this will be the right decision. And I think people will see that in the future. But right now, our teams are working through this change. I have all the confidence in the world that they'll get back to outperforming here in the future. But right now, we're going to work through it, and -- but a great team there that's executed for a long time at a high level, and I expect more of that in the future."
},
{
"speaker": "Andy Kaplowitz",
"content": "Appreciate the color, guys."
},
{
"speaker": "Dave Regnery",
"content": "Okay. Thanks, and we'll see you in a couple of weeks."
},
{
"speaker": "Andy Kaplowitz",
"content": "Yeah, see you soon."
},
{
"speaker": "Operator",
"content": "Our next question comes from Joe Ritchie from Goldman Sachs. Please go ahead. Your line is open."
},
{
"speaker": "Joe Ritchie",
"content": "Hey, guys. Good morning."
},
{
"speaker": "Dave Regnery",
"content": "Hey Joe, how are you?"
},
{
"speaker": "Joe Ritchie",
"content": "Doing great, Dave. Thanks. Yes, look, we talked about office. We talked about data centers. Clearly, the commercial HVAC business is humming along. Can you maybe just kind of talk a little bit about some of the megaproject activity, how that's coming through, whether it's semiconductor plants? I know there's been some delays on EV plants. Just any commentary around that would be helpful."
},
{
"speaker": "Dave Regnery",
"content": "Yes. Megaproject is my favorite term, I don't really like it. But look, megaprojects are happening in verticals that we've always been very strong in, and it's dynamic, as you could imagine, right? Yeah, you've talked about a few projects that maybe are getting a little bit delayed, we have others that are pulled up. We have some, especially on the EV battery side, a couple of them, actually, have been canceled. But we also have new ones that are coming in. So, it's dynamic, but we continue to win in the megaproject space, right? Again, verticals we've always been strong in. But a lot of these decisions are made on a global basis. So, you have decision makers that live in different parts of the world. Again, a direct sales force that could help triage those decision makers is extremely important. And we've been very successful, and I anticipate, and I know we'll be very successful in the future as well."
},
{
"speaker": "Joe Ritchie",
"content": "Got it. That's helpful. And look, I know you're not talking about a prebuy on the residential side of the business and yet the industry is seeing pretty significant growth in the back half of this year in resi and a few of your competitors are talking about how much of the kind of [R-54B] (ph) is going to go through their system next year. With one saying 65% of their business, the other one is saying 90% of their business. I'm just kind of curious as you kind of think about your resi business since the next year, like how much of it do you think is going to be the 410A product that you'll manufacture this year versus the R-54B product that will be hitting the market next year? Any thoughts?"
},
{
"speaker": "Dave Regnery",
"content": "Yeah. I mean if you think about inventory in the channel, think about three months of inventory is probably a good average to use, so by definition, you're going to be at 75%. Now, it won't probably be linear, where it will be all in the back half. You'll have some of the 410 that will sell throughout the year. But look, we'll probably be in that 75%, 80% range in resi. In commercial, and by the way, no one wants to take well commercial, but commercial also went through a refrigerant change on the unitary side. And that one will obviously be a lot higher, think of that one in the 90%-plus range."
},
{
"speaker": "Joe Ritchie",
"content": "Helpful. Thank you very much."
},
{
"speaker": "Dave Regnery",
"content": "Okay. Thanks, Joe."
},
{
"speaker": "Operator",
"content": "Our next question comes from Nigel Coe from Wolfe Research. Please go ahead. Your line is open."
},
{
"speaker": "Nigel Coe",
"content": "Thanks. Good morning, everyone. Thanks for the question. Look, I know I know APAC and China are very small for you, so [I'll probably come] (ph) back to this, but I guess the surprise is that it took so long because we've seen terrible markets in China now for some time. So, you mentioned you've been outperforming. That makes sense, but obviously, the string broke this quarter. So, it seems -- if you have to gauge how much of this is elective, enforcing more stringent credit procedures versus genuine deterioration in the market, how would you sort of gauge that? And I'm guessing that this correction has to cycle through into 2025, there's no kind of spring back here. Just any thoughts there?"
},
{
"speaker": "Dave Regnery",
"content": "Yeah. I mean, I think the fourth quarter will be stronger than the third quarter. I mean just -- I mean, Nigel, you kind of hit it. Look, China is 4% of our revenue, first of all. So, it's a small portion of our income, but it's important. And how much of the downturn is market related versus our policy change, it's always hard to say that. I don't know, is it 50-50, maybe it's a little bit more weighted to policy change at least in the short term, probably just because we have to work through that. We have to educate our customers as to what the expectations are. So, our teams are really good. Again, a direct sales force can have that direct conversation, they can understand the why and we'll work through it. We'll see how the fourth quarter, as I said, will be a little bit stronger, we think, than the third quarter, and that's what we have baked into our guide."
},
{
"speaker": "Nigel Coe",
"content": "Okay. That's great. And then, a follow-up for Chris. Not asking the '25 guidance, but maybe just some of the moving pieces. On corporate, running at $330 million now it was as low as $350 million back in 2022, 2021. So, any sense on what would be a good run rate for corporate? And then, it looks like amort comes down in '25. So, I think some of the Trane acquisition, amort starting to roll off. Is that correct? And then finally, just on interest. We got a refi coming up in November, I think, very small, but should we expect interest expense to go up a little bit next year?"
},
{
"speaker": "Chris Kuehn",
"content": "Hey, Nigel. Yeah, corporate, I think, $300 million is probably a good longer-term run rate number. I mean, there are times like this year where we have a little bit higher corporate expense and think of that as where we're driving some of the enterprise investments for the company. So, those are decisions we'll make as we work throughout a year always making sure that, that pipeline of investments is getting funded. So -- but I think going into 2025, a squiggle of $300 million is probably a good place to start. We'll update you as we get together in a few months from now. On amortization, yes, there's going to be a little bit of a roll-off on the Tarne amortization. We'd have to look at that across the new M&A that we've done over the last few years and dial that all in. So yeah, we'll give you some more input on that over the next few months, see if there's any more M&A that comes through the balance of this year. And then, on the interest side, yeah, we -- I would say we had $237 million of guided interest expense for this year. We took out some debt proactively earlier this year just to derisk a refinance that actually is going to come due here in a couple of days. We've held on to that cash actually this year from the bond offering we did in June. It's a net positive on net interest here. So, we'll pay down that cash and pay down that bond going into next year. But maybe that number for 2024 is not far off from what we have for 2025. But we'll see. We'll dial it in. The good thing is, is that we've generated a lot of cash this year, maybe earlier than normal. It's generated a little bit more interest income as well as we've earned it this year. But we have a pristine balance sheet, very strong leverage on the balance sheet, a lot of firepower to go deploy cash. And I would say maybe for next year, interest is probably in that ballpark is 2024."
},
{
"speaker": "Nigel Coe",
"content": "That's great. Thanks, Chris."
},
{
"speaker": "Dave Regnery",
"content": "Thanks, Nigel."
},
{
"speaker": "Chris Kuehn",
"content": "You're welcome."
},
{
"speaker": "Operator",
"content": "Our next question comes from Deane Dray from RBC Capital Markets. Please go ahead. Your line is open."
},
{
"speaker": "Sahil Manocha",
"content": "Hi. Good morning. This is Sahil Manocha on for Deane Dray. My question is on weakness in China, understanding it's a smaller part of the business, but have you taken any write-downs of receivables or increased reserves? And how might the Chinese government stimulus actions play out? And are there any verticals in China doing particularly worse?"
},
{
"speaker": "Chris Kuehn",
"content": "Why don't I start? This is Chris. The first answer is no. We've not seen any material write-downs or bad debt reserves. I think the key there is coming out of the second quarter, working with our business team in China to make sure that they were deploying these tightened credit policies really at the end of the second quarter. And so, we've got orders that are waiting to be delivered. And when the cash comes in, we'll deliver them. So, at this point, no, we're not seeing that. We generally play in the non-resi markets in China and largely commercial HVAC with a smaller transport business. And those are the markets that have been, as you may have seen here in the last several months, the non-resi markets are just seeing a bit of a downturn. So, we've been outperforming for some time. At some point, it does catch up with you a little bit. But to Dave's prior comments, we're also making sure we're focused on the long term here. We don't want to create a short-term problem that's a booking or revenue that three, six, nine months down the road, you wind up with a problem you have to deal with. We're making sure we've got quality orders, quality customers, quality receivables and then ultimately driving the cash."
},
{
"speaker": "Sahil Manocha",
"content": "That's really helpful. And then, one more on data centers. Could you provide an update on your liquid cooling investment in LiquidStack?"
},
{
"speaker": "Dave Regnery",
"content": "Yeah. We continue to work with LiquidStack. We've been partners with them for an extended period of time now. I think the activity is starting to pick up there, but there's some hurdles that we're still working through with them, and we'll keep you posted, but not really any kind of an update right now as far as orders are concerned."
},
{
"speaker": "Sahil Manocha",
"content": "All right. Thank you very much."
},
{
"speaker": "Operator",
"content": "Our next question comes from Andrew Obin from Bank of America. Please go ahead. Your line is open."
},
{
"speaker": "Andrew Obin",
"content": "Hey, guys. Good morning."
},
{
"speaker": "Dave Regnery",
"content": "Hey, Andrew. How are you?"
},
{
"speaker": "Andrew Obin",
"content": "I am going to sort of belabor this China point a little bit more. My understanding was that for you, China was mostly industrial exposure. And I think the prior explanation for the fact that your performance in China was better was because you did not have exposure to these non-residential office buildings. I just want to understand if that's the right way of thinking about it. And yeah, right, because, as I said, the commercial weakness was there. Your response was we're not really on this commercial developments. We're playing mostly on the industrial side. But did I just understand it wrong?"
},
{
"speaker": "Dave Regnery",
"content": "No, it's about -- think about our business in China, think about 90% commercial HVAC, okay, mostly applied systems. So, you're spot on there. Look, the downturn, the markets are down, okay? That's pretty universal as to what's happening in China. But as I said earlier, Andrew, if a customer wasn't going to provide the downpayment, okay, or the progress payment, even though the product was ready to be shipped, we've held it, okay? We're not going to ship it until we get that progress payment. And you saw the acute falloff in the quarter because of that. But again, long term, this is a prudent decision that we're making. And the individual before for Dean was asking about it, have we written off anything in bad debt, and the answer is no, and we don't intend to in the future."
},
{
"speaker": "Andrew Obin",
"content": "No, I understand, but the answer is that all along your China business was mostly commercial real estate, not industrial facilities, not factories, not data centers, it's 90% commercial real estate. Just want to get that point. Is that correct?"
},
{
"speaker": "Dave Regnery",
"content": "No, that's false. No, we're actually the reverse. We don't really play in the commercial real estate place. These are applied systems. So, think of them semiconductor, think of them industrial applications..."
},
{
"speaker": "Andrew Obin",
"content": "No, that's exactly what I was asking. Thank you. Yes, that was my understanding. Okay. Fine. So, it's really industrial weakness. It's weakness outside the real estate market that's getting you down?"
},
{
"speaker": "Dave Regnery",
"content": "You got it."
},
{
"speaker": "Andrew Obin",
"content": "Okay. Thank you. No, that's exactly what -- and maybe just A2L pricing, there's been a lot of data points. I think there was a view that Daikin, right, because they use a different refrigerant, maybe is not going to increase their prices as much. I think your peers are sort of saying high single digits, around 10% maybe. What do you guys -- and I apologize if I missed it, but what do you guys fall in on this A2L pricing into '25?"
},
{
"speaker": "Chris Kuehn",
"content": "Andrew, I mean, think of the introduced pricing for the new refrigerant products really being up in the high-single-digit range. There is more cost associated with the products for many reasons, the refrigerant, the sensors, et cetera. Our target is to be margin neutral here as we think about pricing and cost for end customers. But think of it for us up in that high-single-digit range. As we guide next year, we'll dial in a little bit better based on visibility the percentages that Dave outlined previously of how much will be 454B versus 410A. And then I know, as you know, not all of the residential product we sell is subject to the new refrigerant like furnaces. So we'll kind of walk you through what we think that price contribution is for next year, but it will be a tailwind for next year."
},
{
"speaker": "Andrew Obin",
"content": "Terrific. And I really appreciate this clarification in China. Thanks a lot."
},
{
"speaker": "Dave Regnery",
"content": "Sure. No problems, Andrew. Thanks."
},
{
"speaker": "Operator",
"content": "Our next question comes from Tommy Moll from Stephens. Please go ahead. Your line is open."
},
{
"speaker": "Tommy Moll",
"content": "Good morning, and thank you for taking my questions."
},
{
"speaker": "Dave Regnery",
"content": "How are you doing, Tommy?"
},
{
"speaker": "Chris Kuehn",
"content": "Good morning."
},
{
"speaker": "Tommy Moll",
"content": "Doing fine. Thank you. We've talked a lot about China. So, I wanted to circle back on one of the positive topics from today, which is the backlog you've called out for 2025, which was up sequentially by a pretty large amount. And I'm just curious, as you look at the composition there, is there anything we can learn in terms of what verticals are particularly strong? Why customers may be ordering a little bit earlier in the cycle than in the past? Just anything we can glean? Obviously, you've talked about next year is a strong one for commercial HVAC, but maybe if we go one layer deeper there, what can we learn?"
},
{
"speaker": "Dave Regnery",
"content": "Yeah. I think, as I said earlier, if you think about our order rates, and I'll talk about commercial HVAC in the Americas, they're up close to 20% for the year. It's broad-based. It's in basically all verticals. So -- and the other thing, Tommy, that I haven't talked about is that our pipeline, so this is before something actually becomes an order, is extremely strong, right? We have very sophisticated CRM systems. So, we know what's being worked on. And it is extremely strong, which gives me lots of confidence not only for the fourth quarter but into 2025 as to what we should be expecting in that business. So, I'm very bullish on 2025. We'll dial that in as we get into our fourth quarter earnings. But look, our backlog is up $300 million year-to-date. It's hard to say what's normal now, but it's -- if we look at historical norms, it's over 2.5 times what's normal. We will go into next year with a very strong backlog and the activity -- the market activity across all verticals is very, very strong right now."
},
{
"speaker": "Tommy Moll",
"content": "Which leads to my follow-up, Dave. Office got a little airtime earlier. And so, if we just discuss these commercial trends ex data centers, which we've covered, and think about office and some of the other verticals that we don't talk about as much, am I hearing you correctly that it feels like the rest of that commercial business has actually gotten stronger in terms of the orders as 2024 has progressed?"
},
{
"speaker": "Dave Regnery",
"content": "Certainly, office has. I think all of our verticals have positive growth -- except for one, had positive growth on a year-over-year basis, which is encouraging. But again, it kind of comes back to who we are as Trane Technologies, right? We are very broad-based, right? Our portfolio of products and services is broad-based. We have expertise in all verticals. And it's not like we've become over-indexed on any one. And I know that data centers are certainly very strong, and it will be very strong in the future. We have a great team there that works on the data center. We also have great teams that work on other verticals and have that expertise. And by the way, if they see opportunities, they're going to pivot to that opportunity and really go after it and make sure that they can win with the customer. So very strong, we're seeing right now. Backlog is very strong. activity, this is before an order is extremely strong and we're bullish."
},
{
"speaker": "Tommy Moll",
"content": "Thank you, Dave. I'll turn it back."
},
{
"speaker": "Dave Regnery",
"content": "Thanks, Tommy."
},
{
"speaker": "Operator",
"content": "Our last question today will come from Noah Kaye from Oppenheimer. Please go ahead. Your line is open."
},
{
"speaker": "Noah Kaye",
"content": "Thanks, and I will give it to one question. Dave, in the past, we've talked a little bit about a cascading impact of policies going from, say, ESSER to CHIPS and IRA. And I know there are a lot of fundamental drivers here around decarbonization and improved efficiency paybacks. But just at this point, as we look at '25 and your comments around the pipeline of activity, to what extent are those policy impacts actually impacting the pipeline or the bookings you're seeing? Just help us level set what kind of impact they're actually having on the business?"
},
{
"speaker": "Dave Regnery",
"content": "I'm sure they have a tailwind. But again, our solutions have great paybacks with or without those tailwinds. Obviously, the tailwind makes it more attractive, but we have great paybacks for existing -- whether we have a tailwind or not like ESSER funding. Certainly, some of them have been part of the -- ESSER funding is a great example there where it certainly is part of our backlog. We'll be fulfilling orders all the way through probably about the next year that's in our backlog for schools. And a lot of that has to do -- I know it sounds like a long time, but remember, in schools, you tend to want to do the work when students aren't in the school. So, it will be like the school season in the summer. But look, we'll see what happens with who the next party is in Washington, but we're optimistic that we'll continue to have attractive paybacks regardless of what the policies are, whether they are tailwinds or not, but we'll be successful well into the future."
},
{
"speaker": "Noah Kaye",
"content": "All right. Thanks, Dave. Appreciate it."
},
{
"speaker": "Dave Regnery",
"content": "Thanks, Noah."
},
{
"speaker": "Operator",
"content": "We are out of time for questions. I would like to turn the call back over to Zac Nagle for closing remarks."
},
{
"speaker": "Zac Nagle",
"content": "I'd like to thank everyone for joining today's call. As always, we'll be available for questions at any time. We'll also be on the road quite a bit in the fourth quarter, and we look forward to seeing many of you on the road. So, have a great day. Thanks."
},
{
"speaker": "Operator",
"content": "This concludes today's conference call. Thank you for your participation. You may now disconnect."
}
] |
tt | 2,024 | 2 | [
{
"speaker": "Operator",
"content": "Good morning. Welcome to the Trane Technologies Q2 2024 Earnings Conference Call. My name is Adam, and I’ll be your operator for the call. The call will begin in a few moments with the speaker remarks and Q&A session. At this time, all participants are in a listen-only mode. [Operator Instructions] I would now like to turn the call over to Zac Nagle, Vice President of Investor Relations."
},
{
"speaker": "Zac Nagle",
"content": "Thanks, Operator. Good morning. And thank you for joining us for Trane Technologies’ second quarter 2024 earnings conference call. This call is being webcast on our website at tranetechnologies.com, where you’ll find the accompanying presentation. We’re also recording and archiving this call on our website. Please go to Slide 2. Statements made in today’s call that are not historical facts are considered forward-looking statements and are made pursuant to the Safe Harbor provisions of federal securities law. Please see our SEC filings for a description of some of the factors that may cause our actual results to differ materially from anticipated results. This presentation also includes non-GAAP measures, which are explained in the financial tables attached to our news release. Joining me on today’s call are David Regnery, Chair and CEO; and Chris Kuehn, Executive Vice President and CFO. With that, I’ll turn the call over to Dave. Dave?"
},
{
"speaker": "David Regnery",
"content": "Thanks, Zach, and everyone for joining today’s call. As we begin, I’d like to spend a few minutes on our purpose-driven strategy, which enables our differentiated financial results over time. Our purpose is centered on creating a more sustainable world and our strategy is aligned to powerful megatrends like energy efficiency, decarbonization and digital transformation. We’re all seeing the dire effects of climate change, and governments, NGOs and companies around the world are increasingly taking action. We’re hearing a lot about the need to invest in renewables and green the grid. What we’re not talking enough about is demand-side management. That’s where Trane Technologies comes in. Most buildings operate up to 30% inefficiently. Through our leading-edge technical solutions and sophisticated controls in AI, we can help our customers significantly reduce energy demand and emissions. Our relentless innovation, proven business operating system and uplifting culture enable us to consistently deliver a leading growth profile, strong margins and powerful free cash flow. The end result is strong value creation across the Board for our customers, our shareholders, our employees and for the planet. Please turn to Slide #4. In the second quarter, we extended our track record of strong execution. Our global team delivered robust performance across the Board, not only bolstering our outlook for 2024, but strengthening our visibility to another year of leading performance in 2025. Bookings continue to be exceptional, with healthy momentum into the back half of 2024, as our pipeline of projects continues to grow. Q2 bookings of $5.3 billion rose to an all-time high, up 5% from our prior high in the first quarter and up 19% versus the prior year. Organic revenues were up 13%, with strong execution through the P&L, delivering 23% adjusted EPS growth. Notably, we continued to reinvest heavily in our business and accelerated key strategic investments, further strengthening our competitive positioning for continued market outgrowth. Booking strength continued to be led by our commercial HVAC businesses, where we’re seeing broad-based growth. In top growth verticals, such as data centers, market projections call for an exceptionally strong multiyear CapEx cycle and high levels of project complexity play to our unique strengths. The power of our elite direct sales force, deep customer relationships and leading innovation will enable us to capitalize on the tremendous opportunities ahead. As the leading applied solution provider, we are driving significant market outgrowth in the most attractive high-growth verticals in commercial HVAC. As an example, Q2 revenues of our Americas applied solution are up approximately 90% on the three-year stack. We estimate that our applied systems carry an 8 times to 10 times multiple of higher margin service revenue over the life of the equipment. So, we’re also excited about the service opportunities that lie ahead. Our robust bookings momentum and exceptional backlog of $7.5 billion provides strong visibility into the remainder of 2024 and increasing visibility into 2025. Our backlog includes $2.8 billion for 2025 and beyond, which is the level of backlog we would historically see entering a new year and we’re only halfway through 2024. All in, we’re confident in raising our full year revenue and EPS guidance, which would deliver our fourth consecutive year of 20% or greater adjusted EPS growth. Chris will cover guidance in more detail in a few minutes. Please go to Slide #5. In our Americas segment, our commercial HVAC business delivered industry-leading performance. Bookings were up more than 20% in the quarter. Revenue was up mid-20s and broad base across vertical markets, with equipment up more than 30% and services up high-teens. In residential, the team delivered very strong results, with bookings up more than 30% and revenues up low-teens. Turning to transport, the business performed as expected. Revenues were down high-teens against a tough comp of more than 30% growth in the prior year. The two-year stack growth was more than 10% and well ahead of the market, which was down mid-teens. Bookings were solid, up low-single digits. In EMEA, commercial HVAC strength continues, with bookings up 20%. Revenues were also strong, up high-single digits in the quarter and up over 25% on a two-year stack. Our transport business performed in line with our expectations, with bookings and revenue both down modestly. Turning to Asia, results were in line with our expectations for the second quarter. Asia-Pacific bookings were flat, while China bookings were up mid-single digits. Revenues were down low single digits on a tough prior year comp of 40% growth. We’re pleased with our performance through the first half and expect Asia-Pacific to have another solid year overall. Now, I’d like to turn the call over to Chris. Chris?"
},
{
"speaker": "Chris Kuehn",
"content": "Thanks, Dave. Please turn to Slide #6. This slide provides a snapshot of our performance in the second quarter and highlights continued strong execution, top to bottom. Organic revenues were up 13%, adjusted EBITDA and operating margins were both up 140 basis points, and adjusted EPS was up 23%. At an enterprise level, we delivered strong organic revenue growth in both equipment and services, up low-teens and mid-teens, respectively. Our high-performance flywheel continues to pay dividends, with relentless investments and innovation driving strong topline growth, margin expansion and EPS growth. Please turn to Slide #7. At the enterprise level, we delivered robust volume growth with strong incrementals, positive price realization and productivity that more than offset inflation and continued high levels of business reinvestment. In our Americas segment, we delivered about 14 points of volume and about 2 points of price. Our Americas commercial HVAC business again outperformed the markets and delivered very strong volume growth of more than 20 points. Adjusted operating margin expansion of 130 basis points was driven by volume growth, productivity and price realization, more than offsetting inflation and high levels of business reinvestment. In our EMEA segment, we delivered about 4 points of volume and 1 point of price, with strong volume in our commercial HVAC business. Adjusted operating margin expansion of 130 basis points was driven by volume growth, productivity and price realization, more than offsetting inflation and high levels of business reinvestment. In our Asia-Pacific segment, the team delivered 310 basis points of adjusted operating margin expansion, despite a mid-single-digit volume decline. Strong productivity and positive price realization more than offset inflation and high levels of business reinvestment. Now I’d like to turn the call back over to Dave. Dave?"
},
{
"speaker": "David Regnery",
"content": "Thanks, Chris. Please turn to Slide #8. Our end market segment and business unit outlook is largely unchanged, with some notable exceptions in the Americas segment. First, our Americas commercial HVAC business delivered another very strong quarter of market outgrowth. While we’ve highlighted particular strength and key verticals, growth was again broad-based. Revenue growth on a three-year stack was extremely strong, up approximately 45% to 50% in both Q1 and Q2. With our continued positive outlook and exceptional backlog position, we expect three-year stack revenue growth to remain at this high range in the second half of the year. Second, our Americas residential business delivered stronger-than-expected growth in the second quarter, in part driven by three factors. The EPA clarification on the refrigerant transition, the normalization of channel inventories and a strong start to the cooling season. We now expect full-year revenue growth to be up mid-single digits. Third, in our Americas transport business, ACT has lowered their outlook for the 2024 transport markets to down mid-teens. Their expectation is for a much softer second half, which they project to be down more than 25%. We expect to outperform the transport markets in 2024. Looking to 2025, ACT projects approximately 15% growth as freight rates improve. Overall, the changes to our outlook in the Americas segment represent a significant net positive to our enterprise outlook for 2024 and gives us confidence in raising our full year guidance. All other businesses performed largely as expected in the first half and the outlooks for the year are unchanged. We provided additional details on the slide for your reference. Now, I’d like to turn the call back over to Chris. Chris?"
},
{
"speaker": "Chris Kuehn",
"content": "Thanks, Dave. Please turn to Slide #9. Our initial 2024 guidance reflected targets that we believed would deliver top quartile performance on organic revenue and adjusted EPS growth for the full year. Halfway through, we’re exceeding those objectives. Given our strong performance, positive outlook and exceptional backlog, we’re raising our organic revenue guidance to approximately 10%, 1.5 percentage points above the midpoint of our prior range of 8% to 9%. We’re also raising our full year adjusted earnings per share guidance by $0.35 at the midpoint to approximately $10.80, up from a range of $10.40 to $10.50 prior. With this updated guidance, we’re poised to deliver our fourth consecutive year of 20% or greater adjusted earnings per share growth. We continue to expect about one point of growth from M&A in 2024, with a negative impact of approximately $30 million to adjusted operating income for the full year, for a negative impact of about 5 points to reported leverage versus organic leverage. We also expect about 1 point of negative FX impact in 2024, effectively offsetting the point of growth from M&A. Net, organic, and reported revenue growth guidance for 2024 are the same, at approximately 10%. There’s no change to our organic leverage target of 25% plus for the year, consistent with our stated long-term target and we continue to expect free cash flow conversion to adjusted net earnings of 100% or greater. For the third quarter, we expect revenue growth of approximately 8.5% and adjusted EPS of approximately $3.15 to $3.20. Please see Page 17 for additional information that may be helpful for modeling purposes. Please go to Slide #10. We remain committed to our balanced capital allocation strategy, focused on consistently deploying excess cash to opportunities with the highest returns for shareholders. First, we continue to strengthen our core business through relentless business reinvestment. Second, we’re committed to maintaining a strong balance sheet that provides us with continued optionality as our markets evolve. Third, we expect to consistently deploy 100% of excess cash over time. Our balanced approach includes strategic M&A that further improves long-term shareholder returns and share repurchases as the stock trades below our calculated intrinsic value. Please turn to Slide 11 and I’ll provide an update on our 2024 capital deployment. Year-to-date through July, we’ve deployed $1.1 billion in cash, with $379 million to dividends, approximately $100 million to M&A and $650 million to share repurchases. We have $1.8 billion remaining under the current share repurchase authorization, providing us with strong optionality as our shares remain attractive, trading below our calculated intrinsic value. We continue to have an active M&A pipeline, with potential value accretive opportunities to further improve long-term shareholder returns. For 2024, we expect to deploy approximately $2.5 billion in cash. Our strong free cash flow, liquidity and balance sheet give us excellent capital allocation optionality moving forward. Now I’d like to turn the call back over to Dave. Dave?"
},
{
"speaker": "David Regnery",
"content": "Thanks, Chris. Please go to Slide #13. We discussed the transport markets in our outlook discussion on Slide #8, so I won’t cover them again here. However, we’ve continued to provide this slide for your reference. Please turn to Slide #14. We operate our transport business for the long-term and while we’re moving through a down cycle in 2024, this is a great business with a bright future. ACT projects a trailer market rebound in 2025, up mid-teens and forecasts continued growth through their 2029 forecast horizon. We have a diversified transport business globally, with opportunities to grow across the portfolio. With leading innovation, strong execution through our business operating system, and a world-class dealer network, we’re well-positioned to outperform in any market environment. Please go to Slide #15. In summary, we are well-positioned to drive differentiated growth over time. Our leading innovation, proven business operating system and unmatched culture enable us to consistently deliver top quartile financial performance over the long-term, while continuing to reinvest in our business and we believe our best days are ahead. We have the team, the strategy and the track record to deliver leading performance and differentiated shareholder returns in 2024 and beyond. And now, we’d be happy to take your questions. Operator?"
},
{
"speaker": "Operator",
"content": "[Operator Instructions] And our first question comes from the line of Julian Mitchell with Barclays. Your line is open."
},
{
"speaker": "Julian Mitchell",
"content": "Hi. Good morning. Maybe just wanted to start with the organic sales growth guidance. Understand sort of some of the year-on-year dynamics. It can depend, if we’re looking at one-year, two-year, three-year stacks and so forth. So maybe it’s easier to look sequentially. And I think the guidance implies sort of flat sales in Q3 sequentially, normally, they’re up the last few years, sort of mid-single digits, and then the fourth quarter, I think, is implied down double digits sequentially, and recently, it’s been down high singles. So, just wondered sort of from a sequential standpoint, anything in particular you’re seeing or it’s more of just a sort of conservative kind of construct based off the multi-year stacks?"
},
{
"speaker": "Chris Kuehn",
"content": "Hey. Good morning, Julian. This is Chris. I’ll start. Yeah. Look, we’re happy with the guidance we just put forth and raised full year organic revenue growth target to 10%, up 1.5 points from our prior guide. Think about the second half of the year as I’ll start with commercial HVAC Americas. They’re going to have a great year on a full year basis. As I’ve talked about in prior calls, the comps versus 2023 are just tougher as you go into the second half of the year. As a reminder, a year ago, that business grew mid-teens in Q1, high-teens Q2, and the second half of 2023, it grew in the low-20s to mid-20s Q3 and Q4, respectively. So it’s going to have a great year. Think of that second half range. It’s probably in the 10% to 12% range in growth. And what’s interesting, and we did the math on this, when you think about the first half of 2024 in that business, the three-year revenue stack is a 45% to 50% growth, and it’s actually the same when you look at the second half of the year in 2024 as well. It’s a 45% to 50% revenue growth over the last three years. So, it looks really consistent when you think about it over the last several years with a lot of dynamic markets, so to speak, and dealing with supply chain. But they’re going to have a great year. Think of transport second half of the year, as Dave called out in his comments. I mean, those markets are expected to be down further than what we even thought three months ago. ACT has called those markets down in the mid-20s in the second half of the year. So we expect that business to be down, but we expect to outperform on the full year. And then residential, I’ll leave it within the Americas, mid-single-digit growth plan for the second half of the year. And could it be better? Yeah, maybe it could be better. It is a bit of a step down from the second quarter, but we’re cautiously optimistic about that space. We’re very much in the middle of the cooling season right now. We want to really see where it plays out. But maybe I’ll end there, that we’re confident in the full year guide and could things get a little bit better in the second half? Maybe. But we’ll update you as we get to the call next quarter."
},
{
"speaker": "Julian Mitchell",
"content": "Thanks very much, Chris. And just my second question on the operating margin outlook. So you’ve got the higher investments that are sort of pushing the full year up leverage into that mid-20s plus framework after a 30s number in the first half. Anything else we should be aware of for the second half in terms of that margin element? Maybe flesh out anything around mix, perhaps? I suppose if resi and transport are a bit softer, there’s a mix negative. Anything else to highlight in terms of, say, price, cost, tailwinds, and also within commercial HVAC mix, anything moving around on applied versus the light side in the back half?"
},
{
"speaker": "Chris Kuehn",
"content": "Yeah. Good question. I think it’s really less about mix of the businesses. When you think about performance last year and EBITDA margins across EMEA, Asia and the Americas, very different mix of businesses. EBITDA margins were fairly consistent across all three of the businesses, actually Asia leading. But if I think about the second half, this is really where Dave has continued to challenge all of our business units with advancing investments, right? We see it as, and I’ve seen it for a very long time, with accelerating investments, and as we see high returns on them, that’s where I would call it maybe second half of the year. There’s a bit of compounding effect of the investments that we began to ramp in the first quarter of this year. Those wind up being a little bit more costly in the second half, but all of them have really strong returns. So we like the full year guidance and confidence in 25% or better organic leverage. Let’s see where the year plays out. But the focus here is making sure we continuously and relentlessly invest in the business to keep driving this market outgrowth in the next several years and Dave’s keeping the pressure on."
},
{
"speaker": "David Regnery",
"content": "I’m sitting here smiling at Chris as he’s saying that, Julian. So thanks for the questions, but we love investing in our business and we’ve been able to demonstrate the results of the investments we’ve been able to make and expect more of that in the future."
},
{
"speaker": "Julian Mitchell",
"content": "That’s great. Thank you."
},
{
"speaker": "David Regnery",
"content": "Thanks, Julian."
},
{
"speaker": "Chris Kuehn",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Scott Davis with Melius Research. Your line is open."
},
{
"speaker": "Scott Davis",
"content": "Hey. Good morning, guys. Dave and Chris, is that?"
},
{
"speaker": "David Regnery",
"content": "Hey, Scott. How are you doing?"
},
{
"speaker": "Scott Davis",
"content": "I’m good. Thank you. And today’s results have been good. So it’s been a good day. So I wanted to just dig in a little bit of backlog. It’s kind of your comments about 2 times normal. I’m trying to just tease out what’s changed here. Obviously, demand is solid. But are these backlogs 2 times normal largely because lead times have gone up substantially because these projects have gotten bigger and more complex and folks want to get in front of the line? I’m thinking data centers and semi-fabs and things like that. But perhaps I’m overstating that a bit?"
},
{
"speaker": "David Regnery",
"content": "Yeah. It’s a great question, Scott. I would say that we should maybe challenge ourselves as to what’s normal, okay. We’re a lot bigger business than we were four years ago, obviously. Lead times, that’s not -- I would say that’s -- I would say lead times are back to what I would call a normal rate. For data centers, for sure. We have data center customers that are providing us visibility to their needs well in advance than, say, maybe some of the other verticals. So that’s a part of it. But look, we’re seeing tremendous strength, really, in almost all verticals. As we looked in the Americas in our commercial HVAC business in the quarter, I think we spoke before, we tracked 14 different verticals. It was hard for us to find a vertical that was down. So we just have broad-based strength. We certainly are seeing a lot of demand in the high growth verticals like data centers, but we’re also seeing nice demand in other verticals as well."
},
{
"speaker": "Scott Davis",
"content": "Okay. Helpful. And then China, the bookings are up and I know it can be a little bit lumpy, for sure. But is there an indication that China is bottomed? I think kind of -- I guess my question is kind of A, on the macro side, but B, you guys are probably getting some outgrowth, I would imagine there. So if you have some color around that, B."
},
{
"speaker": "David Regnery",
"content": "Yeah. I’d say it’s a good question, Scott. I mean, Asia is less than 10% of the revenue for the enterprise. Okay. Think of it 50% China, 50% the rest of Asia. In the quarter, the region performed as we expected. Revenues were flat. I would tell you that we did see some choppiness in China towards the back half of the quarter. So we have our eyes wide open on that. But I would also tell you that we have that baked into our guide for the year. So I wouldn’t say that China has bottomed. We performed well there. Our team is executing at a very high level. We were a very seasoned team there. A lot of innovations in their pipeline there that they’re rolling out into the marketplace. But just to be clear, getting orders in China are pretty dynamic right now."
},
{
"speaker": "Scott Davis",
"content": "Okay. Congrats, Dave. Thanks. I’ll pass it on."
},
{
"speaker": "David Regnery",
"content": "Thanks. Appreciate it, Scott."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Andy Kaplowitz with Citigroup. Your line is open."
},
{
"speaker": "Andy Kaplowitz",
"content": "Good morning, everyone. Nice quarter."
},
{
"speaker": "David Regnery",
"content": "Thanks, Andy."
},
{
"speaker": "Chris Kuehn",
"content": "Thanks, Andy."
},
{
"speaker": "David Regnery",
"content": "Appreciate it."
},
{
"speaker": "Andy Kaplowitz",
"content": "Dave, just a little bit more about bookings and backlog momentum going forward. We know you’ve more difficult order comparisons coming up, but could you maintain book-to-bill ladder over 1 times? And then the renewed momentum in Americas commercial HVAC, I know you just said it was relatively broad-based, including data centers, but how long do you think this elevated bookings environment could last and at what point do strong orders give you confidence that 2025 should be another strong earnings growth year or even a double-digit growth year?"
},
{
"speaker": "David Regnery",
"content": "Yeah. I’m not going to forecast our incoming order rates for the rest of the year. I will tell you that we’re going to have a backlog that’ll be very strong going into 2025, much like you saw us at the beginning of 2024. We already have 2.8 billion booked for 2025 and I mean, that’s a number that we haven’t talked about that size of a number in the past. So we’re very confident there. As far as the demand that we’re seeing, look, we’re seeing a lot of demand and I emphasize it’s broad-based, right? It’s not just in the high growth verticals because we’re very strong there, but it’s broad-based and it really has to do with a lot of our innovation and our ability to execute. And with our direct sales force, we go to where the opportunities are. Our teams are highly technical and we’re winning in the marketplace. It’s that simple. And I couldn’t be prouder of what that team’s been able to execute. And by the way, we’re talking a lot about the Americas, but I would tell you that our commercial HVAC business in Europe also performed extremely well. Their order rates were up 20%. So you could see that investing in the business, always having that long-term vision as to where you want to go and the payback that you get for that, this is a flywheel, as Chris would say, and we’re seeing the impacts of that and that flywheel is going to continue to spin for us."
},
{
"speaker": "Andy Kaplowitz",
"content": "Thanks for that. Yeah. I tried there to get to the forecast bookings. Oh, well. So let me then ask you a follow-up. Chris, you kind of alluded to resi and the strength that you’re seeing. It looks like revenues in the first half were already up mid-single digits plus. Orders accelerate obviously in Q2 up 30%. I know you said you want to be conservative, but really is mid-single-digit growth the minimum for the year and what did you -- what have you seen so far during the cooling season?"
},
{
"speaker": "Chris Kuehn",
"content": "Andy, good question. Yeah. I think mid-singles is probably the floor for the business. Could it be better? Yeah, we think it could be better. But as you know, bookings in that business, it’s less important. It’s really around seeing through the entire cooling season. As you know, there’s a refrigerant transition that’s happening later into this year, into next year, and we’re ready for that. We can certainly answer any questions there as well. But we’ve got a lot of confidence in that team. It’s been a challenging market leading into this cooling season for about a year, year and a half. But yeah, we feel like could that be better? It could be better. But let’s see how the year kind of plays itself out."
},
{
"speaker": "David Regnery",
"content": "Yeah. Andy, as I said in our prepared remarks, look, three reasons why we did so much better in resi in the second quarter. One is the clarification on the refrigerant transition. The second is certainly the inventory is at what we would call a normal level in the channel list through our independent wholesale distributors. And the third is not that I like to talk about the weather, but it’s been a very, very warm start to the cooling season, which should have us all concerned for a different reason that we could talk about if you’d like. But it’s been a very, very strong start. So as Chris said, we’re cautiously optimistic in this business, the team performed very well in the second quarter and it’s a great start for that team."
},
{
"speaker": "Andy Kaplowitz",
"content": "Appreciate it, guys."
},
{
"speaker": "David Regnery",
"content": "Okay. Thank you."
},
{
"speaker": "Chris Kuehn",
"content": "Thank you, Andy."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Gautam Khanna with TD Cowen. Your line is open."
},
{
"speaker": "Gautam Khanna",
"content": "Yes. Thank you. I was wondering if you could talk about your expectations of any pre-buy given the A2L transition and just, yeah, have you already introduced the product, et cetera?"
},
{
"speaker": "David Regnery",
"content": "Yeah. Gautam, good question. We’ve introduced -- in our commercial business we’ve introduced about half of the products that would be affected. And think about any product that uses a scroll compressor as a target for a refrigerant change, okay. So just in a broad brush. So in our commercial sites, about half of it we’ve introduced. We’re actually selling both. So we’re selling 454B, the new refrigerant, as well as still 410. In our resi business, not yet. We haven’t introduced it. That’ll be rolling out in the back half of the year. As far as pre-buys go, look, we’re not anticipating in our residential business a large pre-buy towards the end of the year. We’ll see how that rolls out. But right now, we’re not forecasting that. There’s just too much timing that you have to work on to make sure that you could sell through all your products in the year and our focus really is on helping our independent wholesale distributors transition their inventory properly. So we’ll be working with them as the year progresses here to make sure that they’re ready for the cooling season in 2025 and then that’s really where our focus is right now. So answer to your question, not a large pre-buy. At least we don’t have one baked in. But I would tell you that the way we designed our operations, we’re able to manufacture both products. So we have mixed model lines, which it was a little bit more upfront cost, but we believe that investment will pay, because as you know, in the resi area, you’ll be providing components of 410 for some time into the future to make sure that we could service our product over the useful life of that product."
},
{
"speaker": "Gautam Khanna",
"content": "Great. Thank you."
},
{
"speaker": "David Regnery",
"content": "Thanks, Gotham. Appreciate it."
},
{
"speaker": "Chris Kuehn",
"content": "Thanks."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Damian Karas with UBS. Your line is open."
},
{
"speaker": "Damian Karas",
"content": "Hey. Good morning, everyone. Congrats on the quarter."
},
{
"speaker": "David Regnery",
"content": "Good morning, Damian. How are you?"
},
{
"speaker": "Damian Karas",
"content": "Doing well, thank you. I was wondering if you could maybe help us unpack the 13% organic growth a little bit. Just give us a sense for how much of this topline being driven by volumes versus some price and mixed benefits and just maybe kind of walk us through how you’re thinking about that for the full year now?"
},
{
"speaker": "Chris Kuehn",
"content": "Hey, Damian. It’s Chris. I’ll start. Yeah. For the quarter, think of it as a little bit over 2 points of price. You’ll see this in the 10-Q that gets filed later today, about 11 points of volume. So as we anticipated coming into the year, we knew that price was going to be a contributor, but less of a contributor than what we saw in 2022 and 2023. That’s been dovetailing. And the offset to that, and a nice offset to that, has been improved productivity. And so as kind of came out at the end of last year, middle last year with supply chain challenges largely resolved, we’re continuing to see improvements on the productivity side. So if I step back, we’re getting the right combination of price, dollars and margin above inflation. It is inflationary out there, to be fair. If I think about tier one costs with copper up, aluminum up to somewhat flat, steel down, refrigerants up, and ultimately, wage inflation really being up, all of that is still going to be a bit inflationary on us for this year. But I like where we are, price versus inflation, the productivity is getting stronger and making sure that we’re funding the business with investments. It was another quarter of a high investment and continued high investment quarter with projects we think that are very, very strong. That volume growth, the 13 points, sorry, 11 points of volume on the 13 points of revenue growth, think of that as 20 points of volume in commercial HVAC Americas. On price that where we were in the second quarter, we’re confident that gives us a lot of view into the full year. Price should be around 2 points as well. And that’ll look a little bit lower in the second half of the year versus the first half, ultimately landing around 2 points on the full year. So hopefully that gives you a little bit of color."
},
{
"speaker": "David Regnery",
"content": "A lot of volume, Damian."
},
{
"speaker": "Damian Karas",
"content": "Yeah. Not a bad thing. That was helpful. Thanks. And then I wanted to see if you might be able to share some color on how things are progressing with some of your kind of early stage, emerging growth opportunities, if you will, investment immersion cooling, your AI partnership. Would you envision these being potential capital deployment opportunities down the road?"
},
{
"speaker": "Chris Kuehn",
"content": "I’ll answer the first question. Emerging cooling, as I’ve said in the past, that’s sort of -- that’s got some hurdles it still needs to work through and we’re working through some of that with our partner there. So that’s not what I would call mainstream. As far as the AI tools, like the Nuvolo acquisition we did, it’s early days, but we really like what we see there and this is going to really help us excel our connected asset solutions. And in my opening remarks, I talked about demand side management and we’re not talking a lot about that. But a lot of people are talking right now about the generation side of power. A lot of people are talking about all the demand that’s coming. What people don’t realize is that, in a building, 30% of the energy that’s consumed is wasted, right? So if you’re connected to the asset, if you’re connected to the building, you’re able to ensure that that asset or that building is going to perform the way it was designed. And this 30% number, right, I’d love to show you some of our stats, but this is a massive amount of energy that can be saved. So we’re really happy. We’re really bullish on Nuvolo. We’re really bullish on what we’re doing with our connected solutions. And I think you’re going hear a lot more about demand side management in the coming years, because it’s not just about generation, it’s not just about forecasting all the demand that’s going to be coming and you see a lot about data centers right now. It’s like, how do we use what we’re generating today in a more efficient way and that’s what we know at Trane Technology we could help our customers with."
},
{
"speaker": "Damian Karas",
"content": "Great. Thanks, guys. Best of luck."
},
{
"speaker": "David Regnery",
"content": "Thank you, Damian. Thank you."
},
{
"speaker": "Chris Kuehn",
"content": "Thanks."
},
{
"speaker": "Operator",
"content": "Next question comes from the line of Joe Ritchie with Goldman Sachs. Your line is open."
},
{
"speaker": "David Regnery",
"content": "Hey, Joe."
},
{
"speaker": "Joe Ritchie",
"content": "Hey, guys. Good morning."
},
{
"speaker": "David Regnery",
"content": "Good morning."
},
{
"speaker": "Joe Ritchie",
"content": "So I’m going to touch on data centers again just quickly. I know that it’s both broad-based growth across commercial HVAC in the Americas. I’m just curious, though, are you seeing any constraints on your bookings for data centers, I know that that’s been a hot topic of late. And then also, can you just maybe tell us a little bit about the margin profile of the business that you’re booking in that vertical?"
},
{
"speaker": "David Regnery",
"content": "I’ll start. I’ll let Chris talk about margins. But constraints from a capacity standpoint, no. I mean, we’ve made capacity expansions over the last several years. So we feel as though we’re in good shape there. It’s more about working with the customers. It’s more about working with the system level within the data center. We’re not just a component supplier within a data center. We look at the entire cooling system, whether you’re cooling at the building level, the server or the servers themselves. This is something that we’re really good at and we’re very strong in this vertical. And we’ve been very strong in this vertical for a long time. I’ll steal a bit of Chris’s thunder here, but the margins in this space are very attractive and we really like our service tail that this provides. Chris, you want to add anything?"
},
{
"speaker": "Chris Kuehn",
"content": "That’s where I was going to go, Dave. I think, again, these are generally highly customized applied systems when you’re talking about data centers for the most part. And so while we’re pricing for innovation, we’re also making sure we’ve got customers for life. These are customers that are putting in multiple locations, multiple data centers, and we want to make sure we have not only a solution for today’s order, but what that order can be a year, two years, five years from now. As all market projections would suggest that this is going to be a multiyear growth factor with the growth of data centers. And with that, to Dave’s ending point, the opportunity still in front of us is to think about services here, and with typical applied systems generating 8 times to 10 times of the revenue and services from a dollar of equipment, that’s still an opportunity well in front of us as we deploy products into this space and you’re starting to see that a bit in the revenues, but more of that in 2025 and 2026, that’s a nice opportunity still in front of us."
},
{
"speaker": "Joe Ritchie",
"content": "Got it. That’s helpful, guys. And then just my quick follow-up, resi HVAC growth this quarter was much better than what some of your other public peers have reported so far. So it looks like you took some share. I was just wondering, was there any disruption that you noticed with any of your public or non-public comps in the quarter? And I know, Dave, you referenced some of the reasons why you grew this quarter, but the growth was surprisingly good?"
},
{
"speaker": "David Regnery",
"content": "Yeah. I mean, the team executed very well. Look, I’ve been saying for a long time, Joe, you got to look at the share in residential over a longer period than just a quarter. So did you do better in a quarter? Tell me what you’ve done over the long-term. So I can’t comment on if there was any one of our other competitors that didn’t do well, I don’t know that. But I am very pleased with our results. But look, we’re cautiously optimistic here. Look at share over the long-term. Don’t just look at it on a quarter. There’s different sell-in models and you could get the wrong answer if you just look at a particular quarter. But I am very happy with the results that we’ve been able to demonstrate."
},
{
"speaker": "Joe Ritchie",
"content": "Okay, guys. Thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Steve Tusa with JPMorgan. Your line is open."
},
{
"speaker": "Steve Tusa",
"content": "Hey. Good morning."
},
{
"speaker": "David Regnery",
"content": "Hey, Steve. How are you?"
},
{
"speaker": "Chris Kuehn",
"content": "Good morning."
},
{
"speaker": "Steve Tusa",
"content": "Are you guys getting bored yet of putting up these kind of results?"
},
{
"speaker": "David Regnery",
"content": "Steve, I never get bored of putting up great results. It’s the flywheel that this talks about, right?"
},
{
"speaker": "Steve Tusa",
"content": "Yeah. Congrats on great execution and very strong results. Could we just get a breakdown of the difference between applied and unitary equipment in the quarter and then what you’re expecting for the second half in those two?"
},
{
"speaker": "Chris Kuehn",
"content": "Yeah. Steve, I’ll start. I’m happy with performance in both of those businesses with applied and unitary. I’d say both up strong. We talked about commercial HVAC revenues up over 20% in the quarter and both contributing to that. Equipment was up 30%, maybe unitary a bit stronger than applied, but not by much. Second half of the year, think of our -- I’ll start with commercial HVAC Americas, think of that all in about up 10% to 12% in the second half. I described earlier great performance last year in terms of tougher comps with the growth in revenue from call it mid-teens in the first quarter of last year to mid-20s by the fourth quarter of last year. That team’s going to have a great year this year. We’re even more excited about 90% of the backlog is commercial HVAC, the $2.8 billion that Dave spoke about that we already have for 2025 and beyond. That’s all equipment, we don’t have service in that backlog and that’s all commercial HVAC. So, it’s going to be a really strong follow-on to this year and it’s giving us a lot of confidence for growth going into next year. Hopefully, that kind of answers the question."
},
{
"speaker": "Steve Tusa",
"content": "And any -- will these diverge in the second half? I mean, it seems like, obviously, with the data center stuff, the applied business and the backlog-related businesses continue to grow really strongly, but the more short-cycle stuff maybe slows a bit given the tougher comps. Is that how we should think about it? Will they diverge a bit, unitary and applied?"
},
{
"speaker": "Chris Kuehn",
"content": "I don’t know if they’ll diverge a bit. I mean, with unitary maybe being up a second quarter, I think they’re going to be somewhat close to each other here in the second half. Services is going to be strong for the second half as well. We’re tracking, as we saw in the second quarter, in Americas business was up high-teens, enterprise was up mid-teens. That’s going to be a nice contributor to the second half as well, but I wouldn’t say that there’s going to be a big divergence in the second half."
},
{
"speaker": "David Regnery",
"content": "Yeah. I would agree."
},
{
"speaker": "Steve Tusa",
"content": "And then…"
},
{
"speaker": "David Regnery",
"content": "… because I think that…"
},
{
"speaker": "Steve Tusa",
"content": "Go ahead. Sorry."
},
{
"speaker": "David Regnery",
"content": "Yeah. Steve, I think that, again, when you talk about broad-based growth, right, different verticals are satisfied with different types of products. And if -- in this broad base that we continue to demonstrate results in, you could see that we’re growing both applied and unitary. Not that we look at the business that way because we’re really selling systems. But so our unitary, as Chris said, we were actually stronger in unitary in the second quarter than we were applied, despite the fact that we have very large backlogs in applied."
},
{
"speaker": "Steve Tusa",
"content": "One last question for you on the services growth. I mean, I usually think of services as being pretty solid growth, but more stable. These types of growth rates in services are obviously very strong. Credit to you guys. What is the key driver here? It seems like it’s more than just a run rate of recurring break, repair, stuff like that. Is there anything that’s standing out, because it just seems these types of growth rates, they’re not lumpy, but they’re just seemingly way higher than what you would consider to be a nice, steady services business?"
},
{
"speaker": "David Regnery",
"content": "Yeah. It’s a great question, Steve, and appreciate you noticing our high growth rates there. Just to remind everyone, we’ve had a compound annual growth rate over the last six years of high-single digits. In the second quarter, we were up mid-teens, right? And I -- I’ll just go back to our operating system, right? It’s a system of things that makes our service business great. For sure, it helps when you keep growing your applied installed base because our service business is really built around our applied installed base. But I would also tell you that the mindset that we have of an asset is not performing when it’s not heating or cooling properly and/or it’s using too much energy is a different way to think about it and there’s a lot of growth potential when you start thinking that way. So think about…"
},
{
"speaker": "Steve Tusa",
"content": "Okay. Thanks. Yeah. Thanks a lot."
},
{
"speaker": "David Regnery",
"content": "Okay, Steve. Thanks."
},
{
"speaker": "Operator",
"content": "Our next question comes in the line of Jeff Sprague with Vertical Research Partners. Your line is open."
},
{
"speaker": "Jeff Sprague",
"content": "Thanks. Good morning, everyone."
},
{
"speaker": "David Regnery",
"content": "Hi, Jeff. Good morning."
},
{
"speaker": "Jeff Sprague",
"content": "Hey. I hope everybody’s well. I want to come back to data centers too, maybe a little bit bigger picture, just competitive and customer behavior question. Obviously, you and your peers are talking about very strong growth. It seems like there’s plenty to go around. It also does look like you’re probably outgrowing them, but it’s hard to tell. The nature of my question is, are your customers in general and maybe the hyperscalers in particular standardizing on OEMs? You end up dominating hyperscaler A and carrier as hyperscaler B, or are we looking at mixed fleets based on what people can deliver at a point in time? Just give us a sense kind of in this almost gold rush to stand this stuff up, just how the competitive landscape and customer behavior is unfolding?"
},
{
"speaker": "David Regnery",
"content": "Yeah. I’d say hyperscales, first of all, they like technology and they like always pushing the envelope and trying to increase the efficiency of the system. So, they’re always working with us and they may be working with our competitors as well as to make sure that we can have a more efficient system tomorrow. And we have a lot of cool things that we’re working on there with them. Some of it includes some things that are maybe a little bit outside of that, which is the heat recovery side of things, which I’ve talked about in the past. Look, at the end of the day, these hyperscale customers, they like resiliency as well. So, they’ll typically pick a prime and then they’ll pick a secondary and that’s just prudent behavior on their behalf and we’ve seen that before, but I would tell you they really, really, really like innovative technologies."
},
{
"speaker": "Jeff Sprague",
"content": "And Dave, is there a way to think about just your available serve market here, dollars per megawatt deployed or some other metric as you try to really game plan for the capacity you need and the revenue trajectory you might be looking at? Any way you could help us frame that?"
},
{
"speaker": "David Regnery",
"content": "We have some internal models that I won’t share with you the results, but look, it’s allowed us to be able to help forecast based on talking to our customers, understanding what their demands are, okay. And then kind of pushing that back into what would it mean for us. I would tell you that think of units getting bigger, think of units getting more complex, and think of added features on units like heat recovery. That’s certainly a trend that we’re seeing and that’s certainly something that we’re working with our customers’ kind of pushing into the marketplace."
},
{
"speaker": "Jeff Sprague",
"content": "Okay. Great. I’ll leave it there. Thanks."
},
{
"speaker": "David Regnery",
"content": "Thanks, Jeff."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Nigel Coe with Wolfe Research. Your line is open."
},
{
"speaker": "Nigel Coe",
"content": "Thanks. Good morning, everyone. Great quarter…"
},
{
"speaker": "David Regnery",
"content": "Good morning, Nigel. How are you?"
},
{
"speaker": "Nigel Coe",
"content": "… obviously. Yeah. Good. Thanks. Look, everything’s really good. I’m going to focus on a couple areas that aren’t so great right now. So, Dave, in a world of down 15% trailer declines this year in NAFTA, how does TK Americas perform? And maybe just on top of that, to add in how the other verticals are performing, your bus rail, et cetera, and spare parts?"
},
{
"speaker": "David Regnery",
"content": "Yeah. It’s a fair question. Look, the Americas transport business is going to be down in 2014. It’s a more cyclical business than our commercial HVAC business. ACT is projecting the back half of the year to be down 25%. To be fair, our internal models say it could be down even a little bit more than that and that’s what we have baked into our full year guide. Look, I had the opportunity early in my career, Nigel, to run this business. And I would tell you that I’ve seen these downturns in the past. And I would tell you that these markets will come back. And right now it’s projected they’ll come back in 2015. We’ll stay tuned on that. But this is a very strong business. And when these markets come back, they’re going to come back strong. And the key is to continue to invest in the business when you’re in this down cycle. And when you do that, when the markets come back, you’re able to delight your customers with a portfolio of innovation that really allows you to win through that cycle and that’s what our plan is right now. As Chris said, we’ve been investing heavily in the business. We’re not stopping that. And TK is a big part of those investments that we’re making. And I’m excited about the innovation pipeline that’s going to come out in the Thermo King business and when the markets come back, we’re going to be ready. As far as the other businesses, I mean, they tend to follow a trailer, I mean, and the trailer is the big one, but they tend to follow that same cycle. We start to get freight rates to improve. If we start to get capacity coming out of the channel, we’ll see the market start to rebound and I know they will."
},
{
"speaker": "Nigel Coe",
"content": "Okay. They certainly will. Absolutely. So, would down mid- to high-teens be reasonable for TK Americas in the back half of the year?"
},
{
"speaker": "Chris Kuehn",
"content": "Nigel, this is Chris. Yeah. I mean, I think they could be down mid-single to high-single in the second half of the year. I mean, we expect it to be down probably in a range of low doubles, double digits on the year. If trailer markets are down mid-teens, we expect to outperform. And again, that’s the innovation and the investments we’ve had in this business for many, many years. And the key here is to make sure that while it is a down year and we’re going to manage the decrementals as so far we have, and we expect to do that for the balance of the year, it’s making sure that we’ve got the investment pipeline that continues to run the business. Just in June, we finished our long range plans for each of our business units, thinking about capacity and not only in commercial HVAC, but all of our businesses. And this is one that we like these markets to Dave’s point, want to make sure we’re still investing so that when the markets do recover, we’re ready. Could the market be down more than mid-teens? I mean, that’s what we’ve called it right now. To be fair, I know ACT’s had multiple revisions here over the last several months. I think it’s four or five this year already. Our internal models would suggest maybe it’s down a little more than that. So we’re making sure we bake that into our guide at this point. Second half of the year, we expect it to be down on down comps from a year prior, but we do expect to outperform the market."
},
{
"speaker": "Nigel Coe",
"content": "Okay. Guys, I had a follow-up question, but that was a great answer. So I’ll leave it there. Thanks a lots, guys."
},
{
"speaker": "David Regnery",
"content": "Okay. Thanks, Nigel."
},
{
"speaker": "Chris Kuehn",
"content": "Thanks."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Deane Dray with RBC. Your line is open."
},
{
"speaker": "Deane Dray",
"content": "Thank you. Good morning, everyone."
},
{
"speaker": "David Regnery",
"content": "Hey, Deane. How are you?"
},
{
"speaker": "Deane Dray",
"content": "I’m doing real well. Thank you. I just want to circle back on unitary. One of your competitors this quarter talked about making a push into the emergency replacement of unitary into that market where they said they really don’t have any share. How might the competitive dynamics change here and the economic returns? Just any comments from you would be helpful. Thanks."
},
{
"speaker": "David Regnery",
"content": "That’s a tough one for me to answer. I’m not sure what they’re planning on doing. I would tell you that we’re very strong in unitary as far as the replacement market goes. Yeah, in the heat of the summer, if the unit stops working, it needs to be replaced and having the available unit on hand is very, very important. And we carry a lot of inventory stock and we also have, with our lean thinking in manufacturing, quick ship programs, which allows us to really win in this space."
},
{
"speaker": "Deane Dray",
"content": "Is it fair to say that the emergency replacement market is basically half of the business today or is that overstated?"
},
{
"speaker": "David Regnery",
"content": "Yeah. I can’t comment on that and I think it would be -- it would really -- it would depend on the time of year, okay. You also have a planned replacement market as well. So there’s a lot of things that are part of that statement that you just made. So it really depends."
},
{
"speaker": "Deane Dray",
"content": "All right. I understand. That’s helpful. And then second question, any updates on all of the megaprojects? Are you seeing any bidding coming through? Any updates would be helpful. Thanks."
},
{
"speaker": "David Regnery",
"content": "Yeah. I mean, we continue to track megaprojects. And as I’ve said in the past, megaprojects tend to be in verticals that we were always strong in. So it’s hard to say what’s incremental in that space. But right now, our teams are tracking over 300 projects and some of them have been closed, but many of them are still in the pipeline. And one of the things about these megaprojects is they tend to have lots of different decision makers, especially if any of the semiconductor space that, I mean, I’ll give you an example. We had a project that the decision maker was in Asia, the engineer was in Seattle, Washington, and the mechanical was in Austin, Texas. And one of the advantages that we have with our direct sales force is we could really help the customer triage all the information that’s required. And it allows us to really be focused on the customer needs, but also all the different individuals that are part of that process. So we really like our positioning with these megaprojects. And a lot of these megaprojects are very sophisticated, engineered products, which actually plays to our strength as well."
},
{
"speaker": "Deane Dray",
"content": "Great. Thank you."
},
{
"speaker": "David Regnery",
"content": "Sure, Deane."
},
{
"speaker": "Operator",
"content": "Our final question comes from the line of Noah Kaye with Oppenheimer. Your line is open."
},
{
"speaker": "Noah Kaye",
"content": "Yeah. Thanks. I’ll just ask one question. And David, goes back to your opening comments around demand-side management as an underappreciated lever here. You’re sitting on one of the largest flexible capacity assets on the grid and you’re expanding your ability to play in distributed resource management and virtual power plants, district heating. I was hoping you could maybe connect the dots for us a bit more and just frame up how meaningful this is becoming in terms of some of the commercial HVAC bookings and revenue trends, how much they expand your wallet share, anything you can do to help quantify for us some of these additional facets of the business?"
},
{
"speaker": "David Regnery",
"content": "Well, I appreciate the question, Noah. I think we’re still in the early innings on this. I know we’re in the early innings. It’s more about an education process. We were working with a customer, a large customer in New York City and we created a digital twin for their particular building. And we were connected and we were watching the energy consumption. And we saved that particular customer, it may not sound like a lot, but it was like $120,000, right, in energy that they would have wasted if we weren’t connected to their solution. So, and you think about the universe, okay? If you think about the commercial space at 400 billion square feet, I mean, it’s crazy the opportunity that exists. So, look, this is a massive opportunity. Demand-side management, you’re going to hear a lot more about it. And the neat thing about it is you don’t have to wait for new technology to be developed, right? This is technology that’s readily…"
},
{
"speaker": "Noah Kaye",
"content": "Right."
},
{
"speaker": "David Regnery",
"content": "… available and being connected from a structured data standpoint, which we’ve been for a while, but now we’re adding in unstructured data with our AI tools. We’re able to really dial in algorithms to really help our customers save energy, which is saving carbon, which is good for the planet as well."
},
{
"speaker": "Noah Kaye",
"content": "Okay. Thank you. We’ll look forward to hearing more."
},
{
"speaker": "David Regnery",
"content": "All right. Thanks, Noah."
},
{
"speaker": "Operator",
"content": "I will now turn the call back over to Zac Nagle for closing remarks."
},
{
"speaker": "Zac Nagle",
"content": "We’d like to thank everyone for joining on today’s call. As always, we’ll be around for any questions that you may have. So, feel free to bring us up. And then in the coming months, we’ll be on the conference circuit, obviously, and we’ll hope to see some of you on the conference as well. So, thanks for joining, and have a great day."
},
{
"speaker": "Operator",
"content": "Ladies and gentlemen, that concludes today’s call. Thank you all for joining. You may now disconnect."
}
] |
tt | 2,024 | 1 | [
{
"speaker": "Operator",
"content": "Good morning. Welcome to the Trane Technologies' Q1 2024 Earnings Conference Call. My name is Briana, and I will be your operator for the call. The call will begin in a few moments with the speaker remarks and the Q&A session. [Operator Instructions] I will now turn the call over to Zac Nagle, Vice President of Investor Relations."
},
{
"speaker": "Zac Nagle",
"content": "Thanks, operator. Good morning, and thank you for joining us for Trane Technologies' First Quarter 2024 Earnings Conference Call. This call is being webcast on our website at tranetechnologies.com where you'll find the accompanying presentation. We're also recording and archiving this call on our website."
},
{
"speaker": "",
"content": "Please go to Slide 2. Statements made in today's call that are not historical facts are considered forward-looking statements and are made pursuant to the safe harbor provisions of federal securities law. Please see our SEC filings for a description of some of the factors that may cause our actual results to differ materially from anticipated results. This presentation also includes non-GAAP measures, which are explained in the financial tables attached to our news release."
},
{
"speaker": "",
"content": "Joining me on today's call are Dave Regnery, Chair and CEO; and Chris Kuehn, Executive Vice President and CFO. With that, I'll turn the call over to Dave."
},
{
"speaker": "David Regnery",
"content": "Thanks, Zac, and thanks, everyone, for joining today's call. As we begin, I'd like to spend a few minutes on our purpose-driven strategy, which drives our engaging, uplifting culture and enables our differentiated financial results over time. Our purpose is centered on creating a more sustainable world, and our strategy is aligned to powerful mega trends like energy efficiency, decarbonization and digital transformation."
},
{
"speaker": "",
"content": "Customer demand continues to increase as the need to address climate change becomes more urgent. We need creative solutions and game-changing innovation to bend the curve on global warming and that's where Trane Technologies leads. Our relentless innovation, proven business operating system and high-performing culture enables us to consistently deliver a leading growth profile, strong margins and powerful free cash flow. The end result is strong value creation across the board for our customers, our shareholders, our employees and for the planet."
},
{
"speaker": "",
"content": "Please turn to Slide #4. In the first quarter, we extended our track record of strong execution. Our global teams delivered robust performance across the board. Quarterly bookings of more than $5 billion were at an all-time high and up 17% organically. Organic revenues were up 14%. Adjusted operating margins were up 230 basis points and adjusted EPS was up 38%. First quarter bookings strength was again led by our Commercial HVAC businesses globally, which were up over 20% with growth in more than 30% in equipment and mid-teens in services."
},
{
"speaker": "",
"content": "Bookings in our Americas Commercial HVAC business were once again a standout, up 30% with more than 40% growth in equipment and more than 15% in services. Booking strength was broad-based with growth in nearly all vertical markets. We delivered exceptional bookings growth across our applied solutions, leveraging the power of our direct sales force, deep customer relationships and leading innovation to capitalize on increasing project complexity in high-growth verticals."
},
{
"speaker": "",
"content": "Our Commercial HVAC pipeline remains robust around the world, and we see tremendous growth opportunities well into the future. Our strong growth profile provides us with excellent optionality to accelerate key investments in 2024 while delivering strong leverage, EPS and free cash flow. And we put a number of high ROI investments in flight in the first quarter. With a focus on future growth, these investments include product innovation, increased capacity, sales and service excellence, digital and automation."
},
{
"speaker": "",
"content": "Our bookings performance further strengthens our position for 2024 and increasingly for 2025. Q1 ending backlog of $7.7 billion is up 10% from year-end 2023. And we increased our backlog for 2025 and beyond by $800 million to a total of $1.8 billion, increasing visibility to future growth. Based on our Q1 results and expectations for continued strong performance, we're raising our full year revenue and EPS guidance. Chris will cover the details in a few minutes."
},
{
"speaker": "",
"content": "Please go to Slide #5. Demand for our innovative solutions continues to be exceptional with a book-to-bill of 120% on strong organic revenue growth of 14%. In the Americas segment, our Commercial HVAC business delivered strong performance across the board. Bookings were up 30% in the quarter and up over 60% on a 3-year stack, led by our applied solutions portfolio, which we estimate carries an 8 to 10 multiplier of higher-margin services revenue over the life of the equipment."
},
{
"speaker": "",
"content": "Backlog for applied solutions continues to grow, which bodes well for future growth. Commercial HVAC revenues were up mid-20s with more than 35% growth in equipment and mid-teens growth in services. The compounding of services revenue year after year provides strong growth in good times and is resilient in more challenging macro conditions. We're investing heavily in sales and services excellence programs, strengthen our business for the long term."
},
{
"speaker": "",
"content": "Turning to residential. Bookings were down low single digits and revenues were up low single digits. The business performed stronger than our initial expectations for Q1, and we're cautiously optimistic moving forward. Our transport businesses performed as expected, with bookings down low single digits and revenues down mid-teens. While we see the down cycle in transport as modest overall, the business is facing tough comps from 2023, a plus 20% growth comp in the first half and a down 20% growth comp in the second half, which impacts the OpEx in the near term."
},
{
"speaker": "",
"content": "In 2024, we expect to see a soft first half and a strong second half. Turning to EMEA. The region performed in line with our expectations. Commercial HVAC bookings and revenues were strong, up low teens and up high single digits, respectively, while transport bookings and revenues were down low single digits. The book-to-bill was very strong at approximately 120%."
},
{
"speaker": "",
"content": "Turning to Asia. The team delivered strong performance consistent with our expectations for the quarter. China remains very strong, with bookings up more than 20% and revenues up high teens. Asia's book-to-bill was also very strong at approximately 120%. Now I'd like to turn the call over to Chris. Chris?"
},
{
"speaker": "Christopher Kuehn",
"content": "Thanks, Dave. Please turn to Slide #6. This slide provides a snapshot of our performance in the first quarter and highlight strong execution top to bottom. Organic revenues were up 14%, adjusted EBITDA and operating margins were up 200 basis points and 230 basis points, respectively, and adjusted EPS was up 38%. At an enterprise level, we delivered strong organic revenue growth in equipment and services, both up low teens."
},
{
"speaker": "",
"content": "Our high-performance flywheel continues to pay dividends, with relentless investments in innovation, driving strong top line growth, margin expansion and EPS growth."
},
{
"speaker": "",
"content": "Please turn to Slide #7. At the enterprise level, we delivered robust volume growth with strong incrementals, positive price realization and productivity that more than offset inflation. In our Americas segment, we delivered about 12 points of volume and about 3 points price, with our Americas Commercial HVAC business delivering very strong volume growth of approximately 20 points."
},
{
"speaker": "",
"content": "Strong adjusted operating margin expansion of 240 basis points was driven by strength in our Commercial HVAC business, which more than offset the expected impact from revenue decline in our transport business. In our EMEA segment, we delivered about 3 points of volume and about 1 point of price with stronger volume in our Commercial HVAC business. Adjusted operating margins were up 30 basis points for the segment and stronger when you consider the impact of acquisitions and FX in the quarter."
},
{
"speaker": "",
"content": "Excluding FX currency losses related to the devaluation in the Egyptian pound in the quarter, EMEA EBITDA margins would have been 19.5%. The Asia segment delivered mid-teens revenue growth almost exclusively from higher volumes. Strong volume, productivity and modest price contributed to 310 basis points of adjusted operating margin expansion. We reinvested heavily back into each business in the first quarter and expect to ramp these investments through the year to drive growth well into the future."
},
{
"speaker": "",
"content": "Now I'd like to turn the call back over to Dave. Dave?"
},
{
"speaker": "David Regnery",
"content": "Thanks, Chris. Please turn to Slide #8. Our end market segment and business unit outlook is largely unchanged from our Q4 earnings call with a couple of notable differences. First, our Americas Commercial HVAC business had a very strong quarter, stronger than we expected despite a tough comp of mid-teens revenue growth in the first quarter of 2023. We're encouraged by the strong start for the business, especially when you take into account the exceptional 30% bookings growth and 125% book-to-bill ratio on mid-20s revenue growth in the quarter."
},
{
"speaker": "",
"content": "We expect the Americas Commercial HVAC business to remain strong throughout 2024 versus increasingly tough comps from 2023 as we move throughout the year. Second, our residential business performed stronger than we expected in the first quarter. We expect the business to be down modestly on continued destocking, and we believe the EPA clarification on sell-through helped to mitigate some of the independent wholesale distributors concern heading into this season."
},
{
"speaker": "",
"content": "While we're pleased with the results, the first quarter for residential is typically a very small percentage of the year and doesn't provide a sufficient read through to the balance of the season. We believe it's prudent to move through Q2 and gain more visibility before extrapolating too much from Q1. All other businesses performed as expected, and the outlook for the year are unchanged. We provided additional details on the slide for your reference."
},
{
"speaker": "",
"content": "Now I'd like to turn the call back over to Chris. Chris?"
},
{
"speaker": "Christopher Kuehn",
"content": "Thanks, Dave. Please turn to Slide #9. Our initial 2024 guidance reflected optimism about key end markets and our ability to outperform. While we're only 1 quarter in, our exceptional bookings, revenues and backlog in our Commercial HVAC businesses strengthen our conviction that 2024 will be another year of robust top line and bottom line growth."
},
{
"speaker": "",
"content": "We're raising our organic revenue guidance by 2 percentage points to 8% to 9% from 6% to 7% prior. We're also raising our full year adjusted earnings per share guidance by $0.30 at the midpoint and raising the low end of our guidance range above the high end of our prior guidance range. Our new adjusted EPS guidance range is narrowed to $10.40 to $10.50, up from $10 to $10.30 prior. Embedded in our guidance is our philosophy around our value creation flywheel, which builds in relentless high levels of business reinvestment to drive end market outgrowth, healthy leverage and strong free cash flow."
},
{
"speaker": "",
"content": "We expect to see investments continue to ramp in the second quarter and into the back half of the year, accompanied by leading growth and strong incrementals. We continue to expect about 1 point of growth from M&A in 2024 with a negative impact of approximately $30 million to adjusted operating income for the full year or a negative impact of about 5 points to reported leverage versus organic leverage."
},
{
"speaker": "",
"content": "The impact is primarily related to the technology acquisition, Nuvolo which carries noncash accelerated intangibles amortization of approximately $25 million, plus year 1 acquisition and integration-related costs."
},
{
"speaker": "",
"content": "We also expect a negative impact to revenues of about 1 percentage point from FX in 2024. FX is expected to offset the point of M&A revenue growth on a reported basis meaning our organic and reported revenue growth guidance is now the same at 8% to 9% for 2024. There's no change to our organic leverage target of 25% plus for the year, consistent with our stated long-term target."
},
{
"speaker": "",
"content": "Turning to cash. We had a strong start to free cash flow generation in the first quarter, and we expect 2024 to be another year of free cash flow conversion of 100% or greater. For the second quarter, we expect revenue growth of approximately 8.5% and adjusted EPS of approximately $3.05."
},
{
"speaker": "",
"content": "Please see Page 17 for additional information that may be helpful for modeling purposes. Please go to Slide #10. We remain committed to our balanced capital allocation strategy, focused on consistently deploying excess cash to opportunities with the highest returns for shareholders. First, we continue to strengthen our core business through relentless business reinvestment. Second, we're committed to maintaining a strong balance sheet that provides us with continued optionality as our markets evolve."
},
{
"speaker": "",
"content": "Third, we expect to consistently deploy 100% of excess cash over time. Our balanced approach includes strategic M&A to further improve long-term shareholder returns and share repurchases as the stock trades below our calculated intrinsic value. Please turn to Slide #11, and I'll provide an update on our 2024 capital deployment."
},
{
"speaker": "",
"content": "Year-to-date through April, we've deployed $540 million in cash with $190 million to dividends and $350 million to share repurchases. We have $2.1 billion remaining under the current share repurchase authorization, providing us with strong optionality as our shares remain attractive, trading below our calculated intrinsic value."
},
{
"speaker": "",
"content": "Our M&A pipeline remains active. We continue to see potential opportunities for value-accretive M&A as we did in 2023 where we made key, strategic investments to accelerate our progress across energy services and digital solutions, industrial process cooling and precision temperature control technology."
},
{
"speaker": "",
"content": "For 2024, we expect to deploy approximately $2.5 billion in cash. Our strong free cash flow, liquidity and balance sheet give us excellent capital allocation optionality moving forward. Now I'd like to turn the call back over to Dave. Dave?"
},
{
"speaker": "David Regnery",
"content": "Thanks, Chris. Please go to Slide #13. As discussed, our transport performance in Q1 was as expected, and there's no change to our outlook for the year. The overall markets are expected to be down modestly, and we expect to outperform in both regions. We've continued to provide this slide in the deck for your reference. Please turn to Slide #14. We operate our transport business for the long term. And while we're moving through a modest downturn in 2024, this is a great business with a bright future. ACT projects a strong trailer market rebound from 2024 into 2025, up 19% and project continued growth through their forecast horizon in 2029."
},
{
"speaker": "",
"content": "We have a diversified transport business globally with opportunities to grow across the portfolio, with leading innovation, strong execution through our business operating system and a world-class dealer network, we're well positioned to outperform in any market environment."
},
{
"speaker": "",
"content": "Please go to Slide #15. In summary, we are well positioned to drive differentiated growth and value over time. Our leading innovation, proven business operating system and unmatched culture enables us to consistently deliver top quartile financial performance over the long term while continuing to reinvest in our business. And I believe our best days are ahead. We have the team, the strategy and the track record to deliver a leading performance in 2024 and differentiated shareholder returns over the long term."
},
{
"speaker": "",
"content": "And now we'd be happy to take your questions. Operator?"
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Your first question comes from Andy Kaplowitz with Citigroup."
},
{
"speaker": "Andrew Kaplowitz",
"content": "Dave, can you give us a little more color into your order momentum and backlog growth? You obviously enjoyed significant acceleration orders and you mentioned strength in applied. So can you give us any more color to how much of the continued Americas orders acceleration is coming from data centers. Do you think you can continue to grow your backlog from here? And maybe your thoughts on the duration of this order cycle if it is, in fact, data center-led?"
},
{
"speaker": "David Regnery",
"content": "Yes. Thanks for the question, Andy, good question. Look, in the quarter, we saw a broad-based growth -- and it wasn't concentrated necessarily in any 1 vertical. I mean, we certainly had strength in data centers. We certainly have strengthen in education, health care, high-tech industrials. It was almost hard for us to find a vertical that we didn't grow in. We did have a bit of weakness, and I guess you would say, conventional office and some in lodging. But for the most part, it was broad-based growth, and it was really on a global level."
},
{
"speaker": "",
"content": "So a lot of strength in our Commercial HVAC businesses. And the good news is our pipeline is also very strong. So this would be before an order actually comes in to be a booking, this is what our sales teams are working on. That continues to be very strong as well. So look, it's a lot of innovation. I'm certainly proud of what the team's been able to deliver, and we're executing at a very high level right now."
},
{
"speaker": "Andrew Kaplowitz",
"content": "David, definitely, I can appreciate that. So on that note, organic incremental margins continue to trend higher than your 25%. Given the strength in your markets and the overall ability to execute, why isn't 30% or 35% as you've been able to record for a while now, the new 25% for Trane? And then where are you on, let's say, the slope of productivity projects that you've been undertaking? Because we know you've been really focused on productivity after not being able to do as much during the pandemic."
},
{
"speaker": "Christopher Kuehn",
"content": "Andy, it's Chris. I'll start and then Dave may jump in. So as we think about the first quarter, investments back into the business began to ramp really stronger into February and March than, say, the start of the quarter and our run rate exiting Q1 is stronger than when we started. The pipeline for investments continues to grow. And these are across multiple categories."
},
{
"speaker": "",
"content": "So to your question, we really like the long-term framework of the 25% or better incrementals. That's what we're continuing to guide for 2024. But the investment pipeline and where we can see the market outgrowth here and the order rates and the revenue rates, I think, just tells us we want to keep investing back in the business. Think of these investments, again, around innovation, sales and service investments that Dave talked about in the comments."
},
{
"speaker": "",
"content": "These are upfront tools as well as people investments, making sure we've got capacity investments, automation in the factory; digital, the list goes on, and we want to make sure we're always funding back into the business. On the productivity side, we're not there yet. We're getting better on the gross productivity, but there's still more opportunities for us going forward."
},
{
"speaker": "Operator",
"content": "Your next question comes from Scott Davis with Melius Research."
},
{
"speaker": "Scott Davis",
"content": "Guys just following up on Andy's question a little bit. But can you mark to market where you're at on data center capability? I know you made that investment in liquid stack. I think it's called -- do you have kind of -- are you developing kind of soup to nuts capabilities in the data center to be able to handle some of these newer, hotter chips?"
},
{
"speaker": "David Regnery",
"content": "Yes. Great question, Scott. I think we've been very well positioned in data center vertical for a long time. And I think you know this, but technology tends to move pretty fast in this vertical compared to others. And we're certainly aware of these new technologies that are being developed really at the terminal side of cooling. So think of that as direct cooling to the chip or think of it as emerging cooling at the rack level."
},
{
"speaker": "",
"content": "One of the things that we do really, really well at Trane Technologies is we think about systems. And if you think about a data center's cooling systems, you need to think about the entire system. So some of it certainly is what we would call the terminal side, and that's what we just referred to. But these systems also require sophisticated air handling. They also require high efficiency chillers, and we look at the entire system to really help the customer think through the entire energy needs for the whole data center."
},
{
"speaker": "",
"content": "The other thing that's really emerging, you're going to hear more about this is we think of the data center, think of it as a thermal management system. So I know you know this, but when you're cooling a space, you're removing heat from it. Data centers have a lot of heat. What do you do with that heat that you're removing?"
},
{
"speaker": "",
"content": "Conventional thinking would be it gets emitted back out into the atmosphere. But how can you repurpose that heat, and we've done some projects still early stages here, where we're creating district heating loops from the heat that would normally just be wasted and reusing it as an asset. So it's a very dynamic space. It's obviously growing at a nice clip. It will grow at a nice rate for the continued future and we're spot in the middle of it, and it's always been a very strong vertical and it will be in the future."
},
{
"speaker": "Scott Davis",
"content": "That makes sense, Dave. And just a little bit of a pie in the sky here. But does it make more sense to think about you guys in a data center partnering with somebody like Vertiv or explicitly competing against them because it seems like you both have very different capabilities, but obviously overlap on some critical apps there."
},
{
"speaker": "",
"content": "So how do you guys think about that opportunity when you think about these giant, giant about like a 1-gigawatt data center, something where the engineering capabilities would presumably almost rely on maybe more than 1 supplier, not just 1. Is that accurate, Dave? Or am I thinking about it wrong?"
},
{
"speaker": "David Regnery",
"content": "Yes. I wouldn't call out any particular company here, but I would tell you that we have technology partners that we work with because you're spot on. It's a cooling system, right. It's no different than think about a system that exists within a building, right, we may not have every component, but we would have a partner that would have that component, but we would help integrate it into a system that would be operating in an efficient way for the customer."
},
{
"speaker": "Scott Davis",
"content": "Best of luck guys, congrats on this start for the year."
},
{
"speaker": "Operator",
"content": "Your next question comes from Julian Mitchell with Barclays."
},
{
"speaker": "Julian Mitchell",
"content": "Maybe just a first question on the organic sales guide for the year. So it looks like the first half, you're up maybe about 11% based on the guidance, the full year you've got up sort of high singles, so second half is there at maybe 6% or so. Is the way to think about that and understand we haven't yet seen cooling season and so forth. But is the way to think about that revenue guide framework, it's a big slowdown in commercial HVAC versus Q1 because of the extremely tough comps -- because I would have thought resi and TK would look better year-on-year sales in the back half versus the first half. So with the total enterprise sort of going from 11% to 6%, is it just really that Commercial HVAC piece just battling the tough comps?"
},
{
"speaker": "Christopher Kuehn",
"content": "Julian, it's Chris. I'll start. It is tough comps for Commercial HVAC and especially the Americas. They're going to have a great year on a full year basis. But when you think about go back a year in the first quarter of 2023, the growth there in Commercial HVAC Americas is around mid-teens. And then by the fourth quarter of last year, the growth was mid-20s."
},
{
"speaker": "",
"content": "So think of that as a 10-point increase in terms of growth and revenue throughout last year. So the comps do get tougher as we work through 2024. But again, they're going to have an outstanding year this year. But you're right, it is a bit of the tough comps in Commercial HVAC."
},
{
"speaker": "",
"content": "Transport Americas, we do expect the second half to be stronger than the first half. That is also due to tough comps. The business was up 20% the first half of '23, down 20% in the second half of '23. So the comps get easier as we go throughout the year. But you're right, you've dialed it in a little bit there. And look, we feel comfortable with the guide that we put out there now and our ability to meet or exceed that guide on the full year."
},
{
"speaker": "",
"content": "Let us get through another quarter of results here in the second quarter. As you know, the first quarter within Trane Technologies is generally our smallest quarter of the year. Let us get through the second quarter. We'll have a better insight on the second half of the year at that time. We feel very confident with the guide that we just released today."
},
{
"speaker": "Julian Mitchell",
"content": "And maybe just my follow-up would be on the sort of price and price/mix outlook. So I think in the first quarter, maybe price was about a 2-point tailwind to revenue. Maybe remind us kind of what you're embedding for the year as a whole. And has there been any shift in the expectations on the sort of price/mix tailwind in light commercial and resi HVAC from the refrigerant change in the sort of various EPA movements on that?"
},
{
"speaker": "Christopher Kuehn",
"content": "Julian. So in the first quarter, at an enterprise level, we delivered about 3 points of price, those comps get tougher as we move throughout the year as we start getting to a little bit more of a normalization of price. Think of the full year now, we're guiding to about 2 points of price, was certainly a question on the call that we had a few months ago in our full year guide on price."
},
{
"speaker": "",
"content": "We thought we could maybe do a little bit better there. And delivering on Q1 gives us the confidence to raise our full year revenue by 2 points. Think of that as a point of price and a point of volume. In the Americas, we led with price in the Americas, that's generally been the model within the company and within that Commercial HVAC would have been stronger."
},
{
"speaker": "",
"content": "As we think about price/mix and maybe inflation a bit, we're very confident in terms of delivering the 20 or 30 basis points, maybe better in terms of price/cost, price versus inflation on the full year. That's one of the best parts, if I think about our business operating system has been our ability to remain nimble with pricing. We've got the right inputs. And as we think about commodities and how they kind of play out over the next year to 2 years, remaining nimble in terms of pricing is something that [indiscernible] offering. Your comment on residential. We're not -- Dave, do you want to cover that?"
},
{
"speaker": "David Regnery",
"content": "Yes, we don't have a lot of 454B at least in the Americas, built into our guide, okay. We're obviously ready from a product standpoint, we'll be launching those products as we go through the year, but we're not anticipating a lot of volume in 2024, and we'll see how the year progresses for 2025."
},
{
"speaker": "",
"content": "On -- one of the things, too, on 454B is, I saw a couple of pre comments come out about being a new refrigerant. I just want to make sure everyone's clear. We've been using 454B in Europe for over 2 years now. So this is not a new refrigerant for Trane Technologies. We're very comfortable with the refrigerant and we've had in our portfolio for some time. A lot of it's baked in America [indiscernible]."
},
{
"speaker": "Operator",
"content": "Your next question comes from Gautam Khanna with TD Cowen."
},
{
"speaker": "Gautam Khanna",
"content": "Great results. I wanted to ask if you could opine again on what you think happens with resi -- average resi pricing next year given the 454 transition. You still think it's up kind of 10% to 15%? Or just how would you characterize..."
},
{
"speaker": "David Regnery",
"content": "It's a good question, Gautam. Look, we don't anticipate a lot of 454B product in 2024, as I just said. That will obviously ramp up in 2025. We're not projecting 2025 yet. From a pricing standpoint, we're going to -- we'll announce pricing when we release the products. But I think what you've heard from others is probably in the ballpark as to what to expect from a pricing standpoint. We're going to see how the year plays out, okay?"
},
{
"speaker": "",
"content": "We don't see a big pre-buy happening in -- at the end of the year for 410. Maybe you'll get maybe a minor one with some high runners. So it's really going to be -- nobody wants to get stuck with inventory. And it's just -- we have to watch out to see how the balance plays out, and we'll give you an update as we move through the year."
},
{
"speaker": "Operator",
"content": "Your next question comes from Joe Ritchie with Goldman Sachs."
},
{
"speaker": "Joseph Ritchie",
"content": "Yes, stellar results. Just -- maybe just taking it back to the data center discussion for a second. Is there a way to maybe parse out or range or on a relative basis, kind of give us like any sense for your dollar content on a data center and what the opportunity is?"
},
{
"speaker": "David Regnery",
"content": "Yes. You start talking about averages, which are always dangerous, Joe. I mean I've read reports where people have estimated the 3% to 5% range. In some cases, I'd say they're in the ballpark, and then you get into some hyperscale that may have a different configuration. But it's not that far off. Look, we're very strong in this vertical. We have been for a while, and it's going to have a lot of growth in the future, which is exciting. But understand, it's one vertical of many verticals that we play in. And in the first quarter, we had broad-based strategy. So it wasn't just focused on data centers."
},
{
"speaker": "Joseph Ritchie",
"content": "Got it. That's helpful, Dave. And maybe the follow-on question for the other things that are strong, right, you had an electrical peer throughout a $1.2 trillion mega project number today. It seems like there's just a lot of investment on the comp. At the same time, like you do have some other funding like ESSER funding as an example that might be coming down. So just maybe high level, just talk to us about what you see in terms of like your quoting activity? Or what do you see coming through the pipe over the next couple of years?"
},
{
"speaker": "David Regnery",
"content": "Yes. I'll start with mega projects. I mean I think that mega projects are happening in verticals that we've always been very strong in. So it's always difficult to say what's additive versus what's ongoing strength in a particular vertical. That said, our team is tracking over 300 mega projects. And we've had some orders that have been received. However, the majority are still in the pipeline as these are typically longer duration projects to close."
},
{
"speaker": "",
"content": "A lot of these projects that are deemed as mega projects are global in nature, which gives us really a competitive advantage with our direct sales force because we're able to triage decision makers and provide technical support in different parts of the world. So well in tune to what's happening with mega projects. As far as ESSER goes, look, ESSER funding, the way it's designed right now, you can take an order up until September of this year, and it has to be fulfilled within the first quarter of 2026."
},
{
"speaker": "",
"content": "And we've done very well with ESSER funding, but we don't believe that the whole education vertical stops after ESSER funding. There's also IRA funding that's available. And there's, of course, the municipal bond process that's always been very robust in the past. So look, the education vertical has always been strong for Trane Technologies, expected to be strong in the future as well."
},
{
"speaker": "Operator",
"content": "Your next question comes from Steve Tusa with JPMorgan."
},
{
"speaker": "C. Stephen Tusa",
"content": "Some very nice orders. Congrats. Can you just talk about what you're seeing on applied versus light commercial, just orders and revenues?"
},
{
"speaker": "David Regnery",
"content": "Yes. I mean, obviously, in the Americas, which I think is where your question is focused, we were very strong in equipment overall. I mean our order rate for equipment was up over 40%. And we saw strength really in both applied and unitary. And in the past, I've said applied has been a lot stronger. This time, they were pretty close. So there's a lot of strength out there. And that makes sense because if you look, we had broad-based growth across really almost all verticals. And a lot of those verticals are served with different applications. So it was very strong."
},
{
"speaker": "C. Stephen Tusa",
"content": "And I guess what are -- are there particular verticals in like commercial that you think your gaining share in because your main peer had orders down pretty dramatically there."
},
{
"speaker": "David Regnery",
"content": "Yes. I don't -- I can't speak to a competitor because you get comps from 1 year to another. I would just tell you that it broad-based, you're going to have some verticals that are more on the applied side but some verticals are more on the unitary side."
},
{
"speaker": "",
"content": "So think about education, it's probably a 50-50 split. Conventional office typically tends to be more on the unitary side, not always, but tends to be -- retail will be on the rooftop side. But look, we're very happy with the performance we had in Q1. And I don't remember a quarter when I was talking about 40% order growth and it was as broad-based as we saw in Q1."
},
{
"speaker": "C. Stephen Tusa",
"content": "Right. And then just 1 last one, on resi. Can you just break down the -- in that business for the quarter, just the price/mix and volume for the quarter?"
},
{
"speaker": "Christopher Kuehn",
"content": "Yes, Steve. Revenues were up low single digits, think of them as very low numbers, contributing price volume in terms of residential. It's just -- we start getting a [ lot of ] small numbers there in up low single digits. It did better than we expected, as Dave talked to earlier, think of price is really de minimis, maybe volume was up around 1% for resi. But let's see, we're just starting the cooling season here. Let's get through another quarter, and we'll see how the year plays out for residential."
},
{
"speaker": "Operator",
"content": "Your next question comes from Deane Dray with RBC Capital Markets."
},
{
"speaker": "Deane Dray",
"content": "So those were pretty positive comments coming out of China. So could you kind of give us a sense of where the demand is, the outlook? Because we have heard some mixed signals about at best stabilizing, but it sounds like you're seeing some pretty strong growth."
},
{
"speaker": "David Regnery",
"content": "Yes. The team there continues to execute at a very high level, very seasoned team, been in place for -- they have a lot of tenure with the company, a lot of strength in pharmaceutical, health care, high-tech, data centers, which is really where our portfolio plays well with our applied systems. Very happy with what we saw. Now China is a small percentage of the enterprise in the 5% range, but a lot of strength there, which is encouraging."
},
{
"speaker": "Deane Dray",
"content": "That's real helpful. And then can you give us a sense of where you stand on your services mix, refresh us on the target? And how do you think that plays out for this year?"
},
{
"speaker": "David Regnery",
"content": "It's a great question. I was telling, Chris, I think we're going to -- in the Americas, we always said our service business was 50% service and 50% equipment. But with our equipment growth, we got to go back and look at the calculation. Look, we had a very strong services business in the Q1 at a global level, it was up in the low teens. In the Americas, it was up over 15% and there's a compounding effect that's going on there. And this is the sixth year where we've had service growth of low single digits."
},
{
"speaker": "",
"content": "So it's -- we've invested heavily in this. I think it's one of the areas that sometimes gets underappreciated in Trane Technologies. But I'd tell you, it's 1/3 of our business. It's very resilient, and it is an enabler and that team continues to execute at a very high level and expect it in the future as well."
},
{
"speaker": "Christopher Kuehn",
"content": "Deane, the 6 years, up high single digits growth in services, last year was up double digits, and Dave keeps pressuring us to kind of move to the double digits. But I'll tell you, it's -- the resiliency as he called out and we like the margins there and a nice start to the year in the business."
},
{
"speaker": "Operator",
"content": "Your next question comes from Nigel Coe with Wolfe Research."
},
{
"speaker": "Nigel Coe",
"content": "And I don't often say this, but a great quarter, fantastic results. I guess -- I'm sorry, I've been going back and forth on the different calls here. So maybe just step back, I mean, what surprised you to the upside this quarter? I mean, obviously, organic came a lot better, really strong Commercial HVAC trends. But specifically, what really surprised you during this quarter? Was it just backlog conversion? Anything -- any color there would be helpful."
},
{
"speaker": "David Regnery",
"content": "Yes. I think there was really 2 things that were to the upside. One was our commercial HVAC business in the Americas. It really performed better than expectations. Just a lot of demand for our innovative products and the team executed extremely well. The other upside was in our residential business. Look, we thought that was a business that was going to be down low single digits, maybe even mid-single digits in the beginning of the year for Q1 with destocking that was going to occur."
},
{
"speaker": "",
"content": "I think that where we kind of got help there was the EPA coming out with their clarification on the sell-through for 410 and gave confidence to our independent wholesale distributors that they should be stocking up and getting ready for the season, which is what we saw. So those would be the 2 big areas that kind of where we saw the upside. The rest of the world really played out the way we thought."
},
{
"speaker": "",
"content": "Europe, strength in our Commercial HVAC business continues. Our Thermo King business, look, it's going to be a modest downturn in Thermo King in the year, we'll do better than the markets, but that's exactly what we saw play out in the first quarter. Asia, pretty much as we thought, maybe a little bit stronger in our commercial HVAC business, but it really played out as expected in the rest of the world."
},
{
"speaker": "Nigel Coe",
"content": "And then my follow-on is just the stand out here is just the resilience of the Commercial HVAC orders and backlog, especially in the backdrop of such weak [indiscernible] ABI et cetera. So just wondering, are there -- obviously, there's pockets of strength in data center, et cetera, but is there increasing evidence of just more proactive replacement demand, CO2 emission targets really driving demand? Any color?"
},
{
"speaker": "David Regnery",
"content": "Yes. I can't answer that specifically. I haven't looked that way. But I would tell you that we continue to see a very strong pipeline. And so this would be what our sales force is actually are working on that they're putting in our CRM systems. And that remains very robust. So there's a lot of activity out there. And I hear the disconnect, too, when you look at ABI or some of the other macro numbers, you just have to look at -- we don't look at just one, okay. You have to look at several and some are aligned to one vertical versus another vertical. But look, we saw a very strong demand broad-based and the pipelines are still strong."
},
{
"speaker": "Operator",
"content": "Your next question comes from Andrew Obin with Bank of America."
},
{
"speaker": "Andrew Obin",
"content": "Can you hear me?"
},
{
"speaker": "David Regnery",
"content": "I can."
},
{
"speaker": "Andrew Obin",
"content": "Just a question. As we think about cooling for semiconductor plants and data centers, right? It seems that the scale of the project, it's going up. And the question I have for that, a, does this provide an opportunity to provide more sophisticated solution to your customers and also to capture more value to Trane? And second, what are you doing to your aftermarket support organization to take advantage of that?"
},
{
"speaker": "David Regnery",
"content": "Yes. We talked a little bit about data centers earlier. But look, this is a vertical that tends to move faster from a technology adoption than others."
},
{
"speaker": "",
"content": "And we're working closely with partners and data center customers to understand what the trends are, and I would tell you, we're right in the middle of it. In the data center, Andrew, look at the entire system, okay?"
},
{
"speaker": "",
"content": "We like to look at things at a system level. And you're hearing a lot right now on the terminal side of data center. So that would be like direct cooling to the chip or immersion cooling. We look at the entire system. So the air handling side of it as well as the sophisticated chillers, the high-efficiency chillers with next-gen refrigerants that are also required."
},
{
"speaker": "",
"content": "I think where you're going to hear a little bit more is on the thermal management side of a data center. They produce a lot of heat that heat is taken out of the data center, how can you repurpose it. And that's some of the technology that we're in discussions, kind of at a thought leadership level as to how we can take an asset and -- or heat and turn it into an asset in the future."
},
{
"speaker": "Andrew Obin",
"content": "Yes. My question, I think, was more basic. I was just thinking that these systems are bigger and more complex, they're more energy hungry. So more opportunity for -- more need for your customers to partner up with you and more opportunity for you to sort of provide these packaged energy-saving solution. That's where I was going."
},
{
"speaker": "David Regnery",
"content": "You're right on, Andrew, all opportunities, and it's a growing vertical."
},
{
"speaker": "Andrew Obin",
"content": "Got you. And then just a follow-up on M&A. You guys have been pretty active over the past couple of years. But looking at the market, the market is on to the fact that once we get manufacturing, clean rooms, biopharma, all the areas you guys have been focusing on, but these I think, are getting hot, pardon my pun. So what's the environment looking like for these bolt-on? What's your ability to sort of pursue targets at recent valuations? What does the pipeline look right now? What are you interested in?"
},
{
"speaker": "Christopher Kuehn",
"content": "Andrew, I'll start. It's Chris. Yes, pipeline remains very active. It's Sometimes episodic when an M&A transaction closes. So quarter-by-quarter, maybe hard to call. But over the course of the year, I think the pipeline remains very active. We're very happy with the acquisitions we've done over, say, the last 18, 24 months, right? You properly described them as a bolt-on bit of strategy. Think of that around investments in the channel and investments in technology."
},
{
"speaker": "",
"content": "And in some cases, it's both. It's taking a great technology that has a limited channel and applying it to our deep channels in Europe and/or in the Americas. We've been very successful with that strategy. As it looks at the pipeline today, we're going to remain disciplined. We've got our hurdle rates. And as we think about what's constructive to be EPS accretive in 3 years, ROIC accretive in 3 years."
},
{
"speaker": "",
"content": "But I'll tell you that we've got a great balance sheet to really deploy to not only acquisitions but also deploy if the cash isn't available for M&A over to share repurchases as we see the stock trading below our calculated intrinsic value."
},
{
"speaker": "",
"content": "So if you go back even 6, 7 years ago with an acquisition in Europe with Thermocold, then it really started out with our more pipe chillers and thermal management systems and how that's grown over time now, I think to our sixth or seventh generation of thermal management systems, it tells you that we can take that early-stage technology and really grow it over a longer period of time."
},
{
"speaker": "",
"content": "We've got the people, we have a great sales team. We have a great service team. That's where some of those investments are going as well this year is to make sure we have all the infrastructure and support to keep growing those businesses."
},
{
"speaker": "",
"content": "And I'll tell you, we've got a great team in each of our regions that can integrate acquisitions. When you think about the challenge of an acquisition, a lot of time, it's the success is depending on how well you integrate. We don't think of it as Trane Technologies is acquiring and let's take our best of Trane to the business. It really is also what are we learning from the business we just acquired and bring it into our organization."
},
{
"speaker": "",
"content": "And I'll tell you some of our recent acquisitions, it's spot on with taking the learnings of the businesses we've acquired, bring them into the Trane family and how do we replicate that across 40, 50 plants across the globe. So I'll tell you where we're bullish in this area. So I'd just say the pipeline remains strong."
},
{
"speaker": "Operator",
"content": "Your final question comes from Noah Kaye with Oppenheimer."
},
{
"speaker": "Noah Kaye",
"content": "Dave, this is going to be a broad question, but it goes to what you discussed around the increase in complexity in applied. When we think about the customer value proposition, and I understand there are many dimensions, it's going to differ across verticals. How does the increasing complexity play into the customer value proposition? Maybe give us the 2 or 3 biggest dimensions that, that really speaks to and where that creates a sustainable competitive differentiation for the company."
},
{
"speaker": "David Regnery",
"content": "Yes, great question, Noah. I think it all starts with our direct sales force that's highly technical, right, they understand the applications and a lot of times, helping the customer think through what the best solution is for whatever their need may be."
},
{
"speaker": "",
"content": "I always tell people we don't sell products, we sell solutions. And that's the way our account managers behave with customers. We don't -- and as the sophistication of these products continue to increase, obviously, our strength shines, not really on a global basis."
},
{
"speaker": "",
"content": "A lot of the decision-makers on -- especially some of these mega projects right now are on a global basis. And because we have this direct sales force globally, we're able to really triage the decision-makers and help them think through the technical side. And then, of course, the downstream effect is -- these products are more sophisticated, they require OEM service in the future. So there's a long tail associated with these applied systems that we're selling."
},
{
"speaker": "",
"content": "And we're investing heavily, too. It's not like people sometimes think about, as I say, we're investing in capacity. They think of it as just the plant, okay, that's part of our capacity investment, but we're also investing heavily in training of our direct sales force, adding to our direct sales force, adding to our service technicians, adding to our engineer skill set, adding to our critical to close process, adding to our back offices to make sure we have the right customer support. So it's all inclusive but it really -- the sophistication of these systems as they become more and more engineered, really just plays into the strength we have as Trane Technologies."
},
{
"speaker": "Noah Kaye",
"content": "And the follow-up is really around the attach rate of services to those projects, right. I think you've answered it in part, but just quantitatively how do we think about services attach rates for applied at this point? And where those grow to as you see the increasing complexity of the projects you're working on?"
},
{
"speaker": "David Regnery",
"content": "As I said in my opening remarks, we think about an applied system, you can think about an 8 to 10x multiplier of services over the life of that system. And we want to be connected to the system, okay?"
},
{
"speaker": "",
"content": "So the -- it's no longer just a break/fix. This is all connected solutions. And by the way, the customer wants us connected to the solution. They want to make sure that it's -- their asset is always performing the way it was designed. I was telling a group earlier this week that it's no longer the system isn't operating properly. The system is using too much energy, but we were able to detect that. And that's where the sophistication goes both ways. It's on the application of the system, but then how you monitor and service that system is also increasing in complexity, and we're right in the leading edge there."
},
{
"speaker": "Operator",
"content": "There are no further questions at this time. I will now turn the call back to Zac Nagle for closing remarks."
},
{
"speaker": "Zac Nagle",
"content": "I'd like to thank everyone for joining today's call. We'll be around, as always, for any questions that you may have in the coming days and weeks, and we look forward to seeing many of you on the road or actually at our headquarters in some cases, in the near future here. So thanks again, and have a great day."
},
{
"speaker": "Operator",
"content": "This concludes today's conference call. You may now disconnect."
}
] |
ttwo | 2,024 | 4 | [
{
"speaker": "Operator",
"content": "Greetings and welcome to the Take-Two Fourth Quarter and Fiscal Year 2024 Earnings Call. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Nicole Shevins, Senior Vice President of Investor Relations and Corporate Communications. Thank you. You may begin."
},
{
"speaker": "Nicole Shevins",
"content": "Good afternoon. Thank you for joining our conference call to discuss our results for the Fourth Quarter and Fiscal Year 2024 ended March 31, 2024. Today's call will be led by Strauss Zelnick, Take-Two’s Chairman and Chief Executive Officer; Karl Slatoff, our President; and Lainie Goldstein, our Chief Financial Officer. We will be available to answer your questions during the Q&A session following our prepared remarks. Before we begin, I'd like to remind everyone that statements made during this call that are not historical facts are considered forward-looking statements under federal securities laws. These forward-looking statements are based on the beliefs of our management, as well as assumptions made by and information currently available to us. We have no obligation to update these forward-looking statements. Actual operating results may vary significantly from these forward-looking statements based on a variety of factors. These important factors are described in our filings with the SEC, including the company's most recent Annual Report on Form 10-K and quarterly report on Form 10-Q, including the risks summarized in the section entitled Risk Factors. I'd also like to note that unless otherwise stated, all numbers we will be discussing today are GAAP and all comparisons are year-over-year. Additional details regarding our actual results and outlook are contained in our press release, including the items that our management uses internally to adjust our GAAP financial results in order to evaluate our operating performance. Our press release also contains a reconciliation of any non-GAAP financial measure to the most comparable GAAP measure. In addition, we have posted to our website a slide deck that visually presents our results and financial outlook. Our press release and filings with the SEC may be obtained from our website at take2games.com. And now I'll turn the call over to Strauss."
},
{
"speaker": "Strauss Zelnick",
"content": "Thanks, Nicole. Good afternoon and thank you for joining us today. I'm pleased to report that we concluded fiscal 2024 with strength, including net bookings of $1.35 billion, which exceeded the high end of our guidance range. Contributing to our positive results was the outperformance of NBA 2K24, Zynga's in-app purchases, led by Toon Blast and our newest hit, Match Factory, and the Red Dead Redemption and Grand Theft Auto series. During Fiscal 2024, we generated net bookings of $5.33 billion, driven by our high quality titles and our ability to engage consistently our player communities. With fiscal 2025 underway, our portfolio is gaining momentum and we have many exciting releases planned for the year. We expect net bookings to be in the range of $5.55 billion to $5.65 billion, representing 5% year-over-year growth. Our outlook reflects a narrowing of Rockstar Games' previously established window of Calendar 2025 to fall of Calendar 2025 for Grand Theft Auto VI. We're highly confident that Rockstar Games will deliver an unparalleled entertainment experience and our expectations for the commercial impact of the title continue to increase. As we release our groundbreaking pipeline, we expect to achieve tremendous growth, including sequential increases in net bookings in fiscal 2025, 2026, and 2027. We've been executing our substantial cost reduction program, which we now anticipate will result in over $165 million of annual cost savings from our current and future expenses. This will enable us to run our business more efficiently and achieve greater operating leverage as our large-scale titles come to market. Now turning to our performance during the quarter. NBA 2K24, which remains the number one basketball simulation experience in our industry, surpassed our expectations as players responded to our promotions, in-game content strategy, and updates within seasons. To-date, the title has sold in over 9 million units. Engagement remains high with nearly 2 million consumers playing daily. Our industry-leading NBA 2K brand also continues to expand its audience through several innovative mobile experiences including NBA 2K24 MyTEAM, the new free-to-download mobile experience that allows players to sync progress between console and mobile devices, as they play their favorite MyTEAM modes on the go, NBA 2K Mobile and NBA 2K24 Arcade Edition, which is consistently in the top five on Apple Arcade. The Grand Theft Auto series delivered another fantastic quarter, partially driven by an array of free content updates for Grand Theft Auto Online, including new vehicles, drag races, holiday themed items to celebrate Lunar New Year and Valentine's Day, new community series jobs, and more. Unit sales for Grand Theft Auto V exceeded our forecast, and to-date the title is sold in approximately 200 million units worldwide. We're thrilled that more than a decade after their initial releases, Grand Theft Auto V and Grand Theft Auto Online grew their audience size by an incredible 35% and 23% respectively for the full year. Grand Theft Auto V also reclaimed its top spot as the most watched video game across all platforms according to StreamHatchet, thanks largely to the tremendous viewership from the series' thriving role-play community. Rockstar’s premium subscription service, GTA+, also continues to grow, with membership for the quarter almost doubling over the same period in the prior year as Rockstar continues to add valuable benefits to players. Red Dead Redemption 2 also surpassed our expectations and has sold-in nearly 64 million units worldwide. We continue to expand the audience for the series, with Red Dead Redemption and Undead Nightmare, recently added to the roster of games included within the GTA+ library. Borderlands 3 outpaced our forecasts and we are thrilled that Randy Pitchford and Gearbox Entertainment are slated to join officially 2K’s renowned internal studios in the coming weeks. We have already identified many potential growth opportunities for the Borderlands series and Gearbox’s catalog, which we plan to pursue once the studio is integrated into our organization. We are also excited to see growing buzz for the star-studded Borderlands feature film which is planned for release by Lionsgate this summer. WWE 2K24 has been a resounding success and is the highest rated sports simulation of 2024. The title is also the highest-rated installment in the history of our popular wrestling franchise on Xbox, with an 83 average Metacritic score. Engagement has been exceptional with players logging over 11 million hours across more than 110 million played matches. In addition, the [40 years] (ph) of WrestleMania Pack has the highest attach rate for a Super Deluxe DLC in the series’ history, with more than 25% of WWE 2K24 players owning it. 2K and Visual Concepts are continuing to support the title and will have additional packs launching throughout the Fall. I’d like to thank our friends, Nick Kahn and Ari Emanuel over at WWE, TKO, and WME for their continued support. Additionally, I’d like to express our immense gratitude to our team at Visual Concepts for their outstanding work on our WWE 2K and NBA 2K franchises, which are both important annual contributors for our Company. Zynga delivered outstanding results for the period, led by robust in-app purchases. Match Factory is accelerating and proving to be a hit, already establishing itself as a Top 20 grossing game in the US Apple App Store and reaching millions of new users with its launch on the Google Play store. We are pleased that new bold beats and other exciting features have propelled average daily play time to around 60 minutes per user. Toon Blast maintained its positive momentum, achieving nearly 20% growth of in-app purchases compared to the third quarter, driven by a new Dragons’ Treasure competition and many other features. We’d like to congratulate the team at Peak for their incredible performance. Top Troops launched several content updates, as well as a major cross-media collaboration with the popular influencer, MrBeast. The team plans to release additional enhancements to core gameplay and progression systems to drive further growth. Momentum continues at Rollic, with the studio crossing 3.5 billion all-time downloads and announcing a new partnership with Mattel to introduce a mass-market Barbie mobile game later this calendar year. Our blended monetization efforts in hyper-casual are progressing well within Rollic, which has resulted in Twisted Tangle and Screw Jam both becoming Top-100 grossing games on the U.S. Apple App Store. Our direct-to-consumer business continues to grow, and our teams are working actively to add more titles each quarter to this highly accretive, owned distribution channel. Looking ahead, Zynga has numerous titles in development and soft launch that we are eager to release worldwide this fiscal year, including Star Wars Hunters and Game of Thrones: Legends. In closing, I am highly confident in our business, led by our top creative talent, our industry leading portfolio of owned intellectual property, our sound balance sheet and our increasingly efficient infrastructure. Our teams are laser-focused on our core tenets of creativity, innovation, and efficiency, and as we deliver our ground-breaking pipeline over the next several years, we are poised also to deliver industry-leading growth and shareholder returns. I will now turn the call over to Karl."
},
{
"speaker": "Karl Slatoff",
"content": "Thanks, Strauss. I’d like to thank our teams for their dedication and hard work as we continue to build the foundation for our future which we believe is more promising than ever. We are extremely excited about our upcoming pipeline which includes approximately 40 titles through Fiscal 2027. Our updated release schedule reflects the actions of our recent cost-reduction program, through which we cancelled several titles to focus our efforts and resources on the franchises we believe represent our best opportunities to achieve significant critical and commercial success. These titles did not include any of our core franchises and were not expected to materially affect our net bookings growth. Turning to Fiscal 2025, we have 16 titles in our pipeline, three of which have already been released. We have seven immersive core titles, including TopSpin, NBA and WWE 2K25, and the next iteration in one of 2K’s biggest and most beloved franchises, with the first details coming in just a few short weeks at Summer Games Fest Kickoff Live. Of these titles, TopSpin 2K25 was released by 2K and Hangar 13 on April 26. The revival of our popular tennis franchise has been well-received by critics and provides deep personalization, iconic venues, and industry-leading gameplay. With TopSpin 2K25, we continue to broaden our sports offerings, and 2K will support the title with season packs throughout the year. We have two independent titles from Private Division, the first of which is Moon Studio’s No Rest for the Wicked, which launched on April 18th into Early Access on PC. This new ARPG was well received for its visceral combat, distinct art style and rich narrative. Private Division, along with Wētā Workshop, also announced Tales of the Shire: A The Lord of the Rings Game, which is planned for release later this year. The teams recently revealed a new trailer for this cozy, hobbit life sim, which is set in the Middle-earth universe of J.R.R. Tolkien. We have five mobile titles, including NFL 2K Playmakers, Star Wars Hunters, and Game of Thrones Legends. NFL 2K Playmakers was released on April 23rd by 2K and Cat Daddy Games for iOS and Android devices. In this non-simulation tactical card battle players can collect NFL player cards to assemble an exciting roster, while also experiencing a variety of game modes and features. We’re proud to add NFL 2K Playmakers to our ever-growing mobile portfolio in partnership with the NFL and the NFL Player’s Association. Lastly, we have two new iterations of prior releases planned for the year. As always, our labels will continue to provide new content and experiences that drive engagement and recurrent consumer spending across many of our key offerings. Looking ahead, our pipeline for Fiscal 2026 and 2027 has 24 titles planned, including, l5 immersive core releases, six of which are sports simulation games, one independent title; five mobile games; and three new iterations of previously-released titles. In closing, we believe that the many opportunities ahead of us will deliver a period of meaningful long-term growth, margin expansion, and shareholder returns. I’ll now turn the call over to Lainie."
},
{
"speaker": "Lainie Goldstein",
"content": "Thanks Karl and good afternoon everyone. We delivered a strong finish to Fiscal 2024 and are entering Fiscal 2025 with momentum, including healthy trends across our key franchises. Throughout the year, we released successful hit titles, engaged players with a steady cadence of in-game content, and continued to position our organization for the long-term. We also deepened our commitment to efficiency and made some decisions that, while difficult will align our resources with the initiatives for which we have the highest levels of conviction. We are confident that, over time these steps will drive our scale, enhance our margins, and deliver industry-leading returns for our shareholders. I’d like to thank our teams for their vision, passion, and dedication. Turning to our results, we delivered fourth quarter net bookings of $1.35 billion, which was above our guidance range of $1.27 billion to $1.32 billion. This reflected better-than-expected results from NBA 2K24; Zynga’s in-app purchases, led by Toon Blast and Match Factory; the Red Dead Redemption series and the Grand Theft Auto series. Recurrent consumer spending declined 2% for the period and accounted for 79% of net bookings. This was above our outlook, driven by the outperformance of NBA 2K, Toon Blast, and Match Factory. Recurrent consumer spending declined for Grand Theft Auto Online, although it was up for virtual currency and GTA+. NBA 2K was in-line with the prior year; and mobile increased slightly. During the quarter, we successfully launched WWE 2K24, which demonstrates 2K and Visual Concept’s ability to raise the bar further for our popular wrestling series. GAAP net revenue decreased 3% to $1.4 billion, while cost of revenue declined 24% to $930 million and included an impairment charge of $304 million related to acquired intangible assets. Operating expenses increased by 244% to $3.2 billion, due to a goodwill impairment charge of $2.2 billion and $93 million of business reorganization expenses related to our recently announced cost-reduction program. On a management basis, operating expenses rose 20% year-over-year, which was slightly above our guidance, due to higher personnel and IT expenses, and professional fees. For fiscal 2024, we achieved net bookings of $5.33 billion, which was slightly above our revised guidance range of $5.25 billion to $5.3 billion. Recurrent consumer spending grew 2%, which exceeded our outlook, and accounted for 78% of net bookings. Recurrent consumer spending for mobile increased high single-digits; NBA 2K virtual currency and seasons was up slightly; and Grand Theft Auto Online virtual currency and GTA+ membership was flat. Non-GAAP Adjusted Unrestricted Operating Cash Flow was $42 million as compared to our outlook of approximately $100 million due to higher external developer advances, cash tax and interest payments. We spent approximately $142 million on capital expenditures, primarily for game technology and office build outs. GAAP net revenue was flat at $5.35 billion, and cost of revenue increased 1% to $3.1 billion, which included an impairment charge of $577 million related to acquired intangible assets. Operating expenses increased 69% to $5.8 billion, due to an impairment charge of $2.3 billion related to goodwill and a $105 million business reorganization charge related to our cost-reduction programs. On a management basis, operating expenses rose 15% year-over-year and were slightly above our guidance, due to the factors I mentioned earlier that affected the fourth quarter. Today, we provided our outlook for Fiscal 2025. We project net bookings to range from $5.55 billion to $5.65 billion, which represents 5% growth over Fiscal 2024. The largest contributors to net bookings are expected to be NBA 2K, the Grand Theft Auto series, Toon Blast, Empires & Puzzles, our hyper-casual mobile portfolio, Match Factory, the Red Dead Redemption series, an unannounced immersive core title from 2K, and Words With Friends. We expect recurrent consumer spending to be up approximately 3% compared to fiscal 2024, and to represent 76% of net bookings. Our recurrent consumer spending forecast assumes high single-digit growth for mobile, a slight increase for NBA 2K, and a decline for Grand Theft Auto Online. We expect the net bookings breakdown from our labels to be roughly 50% Zynga, 31% 2K, 17% Rockstar Games, and 2% Other. And, we forecast our geographic net bookings split to be about 60% United States and 40% International. We expect Non-GAAP adjusted unrestricted operating cash flow to be an outflow of $200 million, and we plan to deploy approximately $140 million for capital expenditures, primarily for game technology and office buildouts. We expect GAAP net revenue to range from $5.57 billion to $5.67 billion and cost of revenue to range from $2.43 billion to $2.46 billion. Turning to operating expenses, we recently implemented a cost reduction program that is expected to deliver over $165 million of annual cost savings across our entire business. As part of these efforts, we have eliminated several projects in development that we did not anticipate would meet our financial benchmarks. We also took actions to streamline our organizational structure, which reduced both existing headcount and future hiring needs. Our total operating expenses are expected to range from $3.56 billion to $3.58 billion as compared to $5.83 billion last year. On a management basis, we expect operating expense growth of approximately 7% year-over-year, which is largely due to an increase in ongoing marketing support for Match Factory, as well as other mobile and immersive core launches planned for the year, partially offset by savings from our cost reduction program. Looking ahead, and as Strauss mentioned earlier, we have narrowed the previously established release window for Grand Theft Auto VI to Fall of Calendar 2025 from Calendar 2025. As development advances, our confidence in the title and its potential commercial impact continue to grow. That said, we are not providing specific guidance beyond fiscal 2025, as our release schedule includes numerous titles each year and even modest shifts can have a significant effect on results in any given period. Our outlook for the lifetime value of our pipeline remains as strong as ever and we expect sequential growth in net bookings in Fiscal 2025, 2026, and 2027. Now, moving onto our guidance for the fiscal first quarter. We project net bookings to range from $1.2 billion to $1.25 billion, compared to $1.2 billion in the first quarter last year. Our release slate for the quarter includes TopSpin 2K25, No Rest for the Wicked on Early Access for PC and NFL 2K Playmakers, all of which have already released, and Star Wars Hunters. The largest contributors to Net Bookings are expected to be NBA 2K, the Grand Theft Auto series, Toon Blast, Empires & Puzzles, our hyper-casual mobile portfolio, Match Factory, the Red Dead Redemption series, Words With Friends, and Zynga Poker. We project recurrent consumer spending to increase by approximately 1%, which assumes mid single-digit growth in mobile, flat results for NBA 2K, and a decline for Grand Theft Auto Online. We expect GAAP net revenue to range from $1.3 billion to $1.35 billion. Operating expenses are planned to range from $928 million to $938 million. On a management basis, operating expenses are expected to grow by approximately 14% year-over-year, which is primarily driven by additional marketing for Match Factory, partially offset by our cost reduction program. In closing, we believe that we are very well positioned to deliver the highest quality content in our industry and to enhance our profitability, as we grow our scale and maintain our focus on efficiency. We are extremely excited about our path for the future, and we look forward to sharing more details about the many catalysts ahead for our Company. Thank you. I’ll now turn the call back to Strauss."
},
{
"speaker": "Strauss Zelnick",
"content": "Thanks, Lainie and Karl. On behalf of our entire management team, I'd like to thank our colleagues for their dedication to our business and for creating the highest quality, most engaging entertainment franchises to captivate our global audiences. And to our shareholders, I want to express our appreciation for your continued support. We'll now take your questions. Operator?"
},
{
"speaker": "Operator",
"content": "Thank you. We will now be conducting a question-and-answer session. [Operator Instructions] Our first question comes from the line of Eric Handler with Roth MKM. Please proceed with your question."
},
{
"speaker": "Eric Handler",
"content": "Good afternoon. Thanks for the question. Strauss, I wonder if you could talk a little bit about the Gearbox acquisition. In the past, you've expressed that you never really felt the need to own all of gearbox here you are about to own all of Gearbox. Can you talk about how you think about now owning all of Gearbox and some of the opportunities that you have with that?"
},
{
"speaker": "Strauss Zelnick",
"content": "Thanks, Eric. What I was referring to is when asked, when Gearbox was sold to Embracer whether that caused us to have any concern, my response was no because we have a long-term publishing agreement, and that's been mutually beneficial for our company and for Gearbox and as it was for Embracer. However, when the opportunity presented itself for us to acquire the company on terms that we felt were reasonable, we frankly jumped at the opportunity. We have all the respect in the world for Randy Pitchford and his team. He has the ability to bring AAA products to market, responsibly and on a very reliable and rather rapid cadence. And he is a hit maker. And it's very hard to make a new hit, and [Tiny Tino] (ph) was a new hit. And of course, Borderlands just goes from strength to strength. So we're thrilled to have Gearbox in the family."
},
{
"speaker": "Eric Handler",
"content": "Okay. And then, Lainie, with regards to the annual cost savings that you announced, how much of that should be seen in fiscal '25?"
},
{
"speaker": "Lainie Goldstein",
"content": "So we'll start to see it in fiscal '25, but we'll see a full annualization of it in fiscal year '26. So the majority of the plan was executed in Q4 and Q1, but pieces of it will come through this year."
},
{
"speaker": "Operator",
"content": "And our next question comes from the line of Doug Creutz with TD Cowen. Please proceed with your question."
},
{
"speaker": "Doug Creutz",
"content": "Hi, thank you. The ability of Rollic to launch top 100 grossing games is a really pleasant surprise. Just wondering if you could talk about how to think about the life cycle of those games. Typically, Rollic's games are sort of -- they're hot for a while and then they move on to something next, something else. Is this going to be the case for these monetizing games as well? Or is it a plan to have a longer life cycle. Thank you."
},
{
"speaker": "Strauss Zelnick",
"content": "Undoubtedly, this so-called hybrid casual approach should lead to longer life cycles because the hypercasual approach really was put it out there, get a bunch of downloads offer a rather light experience, generate advertising revenue, have the users move on to the next. And that was great while it lasted, but long-term entertainment businesses are all driven by great content. And Rollic's proving that it has the ability with its partner studios to do just that and to deliver content that is durable and long lasting. It remains to be seen whether we can truly create forever franchises at Rollic. I believe we can. We haven't done so yet, but we are off to a really good start."
},
{
"speaker": "Doug Creutz",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "And our next question comes from the line of Colin Sebastian with Baird. Please proceed with your question."
},
{
"speaker": "Colin Sebastian",
"content": "Thanks, good afternoon. Maybe a couple for me. I guess, first off on the change to the guidance and the outlook. What is your level of confidence, Strauss, in the calendar '25 launch of GTA VI. And is there anything else more specific you can talk about that's behind that postponement. And then secondly, on the high single-digit mobile growth. I'm curious how much of that is related to any recovery you're seeing broadly in mobile gaming? Or is that more specific to the increase in marketing spend and these titles that are outperforming your expectations for this year? Thank you."
},
{
"speaker": "Strauss Zelnick",
"content": "Thanks, Colin. We actually narrowed calendar 2025 to fall of 2025, and we feel really good about that release date. And obviously, we feel great about the title that is to come. And with regard to mobile, what we do at Zynga because we are a market leader, of course, is driven by the market in which we live. And it is gratifying that after a down year and then a slightly down year we're heading into a flatter up year for the industry. Obviously, though, what's driving our expected results would be our hits, including Match Factory!, which is performing really, really well. And we said that we were spending a lot on UA in the fourth quarter we did, and that's turned out to be productive spending."
},
{
"speaker": "Colin Sebastian",
"content": "All right. Thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Matthew Cost with Morgan Stanley. Please proceed with your question."
},
{
"speaker": "Matthew Cost",
"content": "Hi, everyone. Thanks for taking my question. I guess between the success you've had with Match Factory! and some new launch titles setting release date for Star Wars Hunters and then the incremental marketing behind mobile. It seems like there is definitely more momentum in that business, which is great to see. I guess when we think about your analytical framework for investing in the marketing behind mobile, what are you targeting from a margin or payback perspective? And when should we expect to see this investment turn into a profitable flow-through from the mobile side?"
},
{
"speaker": "Strauss Zelnick",
"content": "So I hope like everyone else, we look at the very same metrics, which is cost of acquisition, what kind of retention you expect which is to say what kind of churn you get. The spending that you have on average and therefore the lifetime value. And the longer payback period you're willing to accept, of course the more risk you take in those calculations because they're all based on extrapolating from current data and past data and they change at any given time. So I'm not prepared to share sort of our outside payback period. Suffice to say, though that we want to have a great deal of confidence that we're looking at a positive LTV."
},
{
"speaker": "Matthew Cost",
"content": "Great. Thank you. And when would you expect to see mobile this investment that you’re making in mobile flip from a cost center due to driving incremental profit?"
},
{
"speaker": "Strauss Zelnick",
"content": "So of course, our mobile division is profitable. I understand what you're asking which is frankly, just another way of asking the same question you asked before, which I decline to answer. However, I do give you extra credit points for rephrasing it in a way that I might dive into it. However -- so we don't share our exact payback periods. We do however tailor our user acquisition spending so that we expect a meaningfully positive LTV in a period of time such that we have confidence that even if we're wrong, we're not so wrong that we're not making money. I hope that clarifies it a bit."
},
{
"speaker": "Matthew Cost",
"content": "Okay, thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Drew Crum with Stifel. Please proceed with your question."
},
{
"speaker": "Drew Crum",
"content": "Thanks. Hi guys, good afternoon. So could you address your forecast for NBA 2K RCS in fiscal '25 for a slight increase, is low single digits growth the new normal for this going forward? Or is there something unique in fiscal '25 that's influencing that view? Thanks."
},
{
"speaker": "Karl Slatoff",
"content": "So we absolutely expect growth in NBA. And that's not just on the RCS side but also on the full game sales side as well. This year is a little bit more challenging because we are still in the transition from Gen 8 to Gen 9. And Gen 9 is outperforming our expectations and doing fantastically well. I'd say we're a little bit more challenged on the Gen 8 side. As we continue to transition, I think we are going to see more tailwinds than headwinds in that regard. And when you look at the recurring consumer spending, specifically when you look at it specifically as it relates to Gen 9, it's off the chart. It is fantastic. So we’ve seen significant growth there. So again, I think we will have momentum just as we transition to Gen 9 and as people continue to engage more deeply in the game, we’re going to continue to see very strong RCS growth."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Benjamin Soff with Deutsche Bank. Please proceed with your question."
},
{
"speaker": "Benjamin Soff",
"content": "Hi guys. Thanks for the question. I was wondering if you guys could talk a little bit more about the change in bookings this year versus what you guys were talking about last quarter, how much comes from moving GTA versus any other shifts versus the restructuring? And then, yes, I guess I'll stop there. Thanks."
},
{
"speaker": "Lainie Goldstein",
"content": "So for fiscal year '25, the outlook reflects a narrowing of Rockstar Games previously established window from the calendar 2025 to fall, as we mentioned, also some other movements within the release schedule and also with our cost-cutting plan that is also part of the overall results for that year."
},
{
"speaker": "Benjamin Soff",
"content": "Got it. And then a housekeeping question. Does your current outlook reflects the acquisition of Gearbox, or is that going to be updated next quarter after it's closed?"
},
{
"speaker": "Lainie Goldstein",
"content": "No, it is not included since the transaction hasn't closed yet. So we will expect to include it next quarter when we close, and we expect it to be slightly accretive to our management results."
},
{
"speaker": "Benjamin Soff",
"content": "Okay. That’s helpful, thanks guys."
},
{
"speaker": "Operator",
"content": "The next question comes from the line of Martin Yang with Oppenheimer. Please proceed with your question."
},
{
"speaker": "Martin Yang",
"content": "Hi, thank you for taking my question. First question on statistics. With a narrow window of release, is there any associated changes to your plan regarding the live service portion of GTA 6."
},
{
"speaker": "Strauss Zelnick",
"content": "So Rockstar hasn't given any details on what its expectations are for the release. It's been a wonderful trailer that they put out that broke the Internet, and more news will come from Rockstar in the fullness of time."
},
{
"speaker": "Martin Yang",
"content": "Thank you. I have a second question on NBA. How is NBA's transition challenges in between console generations compared to other annually releasing titles on the market, either from 2K or from other external competitors? And do you attribute the challenges to mostly to 2K or to market?"
},
{
"speaker": "Karl Slatoff",
"content": "I'm sorry, was your question about the transition from console generation from the last transition to this transition?"
},
{
"speaker": "Martin Yang",
"content": "Right."
},
{
"speaker": "Karl Slatoff",
"content": "Okay. So that's going back quite some time. And frankly, I don't have the exact figures in front of me. But generally speaking, I would say that the delta between the games in this year, the Gen 8 game is much broader. And I think that creates a more obvious difference between the two-- to do two games. And frankly, I can't remember if we had two completely separate games back then. But in any case, the Delta is quite significant this time around. So I would expect that the transition is more the effect of the transition is more pronounced in this console generation. And I forget your second question. Was there another one?"
},
{
"speaker": "Martin Yang",
"content": "On this [indiscernible] how does it compare to other studios with annual recurring --."
},
{
"speaker": "Karl Slatoff",
"content": "Yes. We're not really commenting on our competitors. And most of our other studios, we don't have as much NBA comes out every year. So you're going to see that transition more rightly. We don't have the same effect in most of our other games. Occasionally, we would, but they wouldn't be comparable games to NBA anyway. And again, like I said we don't really comment about the -- our competitors and their experiences."
},
{
"speaker": "Martin Yang",
"content": "Got it. Thanks Karl."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Mike Hickey with Benchmark. Please proceed with your question."
},
{
"speaker": "Mike Hickey",
"content": "Hi Strauss, Karl, Lainie and Nicole. Congrats on the quarter. Strauss, in your prepared comments, you mentioned that your expectations for the commercial impact from GTA 6 and increased. I'm just curious if you could explain what's driving that up to enthusiasm for the game. And then the second question on your guidance, curious why you're not providing medium-term. You've done that before, and it feels like here you have at least better visibility on the primary catalysts driving that growth. And then on [2027] (ph) tying into that question, I'm wondering where your confidence is that you can grow sequentially [2026] (ph). Is that sort of primarily the GTA ecosystem driving that growth in '27, or is it a combination of that and other AAA games that you plan to release. Thanks guys."
},
{
"speaker": "Strauss Zelnick",
"content": "Thanks, Mike, for those questions. I think our confidence continues to increase just because Grand Theft Auto V continues to perform so well. We've now sold in over 200 million units. And every quarter, we continue to be pleased by the ongoing sales of the full game and engagement in the past fiscal year with Grand Theft Auto V was up about 35% with Grand Theft Auto Online was up about 23%, I believe. That's extraordinary growth at this stage again more than 10 years after the initial release. So I think we feel as though the market's anticipation is at a fever pitch. And of course expectations are very high everywhere in this boardroom and all around the world for the perfection of what Rockstar typically delivers. In terms of your question, I think you were asking your second question, why didn't we provide very specific guidance for a top-line number going forward? And the answer is, generally speaking, we have not done that except when it was necessary to clarify where we felt the company was going. We think now we are being very specific about this fiscal year and about the next couple of fiscal years by saying we expect relating to your third question, sequential growth on top-line. And we think that pretty much answers the question. Finally, the second part of your third question is that driven by the GTA ecosystem. The answer is certainly, we have expectations for that ecosystem. And again, given that full game sales continue to be strong for GTA V this many years later. At the same time, we also have a number of other powerful releases coming about which we're highly optimistic. And of course we have [car hits] (ph) in the marketplace. Match Factory is a huge hit and only accelerating."
},
{
"speaker": "Mike Hickey",
"content": "Thanks, Strauss. Good luck guys."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Eric Sheridan with Goldman Sachs. Please proceed with your question."
},
{
"speaker": "Eric Sheridan",
"content": "Thanks so much for taking the question. Maybe I can just ask a big picture one that's two parts. When you come out of the activity you just went through in terms of reevaluating your pipeline and looking at resource allocation across the organization what were some of the key learnings on right, the right mix of content is for you guys to meet your hurdle rate going forward? And what were some of the key learnings of how much of the resource allocation decisions are now setting the company up on a multiyear view? Or do you think there are going to be a continued refinement as you look to marry resources and the IP pipeline in the years ahead? Thanks so much."
},
{
"speaker": "Karl Slatoff",
"content": "So in terms of looking at our pipeline, I mean this is not really new to us. This is a process that we go through that we've been going through for at least the last 17 years as I've been here. And -- but what we're looking for specifically around this -- the look that we just took is that we're looking look -- we understand in the industry right now that the biggest games are winning, and they're taking more share. And that's obviously a fact that we noticed and take us very seriously. We're simply looking for the projects that we think have the highest chance for commercial success and for critical success. And going through and coming through those and going through and then making the tough choices. It's always difficult to cancel any projects. But in this context, it was something that was necessary and really part of our normalized process. So we absolutely expect that, that will continue in the future. This was a pretty tough look and a pretty big look. So I think most of that is behind us. But we will be adding, and we will be subtracting over the next few years, and that's part of what we do. And it will be both with will continue to invest in new IP as well. That is not off the table for us. That's very important. That's the life level blood of the industry. And if you're not investing in new IP, we think it's a biggest [stack] (ph)."
},
{
"speaker": "Operator",
"content": "The next question comes from the line of Jason Basmo with Citi. Please proceed with question."
},
{
"speaker": "Jason Bazinet",
"content": "I just had one question on GTA VI. This narrowing from calendar '25 to the fall of 25%. Do you think there's an ancillary benefit of that of sort of syncing up with the holiday season? Or do you feel like GTA is such a powerful franchise that it really doesn't confer any sort of incremental benefit ."
},
{
"speaker": "Strauss Zelnick",
"content": "While it probably doesn't matter, I think we'd all rather be in the release window that we're looking at now."
},
{
"speaker": "Jason Bazinet",
"content": "Okay, thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of James Heaney with Jefferies. Please proceed with your question."
},
{
"speaker": "James Heaney",
"content": "Yeah, thank you for taking the question. What have been some of the unlocks on the mobile side of the business. You did call out the better-than-expected results in Zynga's IP business, but just curious if there's anything you could say specifically on the advertising side of the business. Thank you."
},
{
"speaker": "Strauss Zelnick",
"content": "Look, we have two important businesses within mobile in-app purchases and advertising and they're both relevant. We hit on advertising as we rethought our hyper-casual business and turned it into a blended hybrid casual business where they are in-app purchases as well. At the same time, we built up advertising inside Mobile by putting advertising units in games that previously did not have them. In any case, advertising should be a meaningful growth area for us in the mobile business. With regards to app purchases, we have the same opportunities and limitations that any other mobile company has and our ability to grow in our purchases is driven by our ability to have people download and play hip titles. That's what we're focused on."
},
{
"speaker": "James Heaney",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Clay Griffin with Moffett Nathanson. Please proceed with your question."
},
{
"speaker": "Clay Griffin",
"content": "Yes, good afternoon. Thank you. I'm curious if you guys would talk about the broader PC strategy. I know that there's just tons and tons of engagement, particularly for GTA on PC, not all of that gets monetized. I think in the past, you've describe that as maybe it's a good thing to have that there. You don't necessarily need to monetize all of it. But there are some interesting products out there over Wolf and the like. And so maybe I'm just curious what you guys are seeing or thinking about your opportunity to unlock monetization on PC. Thanks."
},
{
"speaker": "Karl Slatoff",
"content": "So we look at the PC platform as we do any platform, and it all starts with content, first and foremost. And we agree, it's a very powerful platform, and we've got some very strong third-party partners. Also the ability for us to sell directly to the consumer. So these are all compelling things for us, and we'll continue to develop and support the PC platform as long as the gamer is there. Wherever the gamer is, that's where we're going to be. And again, I don't really see us looking at the PC monetization any differently than we would on any other platform. It really is more about game to game. What works for certain games, what doesn't work for certain games. And the overarching edict that we live by is overdeliver on content and the monetization will follow."
},
{
"speaker": "Clay Griffin",
"content": "Great, thanks Karl."
},
{
"speaker": "Operator",
"content": "And our next question comes from the line of Chris Schoell with UBS. Please proceed with your question."
},
{
"speaker": "Chris Schoell",
"content": "Hi, great. Thank you for taking the question. We saw Rockstar announce a price increase for GTA. I recognize it's been 7 years, but can you help us think through the rationale? And as you look at GTA VI, so what are your latest thoughts around the pricing dynamics for the franchise or your portfolio in general as these games continue to get larger with more robust experiences? Thank you."
},
{
"speaker": "Strauss Zelnick",
"content": "Look, there's more content constantly being made available, and we really aim to deliver great value at any given time. We're so focused on delivering more value than what we charge. And that's sort of the rubric. And any time we establish our prices, we want to make sure that it's good news for the consumer that the experience vastly over delivers in the context of the cost. That's the goal."
},
{
"speaker": "Chris Schoell",
"content": "Great. Thank you."
},
{
"speaker": "Operator",
"content": "And our next question comes from the line of Omar Dessouky with Bank of America. Please proceed with your question."
},
{
"speaker": "Omar Dessouky",
"content": "Sure, I have two questions, one on mobile and then just one again on the sequential growth. So is there any more color at all you can give us on how you're going to grow sequentially in fiscal '27 after lapping just such a tough comp in fiscal '26 when GTA VI is going to launch. It just seems counterintuitive. When I look back at the last 2 times, Rockstar released a mega title, Red Dead Redemption in fiscal '19, fiscal '20 did not grow. And Grand Theft Auto V in fiscal '14, fiscal '15 was down 30% I'm just kind of trying to square those couple of things there. Will it be Rockstar that continues to drive that sequential growth in fiscal '27? Any more color there would be really great."
},
{
"speaker": "Strauss Zelnick",
"content": "Yes, it's a fair question. Look, the business has really changed and certainly since 2019 and absolutely since 2015 and in ways that are obvious now and in ways that we project in the future. The sequential growth is driven by our overall pipeline, and we're now a large and diversified company. And we do have GTA VI coming. We have great aspirations for GTA VI. And as I said earlier, we've been selling full game, GTA V for over 10 years. And we continue to sell more in a given year than most other standalone releases selling their first year, even at our big competitors company. So we actually think there is a compelling case that the full game sales will continue to be robust for years to come. Equally, we have a pipeline both announced and unannounced, that's very exciting. We have an annualized pipeline that will, of course, continue to come that's quite significant. And we have a mobile business that we frankly feel has been rightsized, well-structured and is now back in growth mode. And there's evidence of that. The performance of Match Factory!, the performance of Toon Blast and the stable performance of many other big titles. There are also geographical growth opportunities that we're very focused on. We don't spend a lot of time talking about it, but it's a huge part of our strategy. Our business and our competitors' businesses remain largely US and Western Europe focused. And we think there are enormous opportunities for growth in Asia, India and Africa, where we and everyone else who isn't located in those geographies are deeply underpenetrated. So there are numerous opportunities for growth, but to put reminded ease, this isn't stick finger in your mouth and hold it in the air and hope for the best kind of number. This is driven by our release schedule and our pipeline."
},
{
"speaker": "Omar Dessouky",
"content": "Okay. And along kind of the same lines, I think a lot of people are going to be super excited about GTA VI coming out. Do you make any assumptions about the perhaps a reacceleration of growth in the console installed base or console sales, because your title may bring a lot of lapsed gamers back into the ecosystem in your forecasts."
},
{
"speaker": "Strauss Zelnick",
"content": "We are using IDG's projections, which are pretty substantial. So for Gen 9 alone, their view is that they're about 81 million consoles worldwide currently that was at the end of the last year, they project that will rise to 111 million by the end of this year and [175 million] (ph) by the end of 2027. Now we don't necessarily subscribe or not subscribe to those views, but that shows an awful lot of growth. And we do expect a very significant attach rate."
},
{
"speaker": "Omar Dessouky",
"content": "Thanks a lot. Appreciate it."
},
{
"speaker": "Operator",
"content": "Thank you. We have reached the end of our question-and-answer session. And with that, I would like to turn the floor back over to CEO, Strauss Zelnick for any closing comments."
},
{
"speaker": "Strauss Zelnick",
"content": "Before we sign off, I just want to thank everyone who works at Take-Two in all of our affiliates. These have been challenging times. And in addition to delivering hits, we've asked everyone to dig deep and make sure the business is highly efficient, rightsized. And that's challenging. And one of the most extraordinary things about our organization is the amazing morale and focus on the common good. We are here for our customers for our first and foremost for our colleagues who deliver to our customers every day and for our shareholders. And we're extraordinarily excited both about the position we're in, about the fiscal year in which we're currently operating and about our amazing pipeline in the years ahead. Thank you for joining us today."
},
{
"speaker": "Operator",
"content": "This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation."
}
] |
ttwo | 2,024 | 3 | [
{
"speaker": "Operator",
"content": "Greetings. Welcome to Take-Two’s Third Quarter Fiscal Year 2024 Earnings Call. [Operator Instructions] Please note this conference is being recorded. I will now turn the conference call over to Nicole Shevins, Senior Vice President of Investor Relations and Corporate Communications. Thank you. You may begin."
},
{
"speaker": "Nicole Shevins",
"content": "Good afternoon. Thank you for joining our conference call to discuss our results for the third quarter of fiscal year 2024 ended December 31, 2023. Today’s call will be led by Strauss Zelnick, Take-Two’s Chairman and Chief Executive Officer; Karl Slatoff, our President; and Lainie Goldstein, our Chief Financial Officer. We will be available to answer your questions during the Q&A session following our prepared remarks. Before we begin, I’d like to remind everyone that statements made during this call that are not historical facts are considered forward-looking statements under federal securities laws. These forward-looking statements are based on the beliefs of our management as well as assumptions made by and information currently available to us. We have no obligation to update these forward-looking statements. Actual operating results may vary significantly from these forward-looking statements based on a variety of factors. These important factors are described in our filings with the SEC including the company’s most recent annual report on Form 10-K and quarterly report on Form 10-Q, including the risks summarized in the section entitled Risk Factors. I’d also like to note that unless otherwise stated, all numbers we will be discussing today are GAAP and all comparisons are year-over-year. Additional details regarding our actual results and outlook are contained in our press release, including the items that our management uses internally to adjust our GAAP financial results in order to evaluate our operating performance. Our press release also contains a reconciliation of any non-GAAP financial measure to the most comparable GAAP measure. In addition, we have posted to our website a slide deck that visually presents our results and financial outlook. Our press release and filings with the SEC may be obtained from our website at take2games.com. And now, I will turn the call over to Strauss."
},
{
"speaker": "Strauss Zelnick",
"content": "Thanks, Nicole. Good afternoon and thank you for joining us today. I’m pleased to report that we achieved solid results, including net bookings of $1.3 billion. Our performance reflects our unwavering commitment to quality, the ongoing contributions from our outstanding portfolio, which is one of the strongest and most diverse in the entertainment industry, and our immensely talented creative teams. During the period, Grand Theft Auto V, Grand Theft Auto Online, the Red Dead Redemption series and Zynga’s in-app purchases, led by Toon Blast, exceeded our plans, driven by engaging new content, partnerships and activations. This was partially offset by some softness in mobile advertising and sales for NBA 2K24. 2K is implementing measures to enhance performance for the title, such as offering new events and promotions and delivering an exciting and engaging content lineup. We expect lifetime net bookings for the title to be in line with NBA 2K23. Due to these factors, a planned release moving out of the fourth quarter and increased marketing for Zynga’s new hit mobile title Match Factory!, we’re lowering our full year outlook. While the timing of Match Factory!’s user acquisition expense will reduce our profitability in the current fiscal year, we believe that this investment will allow us to grow our audience meaningfully and increase the lifetime value of the Match Factory! franchise. We have always managed Take-Two for the long-term and we have great confidence in our groundbreaking pipeline for fiscal 2025 and beyond, which we believe will enable us to grow our net bookings, increase our scale and enhance our profitability. At the same time, our teams are always looking for ways in which we can operate at the highest level of efficiency, which is one of our core tenets. We’re currently working on a significant cost reduction program across our entire business to maximize our margins while still investing for growth. These measures are incremental to and even more robust than our prior cost reduction program, and we aim to achieve greater operating leverage as we roll out our eagerly anticipated release schedule. Turning to the performance of our titles during the quarter. Momentum for Grand Theft Auto remains phenomenal. Sales of Grand Theft Auto V exceeded our expectations during the holiday season, and to date, the title is sold in more than 195 million units worldwide. During the quarter, Rockstar Games released its holiday update for Grand Theft Auto Online: The Chop Shop, which captured the highest number of active users in several years, including the largest ever increase in new Grand Theft Auto Online accounts, driven by the variety and depth of new vehicles in robberies, positive community sentiment and the game’s inclusion in various subscription services. The Grand Theft Auto series is also benefiting meaningfully from excitement surrounding Rockstar’s announcement of Grand Theft Auto VI and the release of its first trailer, which, at 93 million views in 24 hours, broke YouTube’s records for a non-music video launch and, along with partner channels, became the biggest video debut ever. Rockstar’s recent partnership with Netflix to launch the GTA Trilogy is also a resounding success, quickly yielding the highest rate of installs and engagement on the subscription services game platform. In addition, Rockstar’s membership program, GTA+, continues to grow rapidly, powered by enhanced benefits for members, including a rotating assortment of classic Rockstar titles. Red Dead Redemption 2 also surpassed our plans, as our exciting holiday promotions and events resonated deeply with players. To-date, the title is sold in more than 61 million units worldwide. During the quarter, Rockstar Games supported Red Dead Online with free updates, including the new All Hallows’ Call to Arms locations, a trio of new Dead of Night maps and a Hardcore Telegram Mission alongside the return of the Halloween Pass 2. NBA 2K24 remains the number one basketball simulation experience in our industry and, to date, is sold in over 7 million units. Unit sales for the Gen 9 version of the game are growing at a double-digit percentage increase over last year due to an enhanced gameplay experience and wider console availability. As players migrate to Gen 9 platforms, we are seeing significant declines in demand for our Gen 8 offering. Players have been highly engaged with many of NBA 2K24’s new features, including a Season Pass that helped average revenue per user grow 30% year-over-year. On October 6, 2K and Gearbox Software launched the Borderlands 3 Ultimate Edition for Nintendo Switch. We’re pleased to expand further our beloved franchise by enabling players to make some mayhem at home or on the go with this thrilling high stakes adventure. Now turning to Zynga. We’re very pleased with the team’s ability to create successful new mobile games, including Peak’s Match Factory!, which launched on iOS in November and Android in late December. The title is a top 30 grossing game on the Apple App Store in key target markets, such as the U.K. and the U.S., and has shown stellar retention and monetization metrics on par with previous category-leading Peak titles such as Toon Blast. Based on these excellent metrics, we see strong long-term potential for the title, and we’re planning to invest in new features and a robust marketing campaign to capitalize on its popularity with consumers and to scale it further. Zynga’s other recent release, Top Troops, increased its engagement by more than 10% over last quarter, propelled by the launch of new features and semi-monthly battles. Looking ahead, the team is focusing on new brand collaborations, player competitions and social and community engagements. Overall, Zynga’s in-app purchases exceeded our expectations with significant sequential improvement compared to last quarter. This was led by Toon Blast, which materially outperformed, delivering its highest ever average revenue per daily average user and over 50% growth in its daily in-app purchase revenue compared to last quarter. While we’re encouraged by the trajectory of Zynga’s in-app purchases, its ad revenues were below our expectations due to some changes that we’re implementing in the hypercasual business, including a heightened focus on our profitability and the launch of new features that deliver blended monetization. Our direct-to-consumer business continues to grow and enjoyed a record holiday season. Our teams are working actively to add more titles each quarter to this highly accretive owned distribution channel. Looking ahead, Zynga has numerous titles in development and soft launch that we’re eager to release worldwide in fiscal 2025 and beyond. It bears noting that launching hit mobile titles is both highly complex and challenging, and we’re gratified by Zynga’s unique ability to release new properties to capture mind share and market share. In closing, although we’re lowering our outlook for the year, we believe that our company’s potential is vast and unique, driven by our creative talent, our owned and controlled intellectual property and our groundbreaking new pipeline for fiscal 2025 and beyond. As we execute on our strategic priorities, we believe that we’ll deliver an array of unparalleled entertainment experiences that can captivate, engage and redefine our industry for audiences around the globe. I’ll now turn the call over to Karl."
},
{
"speaker": "Karl Slatoff",
"content": "Thanks, Strauss. I’d like to thank our teams for delivering another solid quarter and adding to the continued positive momentum of our business. I’ll now turn to our upcoming launches for the balance of fiscal 2024 and beyond. This quarter, Private Division and Evening Star will launch Penny’s Big Breakaway, a 3D platforming game. Private Division will share more news about this exciting release shortly. On March 8, 2K and Visual Concepts will launch WWE 2K24. The title will feature several franchise advancements, including the 2K Showcase...of the Immortals, celebrating 40 years of WrestleMania, four new match types, two new MyRISE experiences and much more. We’re thrilled to build upon our long-standing partnership with WWE and to continue to set new creative benchmarks for this franchise. At The Game Awards in December, Private Division announced No Rest for the Wicked, an action role-playing game from Moon Studios, creators of the critically acclaimed Ori and Blind Forest and Ori and the Will of the Wisps. The title will launch Early Access on PC in the first quarter of fiscal 2025 with a full release on PlayStation 5, Xbox Series X and S and PC thereafter. We will reveal more information about the game on March 1 during the label’s Wicked Inside digital showcase. After 13 years, we are pleased that 2K will return to tennis and broaden its sports offerings with the upcoming release of Top Spin 2K25. Developed by Hangar 13, the title was poised to provide an incredibly realistic and engaging tennis simulation featuring the world’s top players and courts. 2K will share more details in the coming weeks, including an expected launch date. Zynga continues to deliver on their outstanding pipeline with their much anticipated titles, Star Wars Hunters and Game of Thrones: Legends, each slated for global release in calendar 2024. We are encouraged by both games’ performances and soft launch and are confident that they will resonate with broad audiences when they debut worldwide. At the same time, Zynga’s hypercasual studios plan to release a steady cadence of mobile titles for games that has the potential for enhanced retention rates and a mix of in-app purchases and advertising to drive higher monetization and profitability. And as always, our labels will continue to provide new content and experiences that drive engagement and recurrent consumer spending across many of our key offerings. Looking ahead, we remain highly optimistic about what we believe to be the strongest and most exciting development pipeline in our company’s history. I’ll now turn the call over to Lainie."
},
{
"speaker": "Lainie Goldstein",
"content": "Thanks Karl and good afternoon everyone. We delivered solid holiday results, including net bookings of $1.34 billion, which was within our guidance range. I’d like to thank our talented teams for their commitment to creativity, innovation, quality and value, which allows us to provide outstanding entertainment experiences for our players across the world. Grand Theft Auto V, Grand Theft Auto Online, the Red Dead Redemption series and Zynga’s in-app purchases, led by Toon Blast, exceeded our expectations. This was partially offset by softness in mobile advertising in NBA 2K. Recurrent consumer spending declined 7% for the period and accounted for 75% of net bookings. This was slightly less than our outlook, driven by weakness in mobile advertising and NBA 2K, which was largely due to the effect of lower unit sales on its in-game monetization. Recurrent consumer spending for Grand Theft Auto Online, virtual currency and GTA+ membership was up notably. During the quarter, we launched several mobile titles, including Top Troops, Match Factory! and NBA 2K24 Arcade Edition for Apple Arcade as well as Borderlands 3 Ultimate Edition for Switch. GAAP net revenue decreased 3% to $1.37 billion, and cost of revenue declined 1% to $688 million, which included an impairment charge of $53 million and $177 million of amortization of acquired intangibles. Operating expenses decreased by 10% to $808 million. On a management basis, operating expenses rose 4% year-over-year and was favorable to our guidance due to lower marketing and personnel expenses. Turning to our guidance, I’ll begin with our full fiscal year expectations. As Strauss mentioned, we are lowering our outlook to reflect the softness we are currently experiencing in mobile advertising and NBA 2K24, a planned release will be out of the fourth quarter and increased marketing for Zynga’s new hit mobile title Match Factory!, which we believe will enable us to scale it more meaningfully to reach its full long-term potential. Our revised net bookings forecast is $5.25 billion to $5.3 billion. We expect the net bookings breakdown from our labels to be roughly 51% Zynga, 30% 2K and 19% Rockstar Games. And we forecast a geographic net booking split to be about 60% United States and 40% international. We are projecting recurrent consumer spending of 1% compared to fiscal 2023, which includes a full year of Zynga, partially offset by a slight decline in NBA 2K. Grand Theft Auto Online is expected to deliver modest growth for virtual currency and GTA+ membership. RCS is expected to represent 79% of net bookings. We plan to generate approximately $100 million in non-GAAP adjusted unrestricted operating cash flow and to deploy approximately $150 million for capital expenditures, primarily to support our office build-outs and larger footprint. We now forecast GAAP net revenue to range from $5.27 billion to $5.32 billion. Our total operating expenses are now planned to range from $3.55 billion to $3.56 billion as compared to $3.45 billion last year. On a management basis, we continue to expect operating expense growth of approximately 14% year-over-year due to a full year of Zynga and increase in personnel marketing expenses and higher depreciation, which are being partially offset by the realization of synergies from our combination with Zynga and savings from our prior cost reduction program announced last year. Now moving on to our guidance for the fiscal fourth quarter. We project net bookings to range from $1.27 billion to $1.32 billion compared to $1.4 billion in the fourth quarter last year. Our release slate for the quarter includes WWE 2K24 as well as Penny’s Big Breakaway from Private Division. The largest contributor to net bookings are expected to be NBA 2K, Grand Theft Auto Online and Grand Theft Auto V, Toon Blast, our hypercasual mobile portfolio, Empire & Puzzles, WWE 2K24, Red Dead Redemption 2 and Red Dead Online, Words with Friends and Match Factory!. We project recurrent consumer spending to decrease by approximately 5%, which assumes flat results for Zynga and a decline for NBA 2K with Grand Theft Auto Online, virtual currency and GTA+ membership are expected to be up. We project GAAP net revenue to range from $1.32 billion to $1.37 billion. Operating expenses are planned to range from $896 million to $906 million. On a management basis, operating expenses are expected to grow by approximately 17% year-over-year, driven by the additional marketing expense for Match Factory! that I mentioned previously, higher personnel costs and an increase in depreciation, which are being partially offset by the realization of synergies from our combination with Zynga and savings from our prior cost reduction program that we announced last year. Looking ahead, our teams remain committed to efficiency. We’ve begun a rigorous analysis to identify additional areas for cost optimization. The expected savings are incremental to our previously announced cost reduction program, and we expect that it will be more expansive. We believe that these measures will enhance our margin profile and position our business for greater operating leverage in the future. In closing, while we are disappointed to have lowered our outlook for the year, we are exceedingly confident in our growth prospects. With our industry-leading portfolio and passionate teams, we believe that we are poised to deliver the best content in our industry, reach new record levels of operating performance and deliver long-term value for our shareholders. Thank you for your continued support. I’ll now turn the call back to Strauss."
},
{
"speaker": "Strauss Zelnick",
"content": "Thanks, Lainie and Karl. On behalf of our entire management team, I’d like to thank our colleagues for enabling us to achieve our goals and deliver another solid quarter. And to our shareholders, I want to express our appreciation for your continued support. We will now take your questions. Operator?"
},
{
"speaker": "Operator",
"content": "Thank you. [Operator Instructions] Our first question is from Eric Handler with ROTH MKM. Please proceed."
},
{
"speaker": "Eric Handler",
"content": "Yes, thank you and good afternoon. Wonder if you could maybe give a little meat to the bone, so to speak, with your cost-cutting program. How much cost or net savings have you generated so far? What do you think this next plan could do and over what time?"
},
{
"speaker": "Strauss Zelnick",
"content": "Lainie will take that."
},
{
"speaker": "Lainie Goldstein",
"content": "Sure. So for the synergies with Zynga, we realized over $100 million in savings and the original cost-cutting program that we announced previously was over $50 million. So we do expect this plan to enhance our margins, both by reducing costs from our existing cost base and avoiding future costs and they will be incremental to these other cost-cutting programs that we had and even more robust than the prior cost reduction program. And next quarter, we will be in a position to give a little more details on the plan."
},
{
"speaker": "Eric Handler",
"content": "Helpful. And then with regards to the advertising weakness that you are seeing, is that all related to what’s going on with the hypercasual business or does it extend also to in-game advertising for casual games?"
},
{
"speaker": "Strauss Zelnick",
"content": "This is Strauss. So it’s basically the hypercasual business, and we’re really optimizing the business from profitability. So there’s always a balance. We’re also seeing that we can actually have in-app payments in our hypercasual business. So it’s really moving to a hybrid model, and we’re very excited about that. There’s great opportunity in that business."
},
{
"speaker": "Eric Handler",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Our next question is from David Karnovsky with JPMorgan. Please proceed."
},
{
"speaker": "David Karnovsky",
"content": "Thank you. I guess, first, with some of the momentum and investment for Match Factory! and the game delay, is there any update to your fiscal ‘25 or ‘26 forecast?"
},
{
"speaker": "Strauss Zelnick",
"content": "Lainie is going to take that."
},
{
"speaker": "Lainie Goldstein",
"content": "Currently, it’s the middle of our budgeting process. At this time, the number is tracking a little above $7 billion for net bookings for the year and given the typical shifts and tweaks that occur in our forecasting process. And this amount is still huge growth over this year. And our pipeline is groundbreaking for next year and beyond, and our teams are making excellent progress on game development. And nothing material has changed with regard to the lifetime value of our portfolio. And both will provide our initial outlook for fiscal year ‘25 when we report our Q4 and full year fiscal year ‘24 results in May."
},
{
"speaker": "David Karnovsky",
"content": "And then just on Match Factory! It looks to be the most substantial new launch for Zynga since the acquisition. Want to see if you could speak kind of more broadly to the process of launching new mobile games, whether this reflects any kind of broader improvement in UA or content generation there? Thanks."
},
{
"speaker": "Strauss Zelnick",
"content": "I think so. I mean, I’ve said repeatedly in the past few years that the hardest thing that anyone in the industry can do is create a new mobile hit. It’s super hard. And so much so that one of our big competitors just decided they weren’t going to try it anymore. It was off the table. We stuck with it and so did some of our competitors. So clearly, the market’s becoming more receptive and more reactive. There’s a big title from one of our competitors, Monopoly GO!, which is a huge hit. And we’re gratified obviously here to see so much traction already in Top Troops and Match Factory!. And Match Factory!’s already a top 30 title in the U.S. and UK Apple App Stores with lots of continued traction in the rest of the world, and it’s really just beginning. We are supporting the title in the quarter, and that’s not money that we could possibly recoup in the quarter. So to put some color around the guidance change, that’s really good news, not bad news. That’s going to be a very profitable expenditure that will come back to us in the next fiscal year. Because of the way we structure UA, we structure for relatively quick paybacks compared to the industry because we’re conservative. So I do think – look, I think the team in Zynga is doing a phenomenal job delivering great properties. It starts there. It always starts there. And yes, I also believe the market’s becoming more reactive. Remember, the market was down for the first time in its history in 2022, and it was flattish after that. And there were no new hits for years from us or anyone else. That’s clearly changing. I think it puts further evidence on the table that being exposed to mobile through the Zynga acquisition was a really, really good thing for this company, and we’re highly optimistic going forward."
},
{
"speaker": "David Karnovsky",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Our next question is from Doug Creutz with TD Cowen. Please proceed."
},
{
"speaker": "Doug Creutz",
"content": "Yes. I wonder if you could be a little more specific relative to the guidance cut to the fiscal year, how much came from the title delay on the top line versus the other factors you cited. And to what extent the delay of the title out of the year might have impacted your operating income? Because presumably you will be marketing for it less. Thank you."
},
{
"speaker": "Strauss Zelnick",
"content": "Lainie?"
},
{
"speaker": "Lainie Goldstein",
"content": "So for the full year, when you look at the changes that we made to the fourth quarter forecast, the biggest drivers were towards the user acquisition spend and marketing for Match Factory!, then the lower mobile advertising that we were seeing, updating expectations for NBA 2K24 and the shift of an unnamed title out of the year. So those are the top four primary reasons for the change."
},
{
"speaker": "Doug Creutz",
"content": "In that order?"
},
{
"speaker": "Lainie Goldstein",
"content": "Yes, that was the order of magnitude."
},
{
"speaker": "Doug Creutz",
"content": "Okay."
},
{
"speaker": "Operator",
"content": "Our next question is from Andrew Marok with Raymond James. Please proceed."
},
{
"speaker": "Andrew Marok",
"content": "Hey, thanks for taking my questions. Good commentary on the Netflix tie-up with the GTA Trilogy. I guess going back to maybe how that came about, what made you guys want to partner with that kind of fledgling mobile gaming platform and be one of the first major third-party titles out there?"
},
{
"speaker": "Strauss Zelnick",
"content": "Look, we have to balance all the different elements that go into choosing how, where and when to distribute our titles. And as our titles enter the catalog, we can be flexible about how to distribute. We tend to support all emerging platforms as long as they serve consumers and as long as the terms under which we support the platforms make sense to us."
},
{
"speaker": "Andrew Marok",
"content": "Great. And then maybe a little bit more of an esoteric question, but interested to maybe dig into that hypercasual commentary. Is there anything that’s maybe changed in the last few months or quarters with player behavior in hypercasual games that they’re now willing to do in-app purchases?"
},
{
"speaker": "Strauss Zelnick",
"content": "All about quality. I think Rollic has been really focused on making more and more robust titles. Remember, hypercasual came about as a business where you’d actually look at hundreds of games a month and put them out into the market and see what would stick and then a game would stick for 3 months and then roll off. And what’s happening now is Rollic has title. Rollic, we believe, is a leader in the space, has titles that are much more durable and long-lasting and turning into games that could be games that last for years. We hope that, that will happen. And as those games are more durable and offer more playing value to consumers, there’s an opportunity in certain of those games to have in-app purchases, so really, moving from hypercasual to hybrid casual. But it’s all about quality and meeting the consumer where they are. And the story of the entertainment business is always a move to quality. And remember, we’re still, in many ways, in the nascent business. Interactive entertainment is roughly 30 years old, mobile’s roughly 12 years old, and these are early-stage businesses. And they started off as glorified toy businesses and then they turned into entertainment businesses and now they’re year-round entertainment businesses. All of that’s great news for a company like ours. We are the number two pure-play interactive entertainment company on earth, and it’s still early innings. And we’re seeing a lot of movement in mobile. Our 3-part strategy includes the word innovation. And innovation means that even if you start as hypercasual, if consumers want you to go upmarket and give them something that’s deeper and more compelling and more long lasting, you have to be there to do it. I would say our hypercasual team, led by Barak Verdal in Istanbul, is first class."
},
{
"speaker": "Andrew Marok",
"content": "Great. Appreciate the detail."
},
{
"speaker": "Operator",
"content": "Our next question is from Benjamin Soff with Deutsche Bank. Please proceed."
},
{
"speaker": "Benjamin Soff",
"content": "Hey, guys. Thanks for taking the question. A follow-up on the GTA Trilogy for mobile. Does this provide a blueprint for how to bring more of your titles to mobile in the future? And just curious if you see an opportunity for additional partnerships with Netflix for additional mobile titles going forward as well? Thanks."
},
{
"speaker": "Strauss Zelnick",
"content": "We – I’m not sure this is a model for mobile distribution, because ultimately, it all depends on how you define mobile. We think of mobile as a game that you typically play on your phone, and we have a big portfolio of games like that. And we’d love to do more with Netflix, who wouldn’t, as long as the consumers are happy to be there and as long as the economics of those arrangements make good sense."
},
{
"speaker": "Operator",
"content": "Our next question is from Drew Crum with Stifel. Please proceed."
},
{
"speaker": "Drew Crum",
"content": "Okay, thanks. Hi, guys. Good afternoon. So on NBA 2K, I think it was enjoying some pretty strong engagement in RCS trends into the early part of fiscal 3Q, at least. Any thoughts or explanation around what transpired thereafter? And just any more additional color you can give us in terms of your expectations for fiscal 4Q."
},
{
"speaker": "Karl Slatoff",
"content": "So – I’m sorry. Sorry, Strauss. The NBA has – the game has been incredible for NBA 2K24, and that continues to be the case. We still have very strong momentum around RCS, also driven specifically by our Season Pass. The Gen 9 SKU is performing incredibly well. We’ve got double-digit growth over 2K23 at this point. Yet, the real story here is that Gen 8 is actually underperforming our expectations. And I think as people transition more towards Gen 9 and experience all that NBA, the franchise, has to offer in the Gen 9 SKU, then you’re going to see continued growth in that franchise. So we feel really great about where the engagement is. Engagement in the title is fantastic. It really is – any sort of softness that we’re seeing is really a story about the Gen 8 product at this point."
},
{
"speaker": "Drew Crum",
"content": "Okay, thanks."
},
{
"speaker": "Operator",
"content": "Our next question is from Martin Yang with Oppenheimer & Company. Please proceed."
},
{
"speaker": "Martin Yang",
"content": "Thank you for taking my question. The two-part question regarding GTA trailer’s reception, do you see a meaningful uplift for themselves due to the trailer performance on YouTube? And then given that strong performance, do you think that – could be future marketing events for GTA could be planned in conjunction with potential updates from other games, GTA, Red Dead? Does that change your view on how to market to GTA VI in the next 12 months?"
},
{
"speaker": "Strauss Zelnick",
"content": "Look, we’re really gratified that the announcement of the trailer was a huge event online, and then the trailer debut between YouTube and other marketing partners set a record for a video to view. So we couldn’t be happier or more excited by the initial trailer. And I do think that excitement around GTA VI has had a halo effect on the entire franchise. We’ve now sold in 195 million units of GTA V, and GTA Online continues to perform above our expectations. So I do think all things GTA lead to more excitement. As far as the marketing programs, I think Rockstar is particularly expert in marketing their titles and, I think, is considering all the appropriate angles."
},
{
"speaker": "Martin Yang",
"content": "Got it. Thank you. And then another question regarding marketing is we’ve seen Judas and Top Spin with trailers and the revealers or teasers without a release date. Is there overall philosophy to market new games change? Or is it still largely based on studio level decision on when they will release or announce the release dates for new games?"
},
{
"speaker": "Strauss Zelnick",
"content": "Marketing is really driven by our labels and our studios, and we don’t have a fixed march to a release from particular marketing needs."
},
{
"speaker": "Martin Yang",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Our next question is from Timothy O’Shea with BMO Capital Markets. Please proceed."
},
{
"speaker": "Timothy O’Shea",
"content": "Yes. Thank you for taking my question. Back on Grand Theft Auto. We’ve spoken about the Grand Theft Auto trailer. My question is really, is there a way to quantify or maybe compare what you saw in terms of all this anticipation for GTA VI compared with how the level of anticipation that you saw for GTA V ahead of that games announcement? And then I had a follow-up."
},
{
"speaker": "Strauss Zelnick",
"content": "It is possible to do research around that. And our sense is that the anticipation is much higher, much, much higher. On the other hand, 195 million units to date is nothing to sneeze at. So we stopped well short of making predictions about how the title will do, but clearly, anticipation is running very, very high."
},
{
"speaker": "Timothy O’Shea",
"content": "Yes. Thank you. That’s very helpful. And then just quickly, can we talk about how you make the decision about when to launch a game like Grand Theft Auto VI, like who makes the call, what motivates them? Assuming this is game quality, game finish polish, maybe there’s a desire to hit a specific launch window or really anything else that might influence Rockstar’s decision about the timing of when to launch this game. Thank you."
},
{
"speaker": "Strauss Zelnick",
"content": "We’re seeking perfection. And when we feel we’ve optimized creatively, that’s the time to release. So – and we’re all in this together. In terms of motivations and incentives, the financial incentives of everyone who works at this company are aligned with those of the shareholders. So we essentially have – call it what you will, we have profit sharing plans throughout the company at the operating level. And at the senior level, compensation is driven largely by TSR. So our goal is to align the interest of everyone who works there with the interest of the shareholders. That keeps us all pointing in the same direction. So you are right, there is inherent tension potentially between getting something to market and creating perfection, but this company errs on the side of perfection."
},
{
"speaker": "Timothy O’Shea",
"content": "Thanks, Strauss. Yes, anticipation is pretty high around here too. So we look forward to seeing again."
},
{
"speaker": "Operator",
"content": "Our next question is from Mike Hickey with Benchmark Company. Please proceed."
},
{
"speaker": "Mike Hickey",
"content": "Hey Strauss, Karl, Lainie and Nicole. Thanks for taking our questions. Lainie, just curious on your updated ‘25 view, I think this is two quarters it’s come down a bit, maybe now more than the last quarter. And I think I heard you said that maybe ‘25 and ‘26 is sort of the same. So, any color you can give us in terms of sort of bridging where you were for ‘25 versus what you are thinking now? And if in fact you are still thinking ‘25 and ‘26 together is kind of where your original guidance was. And then on the cost cutting, obviously, we are seeing a lot of that in the industry. I don’t know if it’s unprecedented trials or not, but no doubt, it’s significant. And you have already gone through one round. Just sort of curious your motivation here to take another sort of big cost reduction, especially given what it look like, the next 2 years, you are going to have pretty significant growth given your pipeline coming to fruition. Thanks guys."
},
{
"speaker": "Strauss Zelnick",
"content": "Lainie?"
},
{
"speaker": "Lainie Goldstein",
"content": "Hi Mike. So, for fiscal year ‘25, as I mentioned, it’s really driven by changes in the release schedule. And obviously, that will move some of the titles out into years going forward because the lifetime value of our portfolio hasn’t changed. So, we should – we do expect to see growth in fiscal year ‘26 over ‘25, so that hasn’t changed. So, it’s just a regular process of re-forecasting and updating the business. And this time, we are working on our budget. So, that’s where the numbers are falling out."
},
{
"speaker": "Strauss Zelnick",
"content": "And Mike, in terms of cost reduction, as I have said and as you know, we have a three-part strategy that’s supported us well through thick and thin. And that is, first and foremost, to be the most creative company, also to be the most innovative and, finally, always to be the most efficient company in the entertainment business. And that’s a big challenge. And we mean it, and everyone here means it. And I think that it’s time to take another look at efficiency and make sure that everyone is focused on the things that really matter and only the things that really matter and put ourselves in a position where we have the opportunity for great operating leverage as these titles come to market and as the revenues flow through the system."
},
{
"speaker": "Mike Hickey",
"content": "Thanks guys."
},
{
"speaker": "Operator",
"content": "Our next question is from Brian Fitzgerald with Wells Fargo. Please proceed."
},
{
"speaker": "Brian Fitzgerald",
"content": "Thanks. Strauss, I just wanted your opinion on this recent Disney and Epic deal. Obviously, you have your own strong IP, but we are just curious how you think that might impact access to license IP maybe for the industry at large, if we continue to see this type of tie-ups? Thanks."
},
{
"speaker": "Strauss Zelnick",
"content": "It’s a good question. I only know what I read in the release and what you also read. What I read was that they are making an investment in a leading company, Epic, which is – obviously has a spectacular franchise in Fortnite. And then there was some talk around sort of creating a Fortnite/Disney ecosystem. And I don’t know exactly what that means, but I am not betting against my friends at Epic or Disney. And I wish them well. So, I guess it remains to be seen, but they are two fine companies. I think anything that’s good for consumers and it creates excitement in our industry is good for Take-Two because it keeps people engaged with the properties that we bring to market, and we have the best collection of owned intellectual property in the business, bar none. And we are the number two player in the space, so – and we would like to go from here. So, I see it as a net positive for the business, and we will see how they do with it. But I am certainly not betting against them."
},
{
"speaker": "Brian Fitzgerald",
"content": "Thank you. Appreciate it."
},
{
"speaker": "Operator",
"content": "Our next question is from Omar Dessouky with Bank of America. Please proceed."
},
{
"speaker": "Omar Dessouky",
"content": "Hi. Thanks for taking the question. Back in May, on your fourth quarter call, you gave a $1 billion operating cash flow guide. And since you have updated us on the fiscal ‘25 top line outlook, I was wondering if you could also update us on the fiscal ‘25 operating cash flow outlook and any puts and takes around that? And then I have a quick follow-up."
},
{
"speaker": "Strauss Zelnick",
"content": "Great. That’s Lainie."
},
{
"speaker": "Lainie Goldstein",
"content": "So, Omar, we haven’t updated that number. We are still working on our budget right now. We would expect that number to change along with the release schedule changes, and it will depend on when the titles are released during the year of when the – a UFCF will be collected."
},
{
"speaker": "Omar Dessouky",
"content": "Okay. So, maybe riffing off of Brian’s question about kind of Epic and Disney, thinking about Grand Theft Auto online, do you see any potential for Grand Theft Auto to be a trans-media property, which maybe involves brands and IP from franchises outside of Take-Two? Yes, that’s the question."
},
{
"speaker": "Strauss Zelnick",
"content": "Yes. Look, we really do prefer that our labels talk about what’s going to go on in the title creatively. And I could riff endlessly and share my opinions, but I prefer to hear from Rockstar. And they will talk about what’s coming in due time."
},
{
"speaker": "Omar Dessouky",
"content": "Appreciate it. Thank you."
},
{
"speaker": "Operator",
"content": "Our next question is from Chris Shaw with UBS. Please proceed."
},
{
"speaker": "Chris Shaw",
"content": "Great. Thank you for taking the questions. Just going back to the Zynga deal, at the time, you had talked about revenue synergies that would come through in time. Can you just remind us where those initiatives stand today and how your thoughts might have evolved since you closed the deal? And then second question, just any early learnings you can give us on the iOS fee changes in Europe and how this might inform your mobile strategy going forward? Thanks."
},
{
"speaker": "Strauss Zelnick",
"content": "Yes. I mean we have made great progress across the-board, including on the revenue side. The biggest area of synergy so far has been our direct-to-consumer initiative, which is a collective initiative to offer the consumer the ability to purchase in-app currency for mobile games directly. And that’s been exceedingly successful, rolled out very quickly and quite profitable, and there is a lot more upside to come. There are numerous other areas on which we are making progress. We are kind of ticking the box with that one by itself. And in terms of game store changes, this will – there is a lot of moving parts here. And some of the decisions you mentioned in Europe and some of the decisions in the U.S. are contradictory. So there is a lot of dust left to shake out. But on balance, I remain of the view that I have stated years ago that distribution costs will come down meaningfully. They already are."
},
{
"speaker": "Chris Shaw",
"content": "Great. Thank you."
},
{
"speaker": "Operator",
"content": "Our next question is from Clay Griffin with MoffettNathanson. Please proceed."
},
{
"speaker": "Clay Griffin",
"content": "Great. Thanks. Good afternoon. Curious if you guys have a reaction to speculation. I suppose that Microsoft maybe looking to take some of the titles that were formerly exclusive to the Xbox platform and making those more widely available. It seems at least part of that rationale, if it’s true, maybe around just the cost to develop big titles. And Strauss, love to get your thoughts on particular areas of development that are particularly sticky as it relates to cost? Thanks."
},
{
"speaker": "Strauss Zelnick",
"content": "Well, the big console titles are expensive and time-considering to create. And if you want to make the very, very best, it takes a long time and it costs a lot of money. I really don’t want to speak for Microsoft and their strategy. There has been a lot of noise around that lately. I have no doubt that they will express where they’re heading. I would just say that if you take a look at their market cap now compared to a few years ago, you don’t want to bet against that management team."
},
{
"speaker": "Clay Griffin",
"content": "Great. Thanks."
},
{
"speaker": "Operator",
"content": "We have reached the end of our question-and-answer session. I will now turn the call back over to Strauss for closing remarks."
},
{
"speaker": "Strauss Zelnick",
"content": "First, as always, I want to thank our teams for delivering such great work, with such extraordinary commitment. Everything that goes on here is a team effort and we are all aligned, all in this together and all working to do our level best to create the best entertainment for our consumers and to do it within the four walls of superb company with a great culture. I also want to thank our shareholders for their continued support. We are really excited about what is to come. Thanks for joining us today."
},
{
"speaker": "Operator",
"content": "Thank you. That will conclude today’s conference. You may disconnect your lines at this time and thank you for your participation."
}
] |
ttwo | 2,024 | 2 | [
{
"speaker": "Operator",
"content": "Greetings and welcome to the Take-Two Interactive Second Quarter Fiscal Year 2024 Earnings Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Nicole Shevins, Senior Vice President of Investor Relations and Corporate Communications."
},
{
"speaker": "Nicole Shevins",
"content": "Good afternoon. Thank you for joining our conference call to discuss our results for the second quarter of fiscal year 2024 ended September 30, 2023. Today's call will be led by Strauss Zelnick, Take-Two's Chairman and Chief Executive Officer; Karl Slatoff, our President; and Lainie Goldstein, our Chief Financial Officer. We will be available to answer your questions during the Q&A session, following our prepared remarks. Before we begin, I'd like to remind everyone that statements made during this call that are not historical facts are considered forward-looking statements under federal securities laws. These forward-looking statements are based on the beliefs of our management, as well as assumptions made by and information currently available to us. We have no obligation to update these forward-looking statements. Actual operating results may vary significantly from these forward-looking statements based on a variety of factors. These important factors are described in our filings with the SEC, including the company's most recent Annual Report on Form 10-K and Quarterly Report on Form 10-Q, including the risks summarized in the section entitled Risk Factors. I'd also like to note that, unless otherwise stated, all numbers we will be discussing today are GAAP and all comparisons are year-over-year. Additional details regarding our actual results and outlook are contained in our press release, including the items that our management uses internally to adjust our GAAP financial results in order to evaluate our operating performance. Our press release also contains a reconciliation of any non-GAAP financial measure to the most comparable GAAP measure. In addition, we have posted to our website a slide deck that visually presents our results and financial outlook. Our press release and filings with the SEC may be obtained from our website at take2games.com. And now, I'll turn the call over to Strauss."
},
{
"speaker": "Strauss Zelnick",
"content": "Thanks, Nicole. Good afternoon and thank you for joining us today. We delivered another consecutive quarter of excellent results highlighted by net bookings of $1.44 billion, which was at the high end of our guidance and management results that exceeded our plans. While we expect continued macroeconomic uncertainty, we believe that we're well positioned for the holiday season and are reiterating our fiscal 2024 net bookings guidance of $5.45 billion to $5.55 billion. Looking ahead, I'm exceedingly optimistic about our company's multiyear growth trajectory and our ability to deliver long-term value to our shareholders. Our development pipeline is robust and diverse and we're getting closer to delivering the groundbreaking titles that our audiences throughout the world have been anticipating eagerly. Our unwavering commitment to being the most creative, the most innovative, and the most efficient entertainment company gives us great confidence that our offerings will surpass our players' expectations and set new standards of creative excellence in our industry. Now turning to the performance of our titles during the quarter. Grand Theft Auto V and Grand Theft Auto Online continue to surpass our expectations, an outstanding achievement for two titles celebrating their tenth anniversaries. To-date, Grand Theft Auto V is sold in approximately 190 million units. Grand Theft Auto Online experienced continued momentum due to the rollout of new gameplay and items from the San Andreas Mercenaries update with new seasonal events, vehicles, modes, clothes and weapons driving sustained engagement and net bookings. Our GTA+ membership program continued to grow and we're deepening our relationships with our player communities through new offerings, which now include access to a rotating assortment of classic Rockstar Games titles. During the quarter, Rockstar Games announced that CitizenFX, the team behind the FiveM and RedM role-playing communities for Grand Theft Auto V and Red Dead Redemption 2, officially joined the label. With their immense passion and creativity, CitizenFX has been pivotal in expanding the possibilities of user-generated content around Rockstar's leading titles. We're excited to see them continue to build these creative communities and help them thrive into the future. We're also thrilled by today's announcement from Rockstar Games founder Sam Houser that the eagerly anticipated first trailer for the next Grand Theft Auto will be revealed this coming December. As the label approaches its 25th anniversary next month we congratulate Rockstar Games on their constant innovation in the pursuit of the highest quality interactive entertainment. Red Dead Redemption 2 surpassed our plans and has sold in more than 57 million units to date. Rockstar Games continues to support Red Dead Online with new content including bonuses for the naturalist and bounty hunters, and new free roam missions and events. In addition, Rockstar Games expanded the audience for the franchise with the launch of Red Dead Redemption and Undead Nightmare for PlayStation 4 and Nintendo Switch. On September 8th, 2K and Visual Concepts once again redefined the number one NBA simulation experience in our industry with the successful worldwide launch of NBA 2K24. With exciting new features and next generation enhancements, the title is off to a great start and to date has sold in over 4.5 million units. NBA 2K24 features new season pass options that provide players with the opportunity to earn even more rewards as well as a new seasonal progression that tracks and combines my career and my team into one linear reward system. Engagement has been phenomenal with season pass and virtual currency bookings exceeding our plans and driving double growth in ARPU compared to NBA 2K23. Our franchise extensions continue to perform extremely well including NBA 2K Mobile, NBA 2K Online in China, and the recently launched NBA 2K24 Arcade Edition on Apple Arcade. I'd like to thank 2K and Visual Concepts for continuing to bring innovation and creativity consistently to our beloved franchise. 2K continues to support LEGO 2K Drive with its second drive pass season and the Creators Hub and PGA Tour 2K23 with additional pros and gear. In addition, the label harness the power of our industry leading catalog with the launch of the Borderlands Collection Pandora's Box, which bundles together all six acclaimed Borderlands Games and their previously released add-on content into a single offering at an amazing value. We have great respect for the team at Gearbox, and we value deeply our long-term relationship. Zynga once again delivered solid results during the quarter and we remain pleased with its ongoing performance. We continue to benefit from Zynga's ability to create engaging new games, which is a distinguishing capability of our mobile business. For example, Rollic successfully launched PowerSlap, based on the world's first regulated and sanctioned slap fighting promotion. The title is highly entertaining and to date has experienced more than 1 billion slaps across training and matches. With the launch of this new mobile game, Rollic has now had 22 titles reach the number one or two spot in the US Apple app store. We'd like to thank the entire team over at TKO including Ari Emanuel and Dana White for their strong partnership as well as our colleagues at Rollic created this title from inception to release in just eight weeks. Zynga also recently launched Top Troops and Match Factory, both of which delivered excellent KPIs and soft launch and appear to have strong long-term potential for our portfolio. And Star Wars Hunters continues to hit important milestones as we approach its planned release date in calendar 2024. Karl will discuss these titles in greater detail. Other highlights from our mobile business this quarter include our advertising bookings grew year-over-year driven by the addition of Popcore, contributions from strategic partnerships and our efforts to increase adamant inventory in many live games. We continue to make excellent progress in our profitability initiatives, including expanding the number of mobile games to leverage our direct-to-consumer platform. As we convert additional players, we're gaining new insights that we believe will better serve our players' preferences. We remain optimistic that over the next few years, most of our mobile games will leverage this highly accretive owned distribution channel. In addition, we continue to enhance the profitability and performance of our hypercasual business with multiple new games scaling rapidly and several games generating revenue from in-app purchases in addition to ads. Our live games portfolio also continued to deliver. Social Casino maintained steady performance coming off a great first quarter driven by new bold beat features which drove strong results, particularly in Zynga Poker. Additionally, we implemented new updates and events across many games, including Top Eleven and Dragon City, which drove audience growth as well as increased engagement in core systems, leading to better retention and monetization. We stand at an exciting time in our company's history with numerous growth opportunities ahead of us. As we deliver on our strategic priorities, we have the potential to create unparalleled entertainment experiences, engage broader audiences throughout the world and ultimately enhance our scale and margin profile. I'd like to thank all of you for your continued support, and we look forward to delivering our next phase of growth. I'll now turn the call over to Karl."
},
{
"speaker": "Karl Slatoff",
"content": "Thanks, Strauss. I'd like to thank our teams for delivering another strong quarter and adding to the ongoing positive momentum of our business. I'll now turn to our recent and upcoming launches for fiscal 2024 and beyond. On October 3rd, Zynga Socialpoint Studio successfully launched Top Troops, a new mobile game that blends strategy, RPG and merge mechanics to create a thrilling medieval fantasy adventure of combat and conquest. This marked the studio's first worldwide launch under Zynga following our combination last year. The game has seen positive player reception with an average rating of 4.38 on Google Play and 4.5 on the Apple App Store. Engagement has also been fantastic with over 2 million hours played in over 70 million battles fought since its worldwide launch date. 2K and Gearbox Software expanded the audience of our beloved Borderland franchise with the October 6th release of Borderlands 3 Ultimate Edition for Nintendo Switch. The game now allows players to make the mayhem at home or on-the-go in a thrilling high-stakes adventure filed with genre-defining shooter-looter action. On October 20, 2K and Visual Concepts launched the WWE 2K23 Bad Bunny Edition across all platforms. Global phenomenon Bad Bunny is featured on the cover of the edition, which also includes a new playable version of this in-game character wearing the peril that he wore WWE Backlash 2023 live event. Zynga's Peak Games studio, the makers of Tune Blast and Toy Blast released Match Factory, a new puzzle game for mobile where players connect identical items, sort tiles and clear the board in a mesmerizing 3D environment. In soft launch, we observed strong engagement and modernization metrics as well as very positive player response as indicated by App Store review scores, which gives us optimism about the long-term potential for this new mobile title. Private Division has several exciting release as planned for this fiscal year. On November 28th, Roll7 will release their critically acclaimed and wildly imagined a third-person shooter skater, Rollerdrome for Xbox Series X and S and PC as well as Xbox Game Pass for both platforms. Also during the fourth quarter, Evening Star, founded by the industry veterans behind Sonic Mania will launch Penny's Big Breakaway, a kinetic Yo-Yo 3D-platformer for PlayStation 5, Xbox Series X and S, Nintendo Switch and PC. 2K and Visual Concepts are hard at work on WWE 2K24, the next installment of our popular Wrestling series, which will launch during the fourth quarter. Looking ahead, we continue to see great engagement and feedback from audiences enjoying Star Wars Hunters in soft launch across multiple territories. There are several exciting new elements that we are working hard to get into the game causing us to move the title's worldwide launch window to calendar 2024. Private Division is working with Weta Workshop on Tales of the Shire, a game set in the Middle Earth universe and inspired by the books of JRR Tolkien. The team recently released a teaser trailer showing fans a glimpse of the project, which is planned for release in calendar 2024 during our fiscal year 2025. Also, Zynga plans to globally launch Game of Thrones Legends, an all-new RPG puzzle oriented mobile title. In addition to our full game releases, our labels will continue to provide new content and experiences that drive engagement and recurrent consumer spending across many of our key offerings. Our hyper-casual studio plan to release a steady cadence of mobile titles for games that have the potential for enhanced retention rates and a mix of in-app purchases and advertising to drive higher monetization and profitability. Looking at the balance of this fiscal year and beyond, we are highly optimistic about what we believe to be the strongest and most exciting development pipeline in our company's history. I'll now turn the call over to Lainie."
},
{
"speaker": "Lainie Goldstein",
"content": "Thanks, Karl, and good afternoon, everyone. Today, I'll discuss the key highlights of our second quarter before reviewing our financial outlook for the full year and third quarter of fiscal 2024. Additional details regarding our actual results and outlook are contained in our press release. We delivered another great quarter, which demonstrates the enduring strength of our catalog, our ability to deliver deeply engaging post-launch content and our commitment to disciplined execution. At the same time, our teams continue to make excellent progress advancing our development pipeline, which gives us confidence in our multiyear growth trajectory. I'd like to thank our incredible teams worldwide for their hard work and passion for our business. Now moving onto our results. We achieved net bookings of $1.44 billion, which was at the high end of our guidance range. Our performance reflects better-than-expected results from Grand Theft Auto V and Grand Theft Auto Online and Red Dead Redemption. During the quarter, we released NBA 2K24, Red Dead Redemption and Undead Nightmare for Switch and PlayStation 4. Borderlands Collection, Pandora's Box and PowerSlap. Recurrent consumer spending declined 7% for the period, which was in line with our outlook and accounted for 78% of net bookings. GAAP net revenue decreased 7% to $1.3 billion, while cost of revenue increased 24% to $884 million, driven by an impairment charge of $220 million and $190 million amortization of acquired intangibles. Operating expenses increased by 3% to $959 million and included $165 million of loan impairment, representing a partial impairment of one of our reporting units. On a management basis, operating expenses were flat year-over-year, which is favorable to our guidance. This was driven by lower marketing expenditures, some of which shifted to later this year. Turning to our guidance. I'll begin with our full fiscal year expectations. As Strauss mentioned, we are reiterating our net bookings outlook range of $5.45 billion to $5.55 billion. The largest contributors to net bookings are planned to be NBA 2K, Grand Theft Auto Online and Grand Theft Auto V, our hyper-casual mobile portfolio, Empires & Puzzles, Toon Blast, Red Dead Redemption 2 and Red Dead Online, Words with Friends, Merge Dragon and Zynga Poker. We expect the net bookings breakdown from our labels to be roughly 49% Zynga, 31% 2K, 18% Rockstar Games and 2% other. And we forecast our geographic net booking split to be about 65% United States and 35% international. We are projecting the current consumer spending growth of 4% compared to fiscal 2023, which assumes an increase for NBA 2K as well as Zynga since we will own the business for a full 12 months this year. For Grand Theft Auto Online, Virtual Currency and GTA+ membership is expected to be flat. RCS is expected to represent 78% of net bookings. We plan to generate approximately $100 million in non-GAAP adjusted unrestricted operating cash flow and to deploy approximately $150 million for capital expenditures, primarily to support our office build-outs and larger footprint. We continue to forecast GAAP net revenue to range from $5.37 billion to $5.47 billion. Our total operating expenses are now planned to range from $3.53 billion to $3.55 billion as compared to $3.45 billion last year. On a management basis, we continue to expect operating expense growth of approximately 14% year-over-year due to a full year of Zynga, an increase in personnel and marketing expenses and higher depreciation of office build-outs and capitalized IT expenses, which are being partially offset by the realization of synergies from our combination with Zynga and savings from our cost reduction program. We remain vigilant in our efforts to optimize our cost structure and reduce discretionary costs where possible, while still investing for growth. Now moving on to our guidance for the fiscal third quarter. We project net bookings to range from $1.3 billion to $1.35 billion compared to $1.4 billion in the third quarter last year. Our release date for the quarter includes two mobile titles Top Troops and Match Factory as well as Borderlands 3 Ultimate Edition, all of which have been released. The largest contributor to net bookings are expected to be NBA 2K, Grand Theft Auto Online and Grand Theft Auto V, our hyper-casual mobile portfolio, Empires & Puzzles, Toon blast, Red Redemption 2 and Red Dead Online, Words with Friends, Merge Dragons and Zynga Poker. We project the current consumer spending to decrease by approximately 5%, which assumes a modest decline in our mobile business, which is being partially offset by expected growth in NBA 2K. The Grand Theft Auto Online, virtual currency and GTA+ membership is expected to be up. We project GAAP net revenue to range from $1.29 billion to $1.34 billion. Operating expenses are planned to range from $826 million to $836 million. On a management basis, operating expenses are expected to grow by approximately 7% year-over-year driven by higher personnel and depreciation expenses, which are being partially offset by the Zynga synergies and our cost savings initiatives. In closing, there are many exciting upcoming catalysts that we believe will enable our company to achieve new record levels of financial performance. Powered by our incredible talent, we believe that our projects in development will set new standards for creativity and engagement in our industry while also significantly enhancing our financial profile. We'd like to thank all our stakeholders for being on this journey with us, and we can't wait to share more details with you. Thank you. I'll now turn the call back to Strauss."
},
{
"speaker": "Strauss Zelnick",
"content": "Thanks, Lainie and Karl. On behalf of our entire management team, I'd like to thank our colleagues for enabling us to achieve our goals and to deliver another strong quarter. To our shareholders, I want to express our appreciation for your continued support. We'll now take your questions. Operator?"
},
{
"speaker": "Operator",
"content": "Thank you [Operator Instructions] And our first question comes from the line of Andrew Uerkwitz with Jefferies. Please proceed."
},
{
"speaker": "Andrew Uerkwitz",
"content": "Great. Thank you for taking my questions. The first one -- and I just have one follow-up. The first one, in last quarter, you reiterated your fiscal '25 and '26 guidance. I think you announced Sam Houser mentioned, we'll get a trailer for Grand Theft Auto, I think, in December. How are you feeling about those two years? And any reason why you mentioned those two years in the reiteration of guidance?"
},
{
"speaker": "Lainie Goldstein",
"content": "Due to shifts in our pipeline, our expectations are that net bookings will now be below $8 billion, but not necessarily. So it really isn't a big change, and we expect growth in 2016 as well."
},
{
"speaker": "Andrew Uerkwitz",
"content": "Got it. Thank you. And then kind of just turning to high-level question. The acquisition of FiveM seems super interesting. In that it could allow you guys to maybe learn more about user-generated content and find ways to monetize that and expand your audience. What's the broader thought of making an acquisition like that and how it fits in, not just with Grand Theft Auto, but maybe the company as a whole?"
},
{
"speaker": "Strauss Zelnick",
"content": "We're really excited about it. I mean, to be clear, this is a small economic opportunity right now and a small cost to us. We want to be where the consumer is and what's going on in role playing and really in two ways. Number one, the people are actually playing in old playing servers and number two, the people are watching what they're doing on Twitch. Both are really interesting. The actual people playing is a relatively modest audience. It's in the hundreds of thousands. But the people watching, that's a huge audience. And we're interested in first of all making sure that our intellectual property is protected. We're also really interested in meeting the consumer where the consumer is. And for certain consumers bonding is a really important activity. And finally, people are consuming our intellectual property, we would like to monetize it if we can. We think this gives us an opportunity to do all of the above."
},
{
"speaker": "Andrew Uerkwitz",
"content": "Got it. Thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Eric Handler with ROTH MKM. Please proceed."
},
{
"speaker": "Eric Handler",
"content": "Good afternoon. Thanks for the question. I wonder if you could talk a little bit about what you're seeing with players who engage with GTA+? Are there different how they interact with the game versus someone who's not a subscriber."
},
{
"speaker": "Strauss Zelnick",
"content": "We don't see materially different behavior. We think it's a great addition. We're thrilled to engage with our consumers in this way. And it's a learning experience, but it's also gratifying that GTA+ continues to grow and be more and more relevant to more and more consumers."
},
{
"speaker": "Eric Handler",
"content": "Then, Lainie, maybe you can just a quick clarification. At least on a GAAP basis, advertising was down. Is there a difference between GAAP revenue for advertising and advertising bookings?"
},
{
"speaker": "Lainie Goldstein",
"content": "Yes. There is -- in the gap there is some deferral of some of the advertising. So that's the difference between us being up in the quarter versus the gap showing flat."
},
{
"speaker": "Eric Handler",
"content": "Got it. Okay. Thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Doug Creutz with TD Cowen. Please proceed."
},
{
"speaker": "Doug Creutz",
"content": "Hey, thanks. Just wondering if you could give any more color on the write-down you took in the quarter. I'm guessing that had to do with some of your mobile assets, but whatever other color you can give, that would be helpful."
},
{
"speaker": "Lainie Goldstein",
"content": "So we recorded an impairment charge of $220 million related to intangible assets and $165 million of goodwill representing a partial impairment of one of our reporting units. And this is as a result of an updated long-term projection for that reporting unit, but we're not giving any more details other than that."
},
{
"speaker": "Doug Creutz",
"content": "Okay. Thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Andrew Marok with Raymond James. Please proceed."
},
{
"speaker": "Andrew Marok",
"content": "Thanks for taking my questions. So over the last couple of weeks and months of trying out some different additions of content for GTA+ subs, thinking about the Trilogy in particular. I guess kind of what learnings have you had from the different types of content included in the subscription and how it drives uptake?"
},
{
"speaker": "Strauss Zelnick",
"content": "That's the kind of detail that we typically leave to our labels. So we probably don't have much more to add today except what I said earlier which is we are thrilled that Rockstar is offering a subscription to avid consumers, and we think it bodes really well for the future."
},
{
"speaker": "Andrew Marok",
"content": "Right. Appreciate that. And then one more, if I could. I heard a lot about some of the coming titles in mobile, kind of a greater prominence of licensed IP with things like Star Wars, Game of Thrones, Lord of the Rings. Just any difference in thinking as to the value of licensed IP on mobile versus console and PC. Thank you."
},
{
"speaker": "Karl Slatoff",
"content": "So this is Karl. The fact is we do value both, both can be very, very valuable. Obviously, owning the IP in any context and also in mobile, the margin potential is much higher because you own it full and outright. Obviously, with licensed IP you have to pay royalty. But the mobile market is tough to break new IP. It's tough to get attention. And it comes out -- you can't argue with the fact that having a known brand out there is a way for you to get attention. So it's a give and take. I would say our perspective hasn't changed. In a perfect world, we would focus exclusively on owned IP. But the truth is when we see a good license that we think would have -- we have a great idea for a game for and if Zynga folks want to take it to market, then that's something that we're going to continue to pursue."
},
{
"speaker": "Andrew Marok",
"content": "Right. Much appreciated. Thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Eric Sheridan with Goldman Sachs. Please proceed."
},
{
"speaker": "Eric Sheridan",
"content": "Thank you so much for taking the question. Maybe one bigger picture, one first for Strauss. You've seen a lot of media inflation and increases in subscription prices, broadly in the media landscape. How do you think about striking the balance between pricing and attracting a wider array of audience when you think about the content pipeline you're going to bring to market over the next couple of years to capture the right mix between those two dynamics? And then second question would be, are there any guardrails we should be keeping in mind in terms of the evolution of the DTC platform? And what piece or cadence that might continue to evolve as a percentage of the mix?"
},
{
"speaker": "Strauss Zelnick",
"content": "Yes. I mean you don't want to generalize to our business too much from what's going on in linear entertainment because the increase in subscription pricing and linear entertainment is really a reflection of the fact that too many streaming services were underpricing to acquire customers and then they realize those customers were not durable and the LTVs were upside down. So they were basically adjusting their pricing to make sure that the LTVs are potentially positive. And I think there's still more pain to come for some of those services, and I can wax eloquent if you want, although it has nothing to do with our business. In terms of pricing for any entertainment property, basically the algorithm is the value of the expected entertainment usage, which is to say that the per hour value times the number of expected hours plus the terminal value that's perceived by the customer in ownership if the title is actually owned, not say, rented or subscribed to. And you'll see that, that bears out in every kind of entertainment vehicle. By that standard, our frontline prices are still very, very low because we offer many hours of engagement. The value of the engagement is very high. So I think the industry, as a whole, offers a terrific price-to-value opportunity for consumers. That doesn't necessarily mean that the industry has pricing power or wants to have pricing power. However, there is a great deal of value offered. And look, it's our strategy here to deliver much more value than what we charge consumers. It's always been our strategy here. We want to make sure the experience is first class, and the nature of the experience is not just the quality of what we offer, it's also what you pay for it, everyone knows that anecdotally. So that's how we look at it. There have been precious few price increases in the business. The price increase, for example, the $70 for certain frontline products was the first price increase in many years after many generations. So again, I think we offer a terrific value to consumers. On the second question?"
},
{
"speaker": "Karl Slatoff",
"content": "DTC."
},
{
"speaker": "Strauss Zelnick",
"content": "Regarding the direct-to-consumer platform, we think there continues to be a great deal of upside there, again, for consumers and also for our margins. It's still a relatively small part of our business. There's a great opportunity for growth. To be clear, we will always work with third-party retailers. We want to be where the consumer is. We value our third-party retailer relationships, they do provide marketing support. That's important to us. There are times when consumers want to have a direct relationship. We can do both. We can do all of the above. It is not our strategy to bring everything in-house."
},
{
"speaker": "Eric Sheridan",
"content": "Okay. Thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Drew Crum with Stifel. Please proceed."
},
{
"speaker": "Drew Crum",
"content": "Okay. Thanks, guys. Good afternoon. So Strauss, you mentioned that the business is well positioned for the holiday season. What's driving that confidence? And how would you assess the health of your consumer? And then separately, I know it's just a subtle change to RCS, but what's behind the adjustment to that figure for the second half, given your fiscal 2Q is in line? It looks like just based on the commentary around the net bookings mix of Zynga, but just want to confirm that. Thanks."
},
{
"speaker": "Karl Slatoff",
"content": "So speaking to the confidence of our holiday season. Look, simply, I think it's the strength of our catalog and the strength of our products and a lot of our releases are must-have releases. And any time you're heading into a holiday season, and I think everyone around the table and on the phone is hopeful that we're going to have a very strong hardware season this year. We do have a lot of titles that we think are sort of go-to titles for people to engage with. Besides -- and also, you're obviously -- we're also working off of the results that we've had to date, which are very strong. So the momentum feels positive. We've got a great lineup in place. And it looks like it's going to be a pretty good holiday season from a consumer perspective, particularly in the gaming space."
},
{
"speaker": "Lainie Goldstein",
"content": "And for the RCS, the main driver is the reduction in Zynga's business for the remainder of the year. So we forecasted some of our titles including a more muted expectation for the holiday based on the current trends. And we're also continuing to focus on profitability in hyper-casual, which is reducing our top line but enhancing our margins. And then there's also some shifts in the pipeline, including Star Wars: Hunters."
},
{
"speaker": "Drew Crum",
"content": "Helpful. Thanks, guys."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Omar Dessouky with Bank of America. Please proceed."
},
{
"speaker": "Omar Dessouky",
"content": "Hi. Thanks so much for taking the question. I just wanted to get a little bit of clarification on what you said about shifts in your pipeline causing your fiscal '25 guide to be not materially below $8 billion. Is that because of shifts in your very largest AAA games in the pipeline, your smaller AAA games in the pipeline or your mobile games? If you could provide some clarity on that, I'd appreciate it. Then I have a follow-up. Thanks."
},
{
"speaker": "Strauss Zelnick",
"content": "Yes. We haven't even issued initial guidance for the year. We do that in the spring of the New Year, and that's when we'll give a lot more specificity around the release schedule. However, I want to reiterate, we are going to be shy of $8 billion in fiscal '25, but not materially so."
},
{
"speaker": "Omar Dessouky",
"content": "Okay. Right. No problem. So then the other question is, obviously, super happy to see Sam Houser's message about Grand Theft Auto VI -- next Grand Theft Auto trailer coming soon. On September 26th, the SAG-AFTRA voted to approve strike authorization for video game performers covered under the Union's Interactive Media Agreement. Now they haven't actually strike yet, but there are negotiations. And I wanted to know whether if voice actors and motion capture actors were to go on strike, would it slow down the production of the next Grand Theft Auto at Rockstar. Does Rockstar have the type of employment contracts that would allow the workers, the actors to work through a strike?"
},
{
"speaker": "Strauss Zelnick",
"content": "Negotiations are expected to resume next week. We're optimistic and value all of our talent greatly, and we value excellent labor relations and we're looking forward to reaching an agreement that serves everyone well. That's always been my approach. I've been involved with labor negotiations in every entertainment industry there is in my career. They've always worked out just fine. In the event that they don't work out just fine, now we are completely protected."
},
{
"speaker": "Omar Dessouky",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Mike Hickey with Benchmark. Please proceed."
},
{
"speaker": "Mike Hickey",
"content": "Hey, Strauss, Karl, Lainie and Nicole. Great quarter guys. Thanks for taking my questions Two questions. The first one, Strauss, I'd be curious sort of your updated thoughts on AI here. It seems like the technology is -- at least the unlock here is accelerating in some of the use cases that we're seeing in terms of product and productivity seems very remarkable. So just curious what you're thinking there, if that's different or not? And then the second question, on the trailer in early December, curious what sort of impact you could think -- you think that might have on other Rockstar product catalog product. Obviously, it's already been strong. And I'm curious if that would be a catalyst boost for your catalog. And I'm curious on Grand Theft Auto Online, the sort of the strategic value of that live service given the vitality it has into the release of GTA next. Obviously, that's the set up you haven't experienced before. Thanks, guys"
},
{
"speaker": "Strauss Zelnick",
"content": "Mike, look, we've been in the AI business since the dawn of this industry. Our entertainment properties are created largely in and by computers, and we value tools and we create those tools internally, and we license external tools as well, and the new developments in AI are really exciting. And I've said publicly and repeatedly that I believe that they'll help create efficiency and in certain instances, allow us to do things that we haven't been able to do before. But it's going to allow that for our competitors as well. So I think the tool sets that come out of these recent developments will be commoditized quickly. And the efficiencies that we see, others will see. Do I think that generative AI is going to make hit games? No. Do I think that the need for creative people will go away? Absolutely not. I think, if anything, better tool sets just raise the bar. They give us the opportunity to do more and do better. So the changes will be menial work probably is reduced or eliminated, high-level work is enhanced in importance. So I think you'll see shifts in what we can do with our games. So you mentioned product. I think you'll see some shifts in product, positive ones, I hope. And you mentioned productivity, and I think you will, for sure, see shifts in productivity, but I'm not sure those shifts will drop to the bottom line because typically, when we've generated productivity with tool sets, we've just set our sights higher. And that's our story. Our strategy is to be the most creative, the most innovative and the most efficient company in the business and AI, I think, probably ticks all three boxes. But don't expect the price tags to go down, just expect everything to get better and competition probably to become more intense for people who are not able to avail themselves of the resources that we can afford. With regard to the expected trailer that Sam Houser posted about today, we're as excited as anyone else. And do I think there will be an impact on our catalog revenue? Potentially. Things are already going really well in that space. And with regard to GTA Online, I mean, it's one amazing story that here we are 10 years later after the initial release and GTA Online is going strong. Why is it going strong? Because it's phenomenal and because Rockstar continues to supply content and updates and engage consumers and entertain them more effectively than, frankly, anyone else in the business. As long as we keep doing that, we'll be very well positioned, indeed."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] And our next question comes from the line of Clay Griffin with MoffettNathanson. Please proceed."
},
{
"speaker": "Clay Griffin",
"content": "Yes, thanks. Good morning. I couldn't help but notice that Nintendo announced a live action film, Zelda film. I know -- for Strauss, I know this question comes up all the time. I guess maybe we'll close it this way. What's your relative willingness and perhaps even Rockstar's willingness to partner and find ways to extend Red Dead Redemption IP, Grand Theft Auto IP, just because it has been so successful from a marriage perspective. Just wanted to get your updated thoughts on that."
},
{
"speaker": "Strauss Zelnick",
"content": "We've spoken about this many times. If we're willing to use the company's balance sheet to make a movie or a television show, then in the event of great success, we would benefit from it. But we're not prepared to use the company's balance sheet that way because the risk/reward profile is unappealing to us. They're very difficult businesses. I've been in them successfully. They're super challenging. They're not what we do. We'd much prefer the risk/reward profile of the business we're in. So that means that the only way we can be in that business is through a license arrangement with a third party. And let's put it in context. Mattel announced, they said that their profits -- expected profits from licensing the Barbie IP for a movie would be about $125 million. Now Barbie is a massive, massive hit and it's extraordinary hit. So you don't want to posit a massive hit and look at the numbers that way. Even in a really good news scenario, the license fees would be a fraction thereof for many of our properties, not really enough to be meaningful here. And we have to weigh that too against the risk of failure. And the hit ratios in the motion picture business are vastly lower than they are in the interactive entertainment business. Our hit ratios for console properties are in the 80% or 90%. The hit ratio for a well-run movie studio is around 30%, which is to say there's a 70% chance that the movie that we license could fail. And so in success, the number, in terms of the benefit to our bottom line, is it's not de minimis, it's not 0, but it's not really material to what we do around here. And in failure, we run the risk of compromising the underlying intellectual property. So it's a high bar. We have licensed 2 properties. We've licensed Borderlands to Lionsgate's picture coming. We've licensed BioShock. We're looking forward to that as well. And we have other titles in discussions, not anything ready to announce, but we're going to be very, very selective and very careful."
},
{
"speaker": "Clay Griffin",
"content": "Makes sense. Thanks."
},
{
"speaker": "Operator",
"content": "And our next question comes from the line of Brian Fitzgerald with Wells Fargo."
},
{
"speaker": "Brian Fitzgerald",
"content": "We've been seeing more discussion of intrinsic in-game advertising, things like in-game billboards. And it seems like brand advertisers are getting more and more comfortable with in-game advertising. What are your thoughts on the broader opportunity there beyond mobile, beyond games within games, and maybe as well as your outlook for take this owned ad business and how that evolves? Thanks and Congrats on the quarter."
},
{
"speaker": "Strauss Zelnick",
"content": "Thanks. I mean you understand what we're already doing in mobile. So I don't think you want me to cover that. You alluded to that. With regard to console titles, we have advertising when it makes sense creatively and feels organic to the title. So for example, in NBA, if you go to a basketball game, you're going to see advertising in the arena. So it's perfectly reasonable to see the same kind of advertising in our game. But we're not going to do product placement where it's inappropriate, so that we can create a small amount of revenue. First of all, the numbers aren't huge. But secondly, anything that we do that takes a consumer out of the experience is problematic. So years ago, and I don't mean to take a potshot, but I'll do it anyhow. Years ago, there was a Bond movie, and James Bond, everyone knows he only drives an Aston Martin. He's only ever driven an Aston Martin. I don't know which iteration it was, but there was one iteration where they clearly made a deal with BMW and all the cars in the movie were BMW. And look, it ruined the movie for me. Because I -- to me, every time I saw BMW, I was like, wow, look, a little bit of product placement right there, a little bit of an advertisement. That's a disaster. So it's perfectly fine in basketball. It's perfectly fine in WWE. It's not perfectly fine in that title where advertising doesn't fit. As a result, I don't think you should expect that the numbers will be really material, although again, we do have an advertising business when it makes sense. That's completely separate, again, at the risk of being repetitive, from the mobile advertising business. That's a growth category for us. Our mobile advertising was up year-over-year. We feel really good about that."
},
{
"speaker": "Brian Fitzgerald",
"content": "Thanks, Strauss."
},
{
"speaker": "Strauss Zelnick",
"content": "I think those are all the questions we have. I just want to say thank you again for everyone joining us today. We're thrilled with the results, and the results are driven by the creativity and passion and commitment of our colleagues, all 12,500 of them all around the world. They work really hard every day, and we get to talk about it here. But the work is done at the studio level, at the label level, at the corporate level. This is a company of great commitment to our strategy of creativity, innovation and efficiency, and we have a culture of ambition, hard work, excellence, seeking and kindness. And I'm really proud of that. This is a really unusual place. If we pursue our strategy and we do it in a way that's consistent with our culture, we've seen over and over again to do well. We're proud of that, and we feel very optimistic about the future. Thanks so much for joining us today."
},
{
"speaker": "Operator",
"content": "Thank you. This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation."
}
] |
ttwo | 2,024 | 1 | [
{
"speaker": "Operator",
"content": "Greetings. Welcome to Take-Two Interactive's First Quarter Fiscal Year 2024 Earnings Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] Please note, this conference is being recorded. I will now turn the conference over to Nicole Shevins, Vice President of Investor Relations and Corporate Communications. Thank you. You may begin."
},
{
"speaker": "Nicole Shevins",
"content": "Good afternoon. Thank you for joining our conference call to discuss our results for the first quarter of fiscal year 2024 ended June 30, 2023. Today's call will be led by Strauss Zelnick, Take-Two's Chairman and Chief Executive Officer; Karl Slatoff, our President; and Lainie Goldstein, our Chief Financial Officer. We will be available to answer your questions during the Q&A session, following our prepared remarks. Before we begin, I'd like to remind everyone that statements made during this call that are not historical facts are considered forward-looking statements under federal securities laws. These forward-looking statements are based on the beliefs of our management, as well as assumptions made by and information currently available to us. We have no obligation to update these forward-looking statements. Actual operating results may vary significantly from these forward-looking statements based on a variety of factors. These important factors are described in our filings with the SEC, including the company's most recent Annual Report on Form 10-K and Quarterly Report on Form 10-Q, including the risks summarized in the section entitled Risk Factors. I'd also like to note that, unless otherwise stated, all numbers we will be discussing today are GAAP and all comparisons are year-over-year. Additional details regarding our actual results and outlook are contained in our press release, including the items that our management uses internally to adjust our GAAP financial results in order to evaluate our operating performance. Our press release also contains a reconciliation of any non-GAAP financial measure to the most comparable GAAP measure. In addition, we have posted to our website a slide deck that visually presents our results and financial outlook. Our press release and filings with the SEC may be obtained from our website at take2games.com. And now, I'll turn the call over to Strauss."
},
{
"speaker": "Strauss Zelnick",
"content": "Thanks, Nicole. Good afternoon, and thank you for joining us today. I'm pleased to report that fiscal 2024 is off to a strong start, highlighted by first quarter net bookings of $1.2 billion, which was at the high end of our expectations, and management results were in line with our plans. Grand Theft Auto Online and Grand Theft Auto V, and NBA 2K23 exceeded our projections, which illustrates the long-lasting benefits of producing the highest quality offerings and amassing one of the strongest and most diverse portfolios in entertainment. In keeping with our core values of creativity, innovation, and efficiency, this quarter, we introduced new intellectual properties, advanced the development of our eagerly anticipated pipeline, and maintained our vigilance with cost management initiatives across our organization. Turning to the results from our titles for the period. Grand Theft Auto V continued to outperform and to date, the title has sold-in more than 185 million units. On June 13, Rockstar Games launched San Andreas Mercenaries for Grand Theft Auto Online, which offers six new major story-based missions, as well as new Los Santos operations, Hangar upgrades, Smuggler Source and Sell Missions, seven new vehicles, and more. The update also includes a range of fan-requested experience improvements, as well as the Career Progress feature, offering players a new way to track their progression across criminal careers and claim rewards. San Andreas Mercenaries continues to deliver high value content post-launch using a phased approach that is driving sustained engagement and Recurrent Consumer Spending. This June, Grand Theft Auto Online recorded more players than any other June in its history outside of the height of the pandemic. GTA+, Rockstar’s premium membership service for GTA Online on PlayStation 5 and Xbox Series X and S, offered exclusive options for members to test drive and purchase an array of vehicles, and we are continuing to see strong growth in GTA+ adoption with each passing quarter. We were pleased with the performance of Red Dead Redemption 2, which has sold-in more than 55 million units to-date. Rockstar Games continues to support Red Dead Online with new bonuses and rewards, including free apparel inspired by the RedDeadFashion subreddit, and seasonal content such as April’s Condor Egg Freemode Event. NBA 2K23 exceeded our plans and the title has now sold-in over 13 million units, representing a 11% year-over-year growth, driven by higher demand, especially on Gen-9 consoles, as well as a more tailored promotional cadence. This incredible performance marks the title’s second-highest sell-through ever -- with only NBA 2K20 achieving higher unit sales. Engagement with NBA 2K23 remains strong, with approximately 2.6 million Daily Active Users delivering Recurrent Consumer Spending that exceeded our expectations. Our franchise extensions with the NBA continue to perform extremely well and NBA 2K23 Arcade Edition remains one of the top games on Apple Arcade. WWE 2K23, which is the highest-rated game in our wrestling franchise’s history and the second highest-rated sports simulation title of the year, experienced strong engagement throughout the quarter, with players logging nearly 22 million hours of gameplay and facing off in 170 million matches. 2K and Visual Concepts continue to support the title with a series of 5 DLC packs that can be purchased individually or as part of a Season Pass. 2K also continues to support PGA TOUR 2K23 with additional pros, courses, and Clubhouse Passes. In May, 2K and Visual Concepts launched LEGO 2K Drive, the first game in a multi-title partnership between 2K and the LEGO Group. Following the launch, our teams released the first of four Drive Pass Seasons for the title, which features 100 levels and new content inspired by the Fast and the Furious Saga. Also in May, Private Division and Piccolo Studio launched After Us on PlayStation 5, Xbox Series X and S, and PC, which has been praised by critics for its striking visuals and game world. Zynga had a solid start to the year, performing in-line with our plans, and we are pleased with the ongoing progress of our mobile business. Ad revenue grew approximately 11% year-over-year, driven by the addition of Popcore and our ability to open new inventory supplies in our portfolio. Toon Blast has been introducing strong feature releases such as the Toon Race event, which drove outperformance versus our forecasts and helped the game recently surpass $2 billion in lifetime gross bookings. We made excellent progress on our profitability initiatives in mobile. We expanded our offerings on our direct-to-consumer platforms and continue to believe that, over the next few years, the majority of our mobile games will leverage our highly-profitable, proprietary distribution channel. We continue to enhance the performance and profitability of our hyper-casual business, with multiple new games scaling quickly and several titles generating bookings from in-app purchases in addition to ads. A few key highlights of Zynga’s live services during the period include: Empires & Puzzles grew quarter-over-quarter, driven by the new Path of Giants battle pass featuring daily and weekly challenges to unlock rewards. Rollic’s Twisted Tangle reached the number one Free Game spot on the U.S. Google Play store. Social Casino again delivered strong results, driven by Hit It Rich's best quarter in two years, and Game of Thrones Casino’s second best quarter in its history. Casual games continued to improve participation and engagement, with Words With Friends launching the new Club Daily Puzzle and Harry Potter: Puzzles & Spells adding Bonus Levels and Special Delivery prize events. With numerous games in development and soft launch across Zynga’s studios, we are excited to start delivering several new offerings in the coming months. Turning to our outlook, we are reiterating our prior guidance of $5.45 to $5.55 billion in net bookings for fiscal 2024. We remain highly optimistic about our future and our ability to deliver record results in the coming years. Lainie will provide more details on our outlook shortly. In closing, as we continue to execute our strategy, we believe that we can increase significantly our scale and prominence within the industry, grow margins, and pursue the vast opportunities to engage even larger audiences around the world. Led by the passion, creativity, and innovation of our world-class development teams, Take-Two is in a powerful position to set new benchmarks for our player communities, which we believe will drive long-term returns for our shareholders. I will now turn the call over to Karl."
},
{
"speaker": "Karl Slatoff",
"content": "Thanks, Strauss. I’d like to thank our teams for a strong start to the year. Turning to our announced launches for fiscal 2024. Yesterday, Rockstar Games announced that the beloved Western experiences, Red Dead Redemption and Undead Nightmare would be coming to the Nintendo Switch and PlayStation 4 for the first time in a new single package, arriving August 17. In a new conversion by Double Eleven Studios, the Switch and PS4 versions bring the two classic experiences together again for new players and original fans to enjoy across modern consoles, including backwards compatibility with the PlayStation 5. On September 8, 2K and Visual Concepts will celebrate the 25th anniversary of our industry defining NBA 2K series and once again redefine basketball simulations with the launch of NBA 2K24, featuring the iconic Kobe Bryant as the game’s cover athlete for the second time in the history of the franchise. Players will be able to celebrate Bryant’s legacy and replicate his skills in the brand-new Mamba Moments mode. Players in the U.S. and Canada can also purchase the WNBA Edition of the game exclusively at GameStop, featuring WNBA All-Star Sabrina Ionescu, as this year’s cover star. NBA 2K24 will introduce cross-play, a community requested feature for PlayStation 5 and Xbox Series X and S. Available in every multiplayer mode, players will be able to compete with or against others from around the world in dynamic co-op matches, thrilling online tournaments, or casual pick-up games between new generation consoles. The title will also introduce ProPLAY, a groundbreaking new technology that directly translates actual NBA footage into gameplay. 2K will have more to share on NBA 2K24 in the coming weeks. In addition, 2K and Visual Concepts remain hard at work on WWE 2K24, the next installment of our popular wrestling series, which set new creative and critical benchmarks with last year’s highly successful release. In June, Private Division and Evening Star announced Penny’s Big Breakaway, a new 3D action platformer from the team behind Sonic Mania. This kinetic yo-yo adventure is expected to launch in early 2024. Zynga’s Star Wars: Hunters, which offers players the opportunity to join the greatest hunters from across the Star Wars galaxy is expected to launch later this fiscal year. Players will engage in thrilling third-person combat in a range of competitive game modes across battlegrounds from the iconic worlds of Star Wars. Also in mobile, Social point’s latest game, Top Troops, a medieval fantasy-themed title in the PvP merge genre is progressing well in soft launch and is expected to launch worldwide this fiscal year. In addition, our hyper-casual studios will release a steady cadence of mobile titles throughout the year, focusing on games that have the potential for enhanced retention rates and a mix of in-app purchases and advertising to drive higher monetization and profitability. Our labels will also continue to provide new content and experiences that drive engagement and recurrent consumer spending across many of our offerings, including Grand Theft Auto Online, Red Dead Online, WWE 2K, LEGO 2K Drive, PGA TOUR 2K, Kerbal Space Program 2, and Zynga’s mobile portfolio. Throughout fiscal year 2024, we look forward to launching additional releases from what we believe to be the strongest and most exciting development pipeline in our company’s history. I’ll now turn the call over to Lainie."
},
{
"speaker": "Lainie Goldstein",
"content": "Thanks Karl and good afternoon everyone. Today, I’ll discuss the key highlights from our first quarter before reviewing our financial outlook for the full year and second quarter of fiscal 2024. Our combination with Zynga closed on May 23, 2022, which affects the comparability of our results relative to last year. Additional details regarding our actual results and outlook are contained in our press release. We had a strong start to the fiscal year, powered by our portfolio of iconic, industry-leading intellectual properties. As we approach our next phase of growth, our teams continue to make excellent progress advancing our development pipeline and capitalizing on our revenue-driven opportunities and synergies. We also partnered together to maintain our focus on efficiency amidst the challenging macroeconomic backdrop and cautious consumer spending trends. I’d like to thank our incredible teams worldwide for their determination and passion for our business. Now, moving onto our results. We achieved net bookings of $1.2 billion, which was at the high end of our guidance range. In the current backdrop, many consumers are purchasing established franchises and those that offer great value, and our catalog stands at the intersection of these two trends. Accordingly, our performance reflects better-than-expected results from Grand Theft Auto Online and Grand Theft Auto V, and NBA 2K23. During the quarter, we launched Marvel’s Midnight Suns for Gen 8 consoles, Lego 2K Drive, and After Us. Recurrent consumer spending rose 38% for the period, which was above our outlook of 35% growth, and accounted for 84% of net bookings. The outperformance was primarily driven by Grand Theft Auto Online and NBA 2K23. GAAP net revenue increased 17% to $1.28 billion and cost of revenue increased 39% to $606 million, driven by $187 million of amortization of acquired intangibles. We also recorded an impairment charge of $18 million, related primarily to capitalized software and development costs for an unreleased title, which affected our management results compared to our guidance. Operating expenses increased by 25% to $883 million. On a management basis, operating expenses grew by 46%, which primarily reflected a full quarter of Zynga, higher personnel costs, and depreciation related to office buildouts and capitalized IT expenses. Turning to our guidance, I’ll begin with our full fiscal year expectations. As Strauss mentioned, our business is performing well, and we are reiterating our net bookings outlook range of $5.45 billion to $5.55 billion. Largest contributors to net bookings are expected to be NBA 2K, Grand Theft Auto Online and Grand Theft Auto V, our hyper-casual mobile portfolio, Empires & Puzzles, Toon Blast, Merge Dragons, Words With Friends, Red Dead Redemption 2 and Red Dead Online, and Zynga Poker. We expect the Net Bookings breakdown from our labels to be roughly 51% Zynga, 30% 2K, 17% Rockstar Games, and 2% Other. And, we forecast our geographic net bookings split to be about 65% United States and 35% International. We continue to forecast recurrent consumer spending growth of 5% compared to fiscal 2023, representing 78% of net bookings. Mobile trends are projected to remain stable, with Zynga’s ad business continuing to deliver growth. We expect to generate approximately $100 million in non-GAAP adjusted unrestricted operating cash flow, and deploy approximately $180 million for capital expenditures, primarily to support our office buildouts and larger footprint. We continue to expect GAAP net revenue to range from $5.37 billion to $5.47 billion. Our total operating expenses are expected to range from $3.38 billion to $3.4 billion as compared to $3.45 billion last year. On a management basis, our operating expenses are expected to grow by approximately 15% year-over-year, due primarily to a full year of Zynga, an increase in personnel and marketing expenses, and higher depreciation of office buildouts and capitalized IT expenses, which are being partially offset by the realization of synergies from our combination with Zynga and savings from our cost reduction program. As we announced previously, our teams are taking extensive measures to review our cost structure and reduce discretionary costs whenever possible to offset the current consumer backdrop and inflationary environment, while still investing for growth. Now moving onto our guidance for the fiscal second quarter. We project Net Bookings to range from $1.4 billion to $1.45 billion, compared to $1.5 billion in the second quarter last year. Our release slate for the quarter includes Red Dead Redemption and Undead Nightmare for Switch and PlayStation 4, and NBA 2K24. The largest contributors to net bookings are expected to be NBA 2K, Grand Theft Auto Online and Grand Theft Auto V, our hyper-casual mobile portfolio, Empires & Puzzles, Toon Blast, Words With Friends, Merge Dragons, Red Dead Redemption 2 and Red Dead Online, and Zynga Poker. We project recurrent consumer spending to decline by approximately 7%, which assumes modest declines in our mobile business; NBA 2K, driven by changes to its summer promotional cadence; and Grand Theft Auto Online; as well as a reduction in DLC revenue from several titles that were released in prior years. We expect GAAP net revenue to range from $1.26 billion to $1.31 billion. Operating expenses are expected to range from $811 million to $821 million. On a management basis, operating expenses are expected to grow by approximately 5% year-over-year, driven by last year’s acquisition of Popcore and higher personnel costs, which are being partly offset by the Zynga synergies and our cost savings initiatives. In closing, we are confident that the actions our teams are taking this year are preparing us for a strong trajectory of growth. Through our collective efforts, we continue to believe that we are positioning our business for a significant inflection point in fiscal 2025 that will culminate in us delivering new record levels of operating performance next year and beyond. We thank all of our stakeholders for their continued support, and we look forward to delivering on this exciting next chapter. Thank you. I’ll now turn the call back to Strauss."
},
{
"speaker": "Strauss Zelnick",
"content": "Thanks, Lainie and Karl. On behalf of our entire management team, I'd like to thank our colleagues for delivering a strong start to the fiscal year. And to our shareholders, I want to express our appreciation for your continued support. We'll now take your questions. Operator?"
},
{
"speaker": "Operator",
"content": "Thank you. [Operator Instructions] Our first question is from Andrew Uerkwitz with Jefferies. Please proceed."
},
{
"speaker": "Andrew Uerkwitz",
"content": "Yeah. I just have -- I just had one question. Lainie called out consumer weakness kind of continuing. Could you just give an update on where you think the consumer is at. Is there a particular segment that's weaker than others? Just kind of an update on where you think the consumers are today. Thank you."
},
{
"speaker": "Strauss Zelnick",
"content": "Yeah. I mean I love that people are debating whether we're going to be in a recession from the point of view of a digital entertainment company, we've been in a recession for the better part of 18 months. The market for interactive entertainment was down meaningfully in 2022, down for the first time in the history of the mobile business over 10%, pretty much across the board. Things are looking a lot better. The year-over-year comps have stabilized. We're seeing growth in the console market. It's early, but we are seeing some growth. Mobile sort of flat, slightly down. We hope that will improve. I do feel like we're all seeing some green shoots across the economy. But it definitely is a mixed picture depending on the U.S. So in the context of the entertainment business, live entertainment is doing great. But in the context of entertainment that people consumed at home during the pandemic, it's been challenging for a while. And again, I think it's beginning to normalize, but it's early days yet. When asked a couple of calls ago what I thought would happen in the economy, I said that I thought it would bottom out in June, July. And that by the end of calendar '23, we begin to see some good news and then we'd be in reasonably good position from an economic point of view in early '24, and I continue to believe that that's what will happen."
},
{
"speaker": "Andrew Uerkwitz",
"content": "Got it. And then just one quick follow-up on that with -- around media, I guess, if Hollywood stays in a recession, is that a positive, negative or does it not matter for video games?"
},
{
"speaker": "Strauss Zelnick",
"content": "Look, we live within the entertainment ecosystem. So we would never wish for any other industry to have a problem. But if the strike means that new content can't be delivered, then I suppose it could be some small positive benefit for our business. But we aren't counting on that. We're certainly not hoping for it."
},
{
"speaker": "Andrew Uerkwitz",
"content": "Got it. Thank you so much guys. Appreciate it."
},
{
"speaker": "Operator",
"content": "Our next question is from Eric Handler with ROTH MKM. Please proceed."
},
{
"speaker": "Eric Handler",
"content": "Good afternoon and thank you for the question. Strauss, I wonder if you could just talk about with mobile advertising how much -- how many of your games beyond the hyper casual business have integrated advertising now?"
},
{
"speaker": "Strauss Zelnick",
"content": "Some, and we are moving in that direction selectively. Look, historically, for games where you could make in app purchases, less than 10% of the audience actually spent. So we are fielding a game for 100% of the audience and monetizing 10% or so, perhaps a bit more often a bit less. And it's our view that we ought to be monetizing 100% of the audience. So if someone's going to spend, that's great. And if they're not going to spend, then we ought to be able to monetize through advertising. The question is how do you do that and create a high-quality experience. And I think the answer is we can do that. We can distinguish among those audiences. We're not there yet, but I think we're moving in that direction."
},
{
"speaker": "Eric Handler",
"content": "Thanks. And just as a follow-up, I wondered if you could -- willing to give any specifics about how much of the mobile revenue at this point is on the DTC platform and how that's progressing?"
},
{
"speaker": "Strauss Zelnick",
"content": "So we don’t actually give out that percentage. Some of our competitors do. And so one of our biggest competitors, I think, has gone on the record to say it’s about 25% and I think that’s a good number. We’re not remotely in that vicinity. There’s plenty of room for growth. I would note that Zynga’s advertising net bookings were up 11% year-over-year. So it’s really good news. And we’re really happy about the growth of our direct-to-consumer platform and what that can mean for consumers and also for us."
},
{
"speaker": "Eric Handler",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Our next question is from Matthew Thornton with Truist Securities. Please proceed."
},
{
"speaker": "Matthew Thornton",
"content": "Hey. Good afternoon, Strauss, Karl, Lainie. Two quick ones for me. Last quarter, we talked about obviously achieving north of $8 billion in bookings next year and north of $1 billion in operating cash flow. I'm just kind of curious if those are still the right boggies for next year. And then just secondly -- and I apologize if I missed this. Any changes to this year? Is it slate? I saw we've got the $18 million impairment charge here. But I guess relative to where we were three months ago, is there any change to this year's release slate. Thanks so much."
},
{
"speaker": "Strauss Zelnick",
"content": "So the answer to question one is, yes, and Lainie will answer question two."
},
{
"speaker": "Lainie Goldstein",
"content": "Sure. So for question two, there has been some movements within the back part of the year within the slate, but we’re still able to achieve the same guidance for the year, so reiterating our guidance. So just some small changes within the slate, but it has nothing to do with the impairment charge. So the year is still the same."
},
{
"speaker": "Matthew Thornton",
"content": "Perfect. Thank you."
},
{
"speaker": "Operator",
"content": "Our next question is from Matthew Cost with Morgan Stanley. Please proceed."
},
{
"speaker": "Matthew Cost",
"content": "Hi, everybody. Thanks for taking the questions. Maybe I'll start just by asking about mobile M&A. I mean that was historically a very big part of Zynga's business. It seems like the market may be starting to fall out there in terms of deal activity after the three for the past year or two. I guess do you see an opportunity to lean back into M&A at the Zynga business number one. And then number two is just, Lainie, you mentioned in the prepared remarks that some changes to the promotional cadence for NBA 2K. I was wondering if you could just give a little more detail about what those changes are and the size of the financial impact? Thank you."
},
{
"speaker": "Strauss Zelnick",
"content": "So on the deal side, it's hard to know. In terms of our strategy, we think we're in a position to grow organically. We have a lot of new releases coming from Zynga. We're really excited about them. As you know, hit ratios are very low in the mobile business. So we're not claiming success until it occurs. But we do feel really good about some new launches. And in terms of the promotional cadences."
},
{
"speaker": "Lainie Goldstein",
"content": "So on NBA 2K 24, we expect to be up from 2K23 -- but 2K23 versus 2K22, there is some less promotional timing in this quarter versus what we did with 22 last year. So that's why we expect the title to be a little bit down versus last year."
},
{
"speaker": "Matthew Cost",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Our next question is from Doug Creutz with TD Cowen. Please proceed."
},
{
"speaker": "Douglas Creutz",
"content": "Hey. Thanks. You alluded to this a little bit earlier, you and others have talked about how difficult it is to launch a new mobile title these days. We did see, however, a few months ago, competitive of yours launched scope we launched MONOPOLY GO, which is shot to number one in the App Store charts rapidly, has had a lot of success. As you have observed that, is there anything that you would sort of any lessons you would draw from their success that you think could -- you could apply to your own games that you have coming out soon?"
},
{
"speaker": "Strauss Zelnick",
"content": "Look, I think it's an established intellectual property that's been known and beloved for a very long time. And if you combine that with a high-quality expression, I think you can do very well. We don't -- we obviously don't know what they're spending to be in the position that they're in. I do know that we're very focused on profitability. So we're being careful to make sure that our user acquisition spending reflects a high lifetime value for our customer."
},
{
"speaker": "Douglas Creutz",
"content": "Okay. Thank you."
},
{
"speaker": "Operator",
"content": "Our next question is from Eric Sheridan with Goldman Sachs. Please proceed."
},
{
"speaker": "Eric Sheridan",
"content": "Thanks so much. Maybe just one bigger picture question. As you continue to sort of integrate Zynga moved further away from the acquisition. Curious your updated thoughts on how you're thinking about elements of AAA titles having sort of cross-promotion, cross-play across elements of console and mobile and how that might inform some of your development cycles in the next couple of years or some of the pipeline dynamics that fed back into some of the bookings longer-term framework from last quarter. Thanks so much."
},
{
"speaker": "Strauss Zelnick",
"content": "We continue to believe there's an opportunity there. We do have titles coming that will offer an opportunity to engage on console and also in mobile. We don't think it's something that you have to offer, each title will stand alone. And a question you didn't ask, but we've also discussed the possibility of creating new mobile titles based on core Take-Two intellectual property. And that's something that we're also potentially excited about. In all instances, the consumer experience, the quality of the title is what governs, not the business model. So we have to create something great that consumers want. If we do, they'll show up and if we don't, they won't."
},
{
"speaker": "Eric Sheridan",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Our next question is from Mario Lu with Barclays. Please proceed."
},
{
"speaker": "Mario Lu",
"content": "Hey. Thanks for taking the question. The first one is on NBA 2K. You guys mentioned the upcoming cross-play feature was largely asked on by the community. So that being said, curious if there's any data points you could share in terms of how impactful this speech will be in terms of user engagement or recurrent consumer spending? And then is there any reason why it was not included on PC in the last June?"
},
{
"speaker": "Karl Slatoff",
"content": "So this is Karl, Mario. So look, we're very excited about cross play. It's something that our customers have been asking for and something that's natural for NBA. So obviously, we don't do anything in -- we don't put any new boats into a game unless we think that's going to have a significant impact on the experience for the consumer. That's something the consumer is going to love. And as end up leading to increased engagement. And obviously, as we say, when you get increased engagement, you get increased monetization and then everyone's happy in that regard. So all of these decisions are economic decisions, but it starts off first with the experience itself. And at this point, we're very confident that 2K is tracked and not on cross play experiences, and we're looking forward to that. And as it relates to PC and Ogan (ph) in terms of -- it's really just again allocation of resources, these decisions."
},
{
"speaker": "Mario Lu",
"content": "Got it. That makes sense. And then just on a separate note, in terms of the topic of charging a higher price for users to get access to a game like early access during the launch, I noticed it wasn't included NBA 2K preorder pricing. Is this an opportunity in the future or is just something you guys opted out of? Thanks."
},
{
"speaker": "Karl Slatoff",
"content": "Yeah. We have – most of – it’s funny you say a higher price because when we have some early access games in the market right now, we typically would offer them at a lower price because it would imply that there’s more to come in the game, and it’s not necessarily the final version. We have seen the early access models out there in terms of holding back access and making people pay more for earlier access – that’s not something that we’ve done to date. I would never say never. But honestly, that’s a marketing decision. And our priority is really making sure that the game comes out, comes out in a timely fashion as the best experience possible. That’s something that makes sense. So it’s down the line, we could experiment with it. But to date, that has not been something that we’ve looked at."
},
{
"speaker": "Mario Lu",
"content": "Got it. Thank you."
},
{
"speaker": "Operator",
"content": "Our next question is from David Karnovsky with JPMorgan. Please proceed."
},
{
"speaker": "David Karnovsky",
"content": "Thank you. Just on the bookings by label, I wanted to follow up on the guidance for Zynga. I think that's down slightly on the maintained bookings figure. So I wanted to see if you could walk through the adjustment there. And then sticking with mobile, you talked about hyper casual focus on releasing games that retain better, have a higher mix of IP spend. Just wanted to see if you could unpack the thinking behind the strategy there, what the traction has been and maybe how that impacts the ad revenue potentially from Rollic and Bapcor. Thanks."
},
{
"speaker": "Lainie Goldstein",
"content": "So for the bookings for Zynga for mobile, there are some game shifts within the year. So there was some reforecasting of some of the existing games, and that's what has changed within mobile."
},
{
"speaker": "Strauss Zelnick",
"content": "And then in terms of the hyper casual business, what we've seen is that there are some gains, particularly with the acquisition of Bapcor that are a bit stickier than the typical hyper casual business. And they have the opportunity to engage consumers for longer periods of time and also potentially lead to not just necessarily monetizing through advertising, but also monetizing through in-out purchasing. So we're starting to see that. We're starting to experiment with that. And we think that there's a market there for us. I think that people have been -- we've been calling is the hybrid casual market where you have the ability to not only monetize with advertising, but also in out purchases just because the experiences are a bit deeper and they last a little bit longer. So we think that's very exciting. I don't know that it's going to necessarily impact the advertising opportunity overall, but it certainly creates new opportunities within that purchases for us."
},
{
"speaker": "David Karnovsky",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Our next question is from Omar Dessouky with Bank of America. Please proceed."
},
{
"speaker": "Omar Dessouky",
"content": "Hi. Thank you for taking question. So you didn't change your full year guidance. And I wanted to know, I think David Karnovsky asked the question and you talked about Zynga a little bit. I wanted to know what -- whether your implied like-for-like guidance on mobile has changed at all since the last time you guided. And then within that, do you expect advertising to grow on an organic basis, that is excluding Bapcor. And I have one more question."
},
{
"speaker": "Lainie Goldstein",
"content": "So we just mentioned that Zynga has changed a little bit because there was movement in the release schedule and some updates to the forecast. So we did have some changes in the rest of the year. So there were some changes in the release schedule. So there were some ups and downs within the year. But overall, we've kept the entire year the same. So we were at the higher end in the first quarter, but we kept -- we reiterated the full year -- and then in terms of expecting advertising to grow, yes, we do expect it to grow in the full year."
},
{
"speaker": "Omar Dessouky",
"content": "Organically?"
},
{
"speaker": "Lainie Goldstein",
"content": "Organically, yes."
},
{
"speaker": "Omar Dessouky",
"content": "Okay. Great. And then the other part of the question I wanted to ask was in terms of your direct-to-consumer channel, I think Strauss said that the majority of mobile games in a few years will leverage that channel. So you have a lot of games. We've counted well over 100. Not all of them are your big winners. I think there's a long tail of games. So I guess I wanted to ask, is it that the biggest games -- the biggest games are going to be on your DTC platform or is it just the sheer number of games? Because I'm trying to get a sense of how much revenue could potentially flow through that channel, if you understand what I mean?"
},
{
"speaker": "Strauss Zelnick",
"content": "Yes, I do understand what you mean. It really varies game by game. So if the game is not suited to direct-to-consumer and it may not be because of its style, it's the interaction that consumers have with the title, then there may not be an opportunity even though it's a big title and then there are other titles where it's a terrific opportunity. Again, we haven't established a number that we're shooting for, but I did quote the number that a competitor has outlined. And I think that number is kind of the high end of the possibility."
},
{
"speaker": "Omar Dessouky",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Our next question is from Mike Hickey with Benchmark Company. Please proceed."
},
{
"speaker": "Michael Hickey",
"content": "Thanks, Strauss, Karl, Lainie, Nice quarter, guys. Thanks for taking our questions. Curious Strauss, sort of big picture -- pardon upon, Curious what you're thinking on film opportunity. I know you're not Trim bandwagon guy, so -- but maybe this isn't that hard not to notice the results here from Super Mario Brothers and The Last Of Us. And this is an area where historically, it's been a challenge for Game IP to have success in new mediums. It looks like the formulas kind of involved the creative piece to the original game and have great story lines. And when you look at your portfolio of IP, you've got a ton of opportunities. It would seem like you certainly have a creative talent, you definitely have a great storyline. So two questions on that Strauss. Curious if your creative teams are motivated to expand their IP into new entertainment mediums like film or streaming episodic content. And then curious if you think IP expansion into new beam-like film can sort of complement your growth strategy over the long term. Thanks, guys.,"
},
{
"speaker": "Strauss Zelnick",
"content": "Thanks, Mike. We think it's probably a relatively small opportunity economically. We're not going to use our balance sheet to invest in film and television projects. Those are typically very challenged asset classes with which I'm quite familiar. And to point out two success as notable as they may be, lies the fact that there are many, many failures where money was lost. So far, we've taken a very selective approach to licensing and we do have a Boelens (ph) movie coming from Lionsgate, and we have BioShock movie coming as well. We're excited about both. And selectively, we could see licensing in the future when there's a creative imperative and an economic opportunity. I think you're right. The reason there's been success lately was because you had great IP and then there was a great project that was made from it. And the reason you've had failure in the past is that the expression of the IP just wasn't very good despite people's best efforts. It's a really hard business. And we're not going to bet this company's future or the value of our intellectual property based on someone else's execution in another area of the entertainment business. So we'll continue to be very selective indeed. Even if we did take a broad-based approach -- in the absence of investing ourselves, the economic opportunity in the context of the much greater economic opportunity for our core business is limited."
},
{
"speaker": "Michael Hickey",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Our next question is from Brian Fitzgerald with Wells Fargo. Please proceed."
},
{
"speaker": "Brian Fitzgerald",
"content": "Thanks. Two quick ones. Strauss -- not to get wrapped around the axle with semantics, but you said, hey, we had a phased approach when you were talking about GTA Online. Anything to call out there is a difference or an evolution how you're marketing and delivering incremental content or now it's just more of the normal MO? And then second question is on NBA 2K23 added to PlayStation Plus game of the months, that kind -- that definitely contributes to strong engagement, but we're curious whether or not you also see a meaningful uptick in RCS there among those PlayStation plus players, point being, if they are waiting to engage with it once it's in subscription service. Is there a lower propensity to spend in the game or no, actually, we see an uptick in RCS there as well."
},
{
"speaker": "Strauss Zelnick",
"content": "So on the first question, by phased approach, I was referring to delivering somewhat smaller chunks of really high-quality content as opposed to waiting for a longer period of time to deliver something that's much larger. And both approaches can work and of late, the phased approach has been working really well. However, there's not one right approach. It varies with what the team has in mind creatively at any given time."
},
{
"speaker": "Karl Slatoff",
"content": "And then in terms of the things like subscription services or game in a month, where the consumer is necessarily buying the individual game. Obviously, we don't do these things unless we think there's a significant economic opportunity for us to do so. So you can -- if you see it going in some of those services, you can assume that, that math has been done. And yes, we do see an uptick in recurrent consumer spending generally because we bring a lot of new players. And those players are valuable players. And as long as they’re engaged with the game itself, the engagement is strong and the conversion to RCS is very strong. It’s all about – and again, it varies cohort to cohort and varies game to game. But if we do drive significant engagement from folks who are coming into the game, we are seeing very favorable reserves as it relates to monetization."
},
{
"speaker": "Brian Fitzgerald",
"content": "Awesome. Thanks, Karl. Thanks, Strauss."
},
{
"speaker": "Operator",
"content": "Our next question is from Benjamin Soff with Deutsche Bank. Please proceed."
},
{
"speaker": "Benjamin Soff",
"content": "Hey, guys. Thanks for the question. Just wanted to dig back into the revenue breakdown by studio. It looks like the percentage for Rockstar and other went up. And I'm just wondering if that's a function of sheer shift from the things you talked about with mobile or if your expectations for those segments that actually improved? And if so, could you talk a little bit more about that? Thanks."
},
{
"speaker": "Lainie Goldstein",
"content": "So the update for Rockstar is based on the momentum in their current business. So there's some GTA 5 unit sales, some the Red Dead updates and some virtual currency with the GT Online updating. So it's just overall reforecasting of the business."
},
{
"speaker": "Benjamin Soff",
"content": "Okay. Got it. And then just can you talk broadly about the competitive environment in the industry and whether you think it will be sort of at this level more competitive, less competitive, six months or 12 months from now?"
},
{
"speaker": "Strauss Zelnick",
"content": "I think it will be about the same. It's always hard to know. It's a very competitive business at any given time. But ultimately, we're really competing with ourselves because if there's a lot in the market that consumers want, generally speaking, they'll go consume it. And if there's nothing that they want, it's not like they consume the next best. They just stay away. So we have to deliver the highest quality properties. And if we do that, they'll show up in good times and in bad. I mean you're seeing that even in a mixed economy. The best titles still full big audiences."
},
{
"speaker": "Operator",
"content": "We have reached the end of our question-and-answer session. I would like to turn the conference back over to management for closing comments."
},
{
"speaker": "Strauss Zelnick",
"content": "I just want to take a minute to thank our teams again for delivering a superb quarter, and we're really thrilled with the way this year is unfolding. Our titles continue to be a phenomenal quality. We're really excited about our upcoming releases. And obviously, very excited about the future beyond this fiscal year. And we also want to thank all of you for attending the call for your great questions. And naturally, we're grateful to our shareholders for their continued support. So thanks so much, and have a great evening."
},
{
"speaker": "Operator",
"content": "Thank you. This will conclude today's conference. You may disconnect your lines at this time, and thank you again for your participation."
}
] |
txn | 2,024 | 4 | [
{
"speaker": "Dave Pahl",
"content": "Welcome to the Texas Instruments Fourth Quarter 2024 Earnings Conference Call. I'm Dave Pahl, Head of Investor Relations, and I'm joined by our Chief Executive Officer, Haviv Ilan, and our Chief Financial Officer, Rafael Lizardi. For any of you who missed the release, you can find it on our website at ti.com/ir. This call is being broadcast live over the web and can be accessed through our website. In addition, today's call is being recorded and will be available via replay on our website. This call will include forward-looking statements that involve risks and uncertainties that could cause TI's results to differ materially from management's current expectations. We encourage you to review the notice regarding forward-looking statements contained in the earnings release published today, as well as TI's most recent SEC filings, for a more complete description. I would like to provide some information that's important for your calendars. On Tuesday, February 4, at 10 a.m. Central Time, we will have our Capital Management call. Similar to what we've done in the past, Haviv, Rafael and I will share our approach to capital allocation and summarize our progress as we prepare for the opportunity ahead. Moving on, today, we'll provide the following updates. First, Haviv will start with a quick overview of the quarter. Next, he will provide insight into fourth quarter revenue results, with some details of what we are seeing with respect to our end markets. Haviv will then provide the annual summary of revenue breakout by end market. And lastly, Rafael will cover the financial results and our guidance for first quarter 2025. With that, let me turn it over to Haviv."
},
{
"speaker": "Haviv Ilan",
"content": "Thanks, Dave. Let me start with a quick overview of the fourth quarter. Revenue was $4 billion, a decrease of 3% sequentially and 2% from the same quarter a year ago. Analog revenue grew 2% year-over-year after eight quarters of decline. Embedded Processing declined 18% and our Other segment grew from the year-ago quarter. Now, I'll provide some insight into our fourth quarter revenue by end market. Our overall results reflect the performance from our two largest markets, industrial and automotive, which saw modest sequential declines. Similar to last quarter, I'll focus on sequential performance, as it is more informative at this time. First, the industrial market was down low-single-digits. The automotive market was down mid-single-digits. Personal electronics grew mid-single-digits. Next, enterprise systems declined low-single-digits. And lastly, communications equipment grew upper-single-digits. In addition, as we do at the end of each calendar year, I'll describe our revenue by end market. As a percentage of revenue for 2024, industrial was 34%; automotive, 35%; personal electronics, 20%; enterprise systems, 5%; communications equipment, 4%; and other was 2%. In 2024, industrial and automotive combined made up about 70% of TI's revenue, up from 42% in 2013. We see good opportunities in all of our markets, but we place additional strategic emphasis on industrial and automotive. Our customers across all regions are increasingly turning to analog and embedded technology to make their end products more reliable, more affordable and lower in power. This drives growing chip content per application, or secular content growth, which will likely continue to drive faster growth in industrial and automotive. Rafael will now review profitability, capital management and our outlook."
},
{
"speaker": "Rafael Lizardi",
"content": "Thanks, Haviv, and good afternoon, everyone. As Haviv mentioned, fourth quarter revenue was $4 billion. Gross profit in the quarter was $2.3 billion, or 58% of revenue. Sequentially, gross profit decreased primarily due to lower revenue, higher depreciation and reduced factory loadings. Gross profit margin decreased 190 basis points. Operating expenses in the quarter were $937 million, up 4% from a year ago and about as expected. On a trailing 12-month basis, operating expenses were $3.8 billion, or 24% of revenue. Operating profit was $1.4 billion in the quarter, or 34% of revenue, and profit was down 10% from the year-ago quarter. Net income in the fourth quarter was $1.2 billion, or $1.30 per share. Earnings per share included a $0.02 benefit for items that were not in our original guidance. Let me now comment on our capital management results, starting with our cash generation. Cash flow from operations was $2 billion in the quarter. Capital expenditures were $1.2 billion in the quarter. In the quarter, we paid $1.2 billion in dividends and repurchased $537 million of our stock. We also increased our dividend per share by 5% in the fourth quarter, marking our 21st consecutive year of dividend increases. In total, we have returned $5.7 billion in the past 12 months to owners. Our balance sheet remains strong with $7.6 billion of cash and short-term investments at the end of the fourth quarter. Total debt outstanding was $13.7 billion, with a weighted average coupon of 3.79%. Inventory at the end of the quarter was $4.5 billion, up $231 million from the prior quarter, and days were 241, up 10 days sequentially. Now, let's look at some of these results for the year. In 2024, cash flow from operations was $6.3 billion, and capital expenditures were $4.8 billion, as expected. We are nearly 70% through a six-year elevated CapEx cycle that, once complete, will uniquely position TI to deliver dependable, low-cost 300-millimeter capacity at scale to meet customer demand. Free cash flow for 2024 was $1.5 billion, or 10% of revenue. Our free cash flow reflects the strength of our business model as well as our decisions to invest in 300-millimeter manufacturing assets and inventory to support our overall objective to maximize long-term free cash flow per share, which we believe is the primary driver of long-term value. Turning to our outlook for the first quarter, we expect TI revenue in the range of $3.74 billion to $4.06 billion, and earnings per share to be in the range of $0.94 to $1.16. Based on current tax law, we now expect our effective tax rate for 2025 to be about 12%. In closing, we will stay focused in the areas that add value in the long-term. We continue to invest in our competitive advantages, which are manufacturing and technology, a broad product portfolio, reach of our channels, and diverse and long-lived positions. We will continue to strengthen these advantages through disciplined capital allocation and by focusing on the best opportunities, which we believe will enable us to continue to deliver free cash flow per share growth over the long-term. With that, let me turn it back to Dave."
},
{
"speaker": "Dave Pahl",
"content": "Thanks, Rafael. Operator, you can now open the lines for questions. In order to provide as many of you as possible an opportunity to ask your questions, please limit yourself to a single question. After our response, we will provide you an opportunity for an additional follow-up. Operator?"
},
{
"speaker": "Operator",
"content": "Thank you. We will now be conducting a question-and-answer session. [Operator Instructions] Our first question comes from the line of Toshiya Hari with Goldman Sachs. Please proceed with your question."
},
{
"speaker": "Toshiya Hari",
"content": "Hi, good afternoon. Thank you so much for taking the question. First one for Haviv. You're guiding Q1 revenue down, I think, 2% to 3% sequentially. I was hoping you could maybe provide some color by end market, what you're seeing on a sequential basis? You guys were quite helpful last quarter diving deep into automotive, what you're seeing in China, et cetera, et cetera. So, any color, any standouts to the upside or downside relative to what's typical seasonality would be very helpful. Thank you."
},
{
"speaker": "Haviv Ilan",
"content": "Okay. Thanks, Toshiya. So, again, for Q1, as you said, about 3%, I think, sequential, which is I would describe it as a seasonal decline for Q1. I will say that typically in Q1, what we do see is the personal electronics market would usually show quite a significant decline, just seasonality. And we did have a pretty decent Q4 for PE. So, I think that's what we expect there. And typically also, if you look at the markets like automotive, industrial, the decline should be less pronounced there. So, that's kind of my expectation. Nothing specific that I would add on markets. I will provide a little bit more color on Q4, especially in our two main markets, industrial and automotive. I think, again, they behave similarly like the overall company in Q4 and also similar to what we've seen in Q3, but maybe with some little bit small changes. So, if I start with the industrial market, as I described, I think, during the last call, most of the sectors that are kind of hovering at the bottom, maybe found the bottom, and then there are a couple of sectors that are still showing larger declines, especially industrial automation and the energy infrastructure market that still not found, I believe, the bottom. We'll have to see what the first half of '25 has planned for that. And on the automotive market, similar to Q3, we did see kind of a pretty significant weakness, maybe outside of China. So, it declined about mid-single-digit, about 5% sequentially, but China did grow, but not enough to offset the declines in Europe, the US and Japan, which is very -- it was kind of similar to what we've seen in Q3, but maybe the growth in China was less pronounced and decline outside of China was more pronounced. That would be my high-level summary for Q4 and a little bit for Q1."
},
{
"speaker": "Dave Pahl",
"content": "You have a follow-up, Toshiya?"
},
{
"speaker": "Toshiya Hari",
"content": "I do, Dave. Thanks so much. The earnings outlook for Q1, Haviv, there's a pretty significant drop off on a sequential basis for a 2% to 3% decline in revenue. I was hoping you could kind of provide some context there. Is it primarily gross margin and behind that is it continued under loadings, increase in depreciation, some of the same dynamics we saw over the past 12 months, or is it higher OpEx, anything below the line? Any sort of additional color on sort of the drop off in EPS for Q4 to Q1, that would be helpful. Thank you."
},
{
"speaker": "Haviv Ilan",
"content": "Sure. I think I covered revenue. Rafael, maybe you cover the other part there."
},
{
"speaker": "Rafael Lizardi",
"content": "Yeah, happy to. Okay. So, maybe let me start with GPM, and then I'll go to OpEx, and then I'll go to the other income line, which is relevant this time. So, on gross margins, keep in mind that depreciation is increasing, first of all. Second -- well, revenue is decreasing; that has an impact. Then, depreciation is increasing. And then, we are -- in order to manage inventory, we are reducing factory loadings. We've reduced some of that in fourth quarter, but we're going to reduce those further in first quarter. So, I do expect GPM percent to decrease probably a few hundred basis points fourth quarter to first quarter. Then, let me comment on OpEx. OpEx will increase 3% to 5% fourth to first, and that's kind of normal seasonal increases that happened in first quarter on OpEx in addition to the overall increases in investments that we're making. Beyond that, this time, it's relevant that interest income is decreasing by about $50 million. The reason that is happening is short-term interest rates are decreasing, and that's where we invest our cash. And our cash on the balance sheet, cash levels are also decreasing. So, a combination of lower interest rates and lower cash gives you a significant drop in other income. So that's -- in this case, about $50 million less fourth going to first."
},
{
"speaker": "Toshiya Hari",
"content": "Thank you."
},
{
"speaker": "Dave Pahl",
"content": "Great. Thank you, Toshiya. Yeah, we'll go to the next caller, please."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Chris Caso with Wolfe Research. Please proceed with your question."
},
{
"speaker": "Chris Caso",
"content": "Yes. Thank you. I guess first question will be with regard to the Embedded business. And we're seeing a sharp divergence there between those two businesses, particularly on the margin side. Can you give some explanation of what's going on between the Analog and the Embedded businesses, and is the reason for the decline in the Embedded margins?"
},
{
"speaker": "Haviv Ilan",
"content": "So, Chris, let me just say a few words on the revenue side and I'll let Rafael talk about the margins over there. So, again, Embedded and Analog a little bit like many of the phenomena we see regarding market geographies, we are seeing asynchronous behavior between these two markets. As you remember, Embedded -- our Embedded business grew in 2023, while our Analog business in '23 declined double digits. So, we saw a later [peak] (ph), about a year later on Embedded. That's the reason we see a sharper decline in Embedded right now while Analog in Q4 actually grew. So, I think Analog is about a year maybe ahead on Embedded in terms of the cyclical behavior. Regarding profitability, Rafael, I'm sure it's related to LFAB, but you go."
},
{
"speaker": "Rafael Lizardi",
"content": "That's absolutely right. Yeah. So, the profitability, Embedded, first, is revenue. As revenue drops, that clearly has an impact on profitability. But the second part that is different than Analog is that Embedded is taking a disproportionate impact due to LFAB, the Lehi factory in Utah, because that factory, while it's going to serve both Embedded -- and it's serving both Embedded and Analog, but it disproportionately serves Embedded. And since it's underutilized right now, it takes that hit from that underutilization. The factory loading affects Embedded disproportionately."
},
{
"speaker": "Dave Pahl",
"content": "Do you have a follow-on, Chris?"
},
{
"speaker": "Chris Caso",
"content": "Yes, got it. That's helpful. I guess, the follow-up question would be, some update on what's going on in China right now? You had spoken about, I guess, the auto business again is stronger there. Perhaps you could talk about the rest of the business that you're seeing in China, the industrial business for example. And we know that you've been taking some actions to kind of take back some of the share that you may have lost when your lead times were longer. Could you give us an update on that, and how that may be affecting some numbers in the near term?"
},
{
"speaker": "Haviv Ilan",
"content": "Sure. So, first, high level, our China business in Q4 did grow both sequentially, but also year-over-year. I think it was mid-teens or in that area for the entire China business. I think the automotive, in fact, we talked about it last quarter, we're seeing the same phenomena, meaning customers are continuing to do well. And there is a bigger share for the EV vehicle type in China, which has higher content. So, secular growth is helping us in China on the automotive side. But you also see and I think we mentioned it also in the previous calls that we had some supply limitations during the up cycle in China and the personal electronics market was one of the main markets that suffered when we were short. We are seeing this market growing in China. It grew sequentially again nicely in the Q3, but also year-over-year, that market grew significantly in China and also in the US. These are the main markets that we have our personal electronics businesses. So, overall -- again, overall, business in China right now is healthy. You asked about industrial. We haven't seen yet the start of the cyclical growth again in industrial across all of our geographies. So, China here is not an outlier. The strength is coming mainly from, I would say, automotive and from personal electronics."
},
{
"speaker": "Dave Pahl",
"content": "Yeah. Let me just add a little color. The US, China and the rest of Asia, it's really more flat, I'd describe it, sequentially. Europe and Japan were down low-double-digits. As Haviv mentioned, if you look year-on-year, you see the US and China up kind of 12%, 14% in that range, and that growth was offset overall by declines in the other regions."
},
{
"speaker": "Haviv Ilan",
"content": "Yeah."
},
{
"speaker": "Dave Pahl",
"content": "Great. Okay."
},
{
"speaker": "Chris Caso",
"content": "Thank you."
},
{
"speaker": "Dave Pahl",
"content": "Thank you, Chris. And we'll go to the next caller, please. Operator Thank you. Our next question comes from the line of Ross Seymore with Deutsche Bank. Please proceed with your question."
},
{
"speaker": "Ross Seymore",
"content": "Hi, guys. Thanks for letting me ask a question. I want to ask about the pricing environment in general. You didn't mention that Rafael or Haviv in any of your discussions about gross margin or the competitive environment or any of the sequential weakness. But just wondered if that has changed in any meaningful way, either Analog versus Embedded or in certain geographies. Just any update on that front will be helpful."
},
{
"speaker": "Haviv Ilan",
"content": "Yeah. In high-level, the pricing environment does not -- we've not seen any change in Q4 versus what we've seen in 2024. I think we've expected, I think, we said in the beginning of 2024 that pricing would go back to previous behavior pre-COVID, where pricing would decline low-single-digits, like for like parts per year and that's what it did in 2024 as the year ended. Of course, I think I did provide some color on revenue by market, that mix has changed, right? So, the selling price, if you will, has changed, because industrial in 2023 was 40% of revenue, it declined to 34% in 24%, and the PE market grew from 15% in 2023 to 20% in 2024 and that is a big change of mix, if you will. That's what we have seen. But the like-for-like parts has behaved as expected and I'm not expecting that to be different in 2025 and that's a comment across all geographies."
},
{
"speaker": "Dave Pahl",
"content": "You have a follow-on, Ross?"
},
{
"speaker": "Ross Seymore",
"content": "Yeah, I do. A little bit of a longer-term question maybe for Haviv. Historically, the company has talked about share gains and losses in your markets being measured in basis points, I think 15 basis points, 20 basis points, 25 basis points a year, given the fragmented nature of it was kind of what you would aspire to. It can of course go down or up, I guess, for kind of [idio-reasons] (ph), supply shocks, those sorts of things. But now that you have the supply, it seems like the world has plenty of supply, is there any reason that that historical share gain pace would be any different going forward?"
},
{
"speaker": "Haviv Ilan",
"content": "Again, when we talk about share down or up, I think the only way to really measure it is over the long-term. That's always been our approach. That's the way we run the company. That's the way we behave, right? So, TI, yes, there was a lot of, I would say, a shockwave almost during COVID. It was not only supply/demand mismatch, but behavior of customers and almost anxiety of needing parts. So, I think inventory was built and I think it's still playing out. I wouldn't say that this [asynchronous] (ph) behavior across markets is done. We see it still across sectors in industrial, we see it differently between geographies, we even see it internally between our Embedded business and Analog business. So, it's one of these things that, and I kind of hate to say it, but time will tell where we are. I am excited about the fact that now we have the right inventory level, the right supply to support growth. I'm encouraged about our progress in the analog market. As I mentioned in our prepared remarks, we did grow the Analog business from a year-over-year perspective in Q4. It was a couple of points of growth, but after about eight quarters of decline, and I think we -- I look forward to continue to grow that business, especially when you think about the longer-term. And most importantly, the secular growth in the market that we've mentioned, industrial and automotive, I'm convinced that it's there. I'm convinced that our product portfolio is improving and strengthening, and we will have the right level of capacity and inventory to support our customers. So obviously, expectation that I have for the team is that TI will continue to compete for market share and grow it."
},
{
"speaker": "Ross Seymore",
"content": "Thank you."
},
{
"speaker": "Dave Pahl",
"content": "Great. Thank you, Ross. We'll go to next caller, please. Operator Thank you. Our next question comes from the line of Chris Danely with Citi. Please proceed with your question."
},
{
"speaker": "Chris Danely",
"content": "Hey, thanks guys. Hey, Haviv, I guess just a little bit of a drill down on the end markets. How would you expect things to sort of play out this year? Maybe talk about where you would expect relative strength or not strength by the end markets? And have you seen would you say you've seen any change in business conditions over the last three months like better, worse or not really?"
},
{
"speaker": "Haviv Ilan",
"content": "Chris, as I think I told you last time we met, we call it when we see it, meaning I can tell you what happened. It's very hard for us to tell you exactly what will happen. Even for this quarter, I think I mentioned even during the last call, lead times are short, customers are coming real time for demand, and our turn business or what we call aging is running high right now simply because customers are always waiting for the last second before they make the order and we fulfill it because we do have the right level of inventory, and of course, capacity to support further growth. I will say that I think that some of the markets and we've seen it through 2024, they are already on the cyclical upturn. We saw it in PE, then enterprise, really driven by data center joint and we are seeing nice growth over there. And even communication business, I would say that I think it found the bottom. We saw it somewhere in, I think, in Q1 of '24 and grew sequentially since then and even returned to year-over-year growth in Q4. So, these three markets, I think they are on the upturn. And I don't think that I expect at least that if nothing major changes to continue into 2025. The big question for us is also 75% of our business or 70% of our business in 2024 is industrial and automotive. And here, we haven't seen the bottom yet. Let's be very clear about that. We're seeing points of strength. I've given China as an example, but we'll have to see how the year play out. I do believe that this on the industrial side that there is kind of -- as I said last time, kind of this hovering at a low level. It's a great position to grow from, but we'll just have to wait and see when it wants to do it, Chris. And of course, when we see it, we'll say it."
},
{
"speaker": "Dave Pahl",
"content": "Any following, Chris?"
},
{
"speaker": "Chris Danely",
"content": "Sure. Just quickly on Embedded. So, it looks like you guys have the lowest margins there in, I think, over a decade or something like that. Does something need to be changed or restructured there to get Embedded back to an adequate level of margins? Or maybe talk about what needs to be done to get it to some sort of an appreciable level of margin?"
},
{
"speaker": "Haviv Ilan",
"content": "Yeah, let me take a quick high-level answer, Chris, and Rafael will give a little bit more what's going on there. I think you're seeing a business in transition, Chris. I am getting -- I'm growing more excited about Embedded every quarter. I think, our portfolio is strengthening and we are winning business. We are going through a transition, especially on the manufacturing side, and that puts pressure on the margins. But we are convinced that strategically Embedded is going to be a great contributor to free cash flow per share. And so, the short answer to your question about restructuring or anything, the answer is no. Rafael, maybe you can provide some more color what's going on there."
},
{
"speaker": "Rafael Lizardi",
"content": "Yeah. No, I'll just add similar to what I said in a few calls -- a few questions ago. One is the revenue is the main factor. As Haviv talked about earlier in the call, Embedded has seen a sharp decline because it took longer to get into the downturn than Analog did, but if you look at [pick to drop] (ph), they're about the same place, Analog and Embedded. And then, the other reason is LFAB, right? So, Embedded is taking disproportionate amount of the impact from having LFAB underutilized. But let me stress, just like that takes away, it gives it to you on the other end. So, when we ramp -- as we ramp LFAB and as we move from external to internal, you're really going to like the fall-through both to GPM, but even better to free cash flow as we do that. So, Embedded is that -- Haviv said, it's in transition. And when we're on the other side, we're going to like the results."
},
{
"speaker": "Dave Pahl",
"content": "Thank you, Chris. And we'll go to the next caller, please."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Harlan Sur with JPMorgan. Please proceed with your question."
},
{
"speaker": "Harlan Sur",
"content": "Good afternoon. Thanks for taking my question. One of the metrics we look at to gauge the health of the cycle is the number of customer pushouts, cancellations, rescheduling of the backlog relative to prior quarters or maybe big changes, right, on customer forecast inside of the quarter. Has this level activity remained at kind of normalized levels? And then, maybe on another metric we look at is turns orders. And I know, Haviv, you said it's at high levels, but is that coming in about as expected as well?"
},
{
"speaker": "Haviv Ilan",
"content": "Yeah, let me start with the second part of the question. I'll let Dave comment about the first part. So, look, we came in Q4 at the higher side of the range, close to the top of the range, that's all came -- that all came from, what we call the turns business. So, we didn't see that clog in the beginning of the quarter and it came in real time. So, we need to see that that continues into the beginning of next year -- of this year. Of course, there is Chinese New Year right now and we just have to see that it's not that -- it's a trend rather than anything that is a one-quarter phenomena. But the turns business looked very, very good in Q4."
},
{
"speaker": "Dave Pahl",
"content": "Yeah. And Harlan, when you look at those other indicators like you brought up cancellations, we had seen those drop several quarters ago and they continue to be at very low levels. If you look at things like revenue linearity, revenue increase through the quarter, that's very typical for us to see that. And Haviv mentioned earlier, lead times remain short. We have availability of essentially all of our products that we sell via the web available for immediate shipment. So, customers can behave and have that confidence that they can get the product that we've got. Do you have a follow-on?"
},
{
"speaker": "Harlan Sur",
"content": "Yeah. Thank you. So, right before the capital management update back in August, I remember you had just received your preliminary CHIPS Act grant allocation, $1.6 billion. That number was solidified, I think, in December, and this was not contemplated in your free cash flow per share calculation. In the CHIPS Act press release, you guys articulated some of the milestones attached to those grant dollars. And it looks like actually many of those milestones are going to be executed in or before 2026. And that's $1.6 billion in grant dollars, that drives an incremental $1.75 of free cash flow per share versus sort of what you potentially laid out in your 2026 scenario analysis. So, have you mapped out that $1.6 billion in CHIPS Act grants over 2025, 2026? And maybe have an updated view on the potential better free cash flow per share profile for Texas Instruments?"
},
{
"speaker": "Rafael Lizardi",
"content": "So, let me try to answer that question. First, kind of bigger picture, as you alluded to, the Department of Commerce awarded us up to $1.6 billion in CHIPS Act funding. This will help support three of our new 300-millimeter wafer fabs under construction in Texas and Utah. This direct funding, coupled with the ITC, will help us provide a geopolitically dependable supply of Analog and Embedded Processing chips for years to come. Over the life of the -- maybe the most important point is over the life of the program between the ITC and the direct funding, we expect to receive $7.5 billion to $9.5 billion in total. We've received some of that already in 2024 and expect 2025 and beyond to continue. We don't have any specific details to share at this point on the cash payments related to the direct funding, but as those happens, we will share those."
},
{
"speaker": "Haviv Ilan",
"content": "I would just add that the math is not incorrect, but the timing is the problem, right? So, I think, as you said, there is and we talked about free cash flow, so it also depends when we get the cash. We just don't have that visibility. The milestones are related, as we I think mentioned, to cleanroom construction and two installations in Sherman 1, which we are in the -- we started installing tools in the summer of '24 and that moved well. And the construction of SM2, the shell, which it's not done yet, but it's moving well. The other part is one in Utah, it's LFAB2. This is where we talk about cleanroom construction and tool installation for LFAB2. But we are now only now starting the groundwork over there, right? So, there is still quite a bit of execution in LFAB2 and we will see how that timing works as we continue to move forward on that execution."
},
{
"speaker": "Rafael Lizardi",
"content": "Let me add one more thing. Just given that we have been officially awarded a $1.6 billion we already booked that on our balance sheet. So, we have $1.6 billion receivable. You can see that on the balance sheet. The other side of that, $1 billion of that decreased our net PP and E and because that's related to a factory that's already built. $0.6 billion of that is actually deferred liability because it's related to a factory that's not built. But the bottom line where I'm going is that this is already going to decrease our expected depreciation. So, with that, let me give you an update to depreciation. Depreciation for 2025, now you should expect $1.8 billion to $2 billion; that's slightly down from the previous expectation. And for 2026, we're keeping the range the same, $2.3 billion to $2.7 billion, but I'll tell you that we expect to be on the lower half of that range. That's the 2026 depreciation expectation, $2.3 billion to $2.7 billion to be at the lower end of that range."
},
{
"speaker": "Dave Pahl",
"content": "Great. Thank you, Harlan. We'll go to the next caller, please."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of CJ Muse with Cantor Fitzgerald. Please proceed with your question."
},
{
"speaker": "CJ Muse",
"content": "Yeah, good afternoon. Thank you for taking the question. I know you guys are loathe to talk beyond the quarter, but I was hoping you could give us a framework for thinking about gross margins beyond the March quarter. You just gave us the depreciation. That's very helpful. Would love to hear kind of your thoughts on what's optimal inventory and therefore planned utilization beyond March. And is March quarter kind of the low for gross margins and we should start tracking higher? Any thoughts there would be very helpful."
},
{
"speaker": "Rafael Lizardi",
"content": "Yeah. No, happy to do that. It's going to be very similar to what I've said before, but it all starts with revenue. So, revenue is the number one driver of gross margin, both dollars and percent, going forward. You model your revenue, then you fold that through at 75% to 85%. And then, after you do that, then you have to adjust for depreciation increases. And I already gave you the depreciation numbers, so you can model that in the future. This works much better if you do full years and you do it over the long term rather than any given quarter. And on that, the other factor that you have is the factory loadings or underutilization. Right now, as I mentioned, we expect a hit from that in first quarter, but that just as it's a hit sometimes, it's a benefit when you go the other way. And -- but that depends on revenue expectations. So, if revenue materializes in the future and we expect that to continue, then we ramp up the factories and that helps with the loadings and that tends to take the 75% to 85% towards the high end of that range. If that doesn't happen, then you're looking at the lower end of that range."
},
{
"speaker": "Haviv Ilan",
"content": "And the last note, and I think you touched it before, Rafael, is related to our execution. So, of course, revenue, we want to grow it and definitely, we want to do it faster than the market. That's always our objective. But on the other hand, it's that LFAB execution, right? We are executing our transition from our foundry business into Lehi. I expect that to have a step forward in 2025, especially as our automotive business, we have a bunch of products that are what we call -- they have a safety effect that usually the call is a little bit more complex, it just takes a little bit longer, but we are moving well on that execution. And again my expectation from the team is to meet our commitment to our customers and get these parts out of Lehi as they prefer that dependable capacity and for us, it's a way lower cost, and of course, helps as a byproduct on the margins as well."
},
{
"speaker": "Dave Pahl",
"content": "Do you have a follow-on, CJ?"
},
{
"speaker": "CJ Muse",
"content": "Yeah, just a quick one, Dave. Rafael, just to go back to kind of a loading question, if we do assume normal seasonal pattern for your top-line into Q2, Q3, should we assume that loadings would move higher in Q2?"
},
{
"speaker": "Rafael Lizardi",
"content": "We forecast one quarter at a time, so I'm going to stick with that. But I'll also say, maybe as you're alluding to, the more revenue we have, then -- let me put it this way. We're not planning -- $4.5 billion of inventory is a healthy level of inventory, and we would not want to be draining those levels at this point. So, maybe that gives you enough to think about."
},
{
"speaker": "CJ Muse",
"content": "Thank you."
},
{
"speaker": "Dave Pahl",
"content": "Great. Thank you, CJ. Yeah, we'll go to the next caller, please."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Joshua Buchalter with TD Cowen. Please proceed with your question."
},
{
"speaker": "Joshua Buchalter",
"content": "Hey, guys. Thank you for taking my question. I guess, I wanted to follow-up on the previous one. You mentioned not necessarily wanting to drain the inventory levels below the $4.5 billion levels. As we think about how you're thinking about 1Q though, like is this the level you're comfortable with and you're going to manage to the $4.5 billion? And, I guess, to ask more acutely, is there a near- to medium-term inventory target on a days basis that we should be thinking about? Because I know that's obviously evolved through the last several years. I'd be curious how you're thinking about it now as we sort of are [chipping] (ph) closer to end demand."
},
{
"speaker": "Rafael Lizardi",
"content": "Yeah, first, let me give you the big picture, and then I'll give you some specifics. But big picture, inventory, the goal here, the objective is to maintain high levels of customer service while we minimize the obsolescence of inventory. We have target levels at the finished goods, at the chip level for the 80,000 parts that we sell in different end markets, and that is done in a very rigorous and disciplined way on a part by part basis. So that's how we look at it. And the risk of obsolescence on this part is very, very low. This part lasts for a long time. They sell to many, many customers for many, many years in very long life cycles. Now, to the specific that you have, given how we're running the factories right now, I would expect a further increase of inventory levels going into first quarter, but probably in the $100 million, $100 million-plus level, and then potentially stabilize at that point around that level."
},
{
"speaker": "Dave Pahl",
"content": "Do you have a follow-on, Josh?"
},
{
"speaker": "Joshua Buchalter",
"content": "Yeah, thank you for the color, Rafael. Yeah, to follow-up, I wanted to ask about, there were some earlier questions about competition, specifically in pricing. I guess, I wanted to ask bigger picture, not necessarily pricing related, but as some of your peers have sort of gotten through and lapped and are no longer shipping to [NCRS or LTSAs] (ph), have you noticed a change in the competitive backdrop on the number of sockets that are open for competition? I'd be curious to hear about if there's any change competitively over the last couple of quarters. Thank you."
},
{
"speaker": "Haviv Ilan",
"content": "Yeah. I haven't seen a significant change. It feels the same to me, kind of stable. I mean, it's -- we are in a down cycle and I remember throughout my career, every time there is a down cycle, the market gets more competitive and it's still the same now. And that's again across all markets, all geographies, but I haven't seen any significant change in the last couple of quarters to your direct question."
},
{
"speaker": "Dave Pahl",
"content": "Thank you, Josh. And we've got time for one last caller, please."
},
{
"speaker": "Operator",
"content": "Thank you. Our last question comes from the line of Thomas O'Malley with Barclays. Please proceed with your question."
},
{
"speaker": "Thomas O'Malley",
"content": "Hi, guys. Thanks for letting me ask a question. This is for Haviv or Rafael. Just at the Capital Management Day, you guys highlighted different CapEx ranges depending on kind of different revenue CAGRs. And I know the intention there wasn't to guide revenue, but you just updated us on depreciation in response to just the ITC and some of the grants as well. Is the depreciation being at the lower end entirely a function or the updated guide that you're giving today entirely a function of those tax credits and grants, or is that a function of potentially lower CapEx as well?"
},
{
"speaker": "Rafael Lizardi",
"content": "It is not a function of lower CapEx. We continue to expect CapEx for 2025 to be $5 billion. And in 2026, as we said at the last call, between $2 billion to $5 billion depending on further expectations, and we'll have more clarity on that in the second half of the year."
},
{
"speaker": "Haviv Ilan",
"content": "Yeah. And again, I will add, this is not -- I mean, as we said in August, our plan is still -- we like the plan. We're going to be very disciplined executing it. We always look at the environment and what's going on, but based on what I see right now, you shouldn't expect the plan to change in terms of our Phase 1, Phase 2 as I described. Phase 1 is serving us very well. This is how we move revenue from external foundries into our LFAB factory in Utah. And also, on the analog side, we want most of our parts running on 300 rather than, for example, 6-inches fab that we are shutting down, and that's going well. The Phase 2 is very important for our future. So, we are going to complete the qualification line in Sherman 1, we are going to set the shell or build the shell in Sherman 2, and also build the shell in Lehi, so it can give us this flexible capacity phase that we are so excited about and so are the customers. Once they engage with us, they fully understand that not only they will have enough cleanroom capacity to grow into, but also the qualification is going to be behind them. So, the parts are already running, for example, in Sherman or in Lehi and that gives them a very, very easy path to grow their business with us without having to go through a recall and new fabs or new suppliers. So, I think that then serves our customers well, and we will continue to execute to it. And as you said, the slides in August and I will probably see a very similar story in a couple of weeks is that we want to say that we have a plan, but we do always have flexibility into the plan, especially in 2026 and 2027."
},
{
"speaker": "Dave Pahl",
"content": "Great. Tom, you got a follow-up?"
},
{
"speaker": "Thomas O'Malley",
"content": "I do. Thanks for all the detail there. Last one of the call, so broader, and hate to end it on this, but I just wanted to give you a chance to respond. So, article is out on a China statement talking about dumping product in that market. I think there's an ongoing debate just around the sustainability of China longer-term. I guess part of this question is, can you just address what you've seen in the public there? And then, kind of as a derivative of that, you're obviously growing year-over-year in China. You're seeing strength in China auto. You highlighted that. But outside of that, are you seeing any change in the dynamic there in terms of your ability to [ship] (ph) product competition, just addressing the whole debate? Thank you."
},
{
"speaker": "Haviv Ilan",
"content": "Yeah. And again, I'll probably not settle the debate. I'll just tell you what we see and I'll start with the high level on China. It's an important market. China represents 20% more or less of world GDP and you want to play in that market. By the way, our business in 2024 in China was at about 20%. So, we are kind of not over or under penetrated in China, it's kind of just right at 20%. And our commitment is to our customers. Our customers in China, they rely on our parts, they want to have the best products, they want to have the highest quality, they want to get best service, and TI is a good supplier. And on top of it, their ambition is to be global players, right? So, maybe, they are part of the headquarters in China, but they want to sell their end equipment to any geography. And in that sense, TI is a great supplier because we are a global player. We have a diverse footprint of manufacturing and support structure, and that's a great fit for their needs. Now, as you know and I think this is not news, the China end market has always been competitive and is continuing to be. We know that they are very capable, motivated, fast moving competition, but I think the competitive advantages of TI allows us to compete whether it's our broad portfolio, the reach of the channel and also our position in industrial and automotive customers value that and want to continue to do business with TI and we want to compete and that's really the fact that we own our manufacturing, own our technology. I think we have the right cost structure to compete across our entire portfolio, whether it's low AUP general purpose parts or very integrated sophisticated ASSPs that are tailored for a specific application. We don't need to sub select. We want to compete across our portfolio and our customers there appreciate that and I continue to see that. Specifically to your question, at this time, we haven't been notified about an investigation and it's kind of business as usual between us and our customers in China."
},
{
"speaker": "Dave Pahl",
"content": "That's great. Thank you. Thank you for asking that question, Tom. And thank you everyone else for joining us tonight. We look forward to sharing our Capital Management call on Tuesday, February 4 at 10 a.m. Central Time. A replay of this call will be available shortly on our website. Good evening."
},
{
"speaker": "Operator",
"content": "Thank you. And this concludes today's conference. You may disconnect your lines at this time. Thank you for your participation."
}
] |
txn | 2,024 | 3 | [
{
"speaker": "Dave Pahl",
"content": "Welcome to the Texas Instruments Third Quarter 2024 Earnings Conference Call. I'm Dave Paul, Head of Investor Relations, and I'm joined by our Chief Executive Officer, Haviv Ilan; and our Chief Financial Officer, Rafael Lizardi. For any of you who missed the release, you can find it on our website at ti.com/ir. This call is being broadcast live over the web and can be accessed through our website. In addition, today's call is being recorded and will be available via replay on our website. This call will include forward-looking statements that involve risks and uncertainties that could cause TI's results to differ materially from management's current expectations. We encourage you to review the notice regarding forward-looking statements contained in the earnings release published today, as well as TI's most recent SEC filings for a more complete description. Today, we'll provide the following updates. First, Haviv will start with a quick overview of the quarter. Next, he'll provide insight into third-quarter revenue results with some details of what we're seeing with respect to our end markets. And lastly, Rafael will cover the financial results and give an update on our capital management, as well as share the guidance for the fourth quarter of 2024. With that, let me turn it over to Haviv."
},
{
"speaker": "Haviv Ilan",
"content": "Thanks, Dave. Let me start with a quick overview of the third quarter. Revenue in the quarter came in about as expected at $4.2 billion, an increase of 9% sequentially and a decrease of 8% year-over-year. Analog revenue declined 4% year-over-year and embedded processing declined 27%. Our other segment declined 5% from the year-ago quarter. Now, I'll provide some insight into our third quarter revenue by end-market. Our results continue to reflect the asynchronous market behavior that we've seen throughout this cycle. Similar to last quarter, I'll focus on sequential performance as it is more informative at this time. First, the industrial market was down low-single digits as customers continue to reduce their inventory levels. The automotive market increased upper single digit, primarily due to strength in China. Personal Electronics grew about 30%, Enterprise Systems was up about 20%, and Communication Equipment was up about 25% as the cyclical recovery continued in these three markets. With that, let me turn it over to Rafael to review profitability, capital management, and our outlook."
},
{
"speaker": "Rafael Lizardi",
"content": "Thanks, Haviv, and good afternoon, everyone. As Haviv mentioned, third-quarter revenue was $4.2 billion. Gross profit in the quarter was $2.5 billion or 60% of revenue. Sequentially, gross profit margin increased 180 basis points, primarily due to higher revenue. Operating expenses in the quarter were $920 million, about flat from a year ago and about as expected. On a trailing 12-month basis, operating expenses were $3.7 billion or 24% of revenue. Operating profit was $1.6 billion in the quarter or 37% of revenue and was down 18% from the year-ago quarter. Net income in the quarter was $1.4 billion or $1.47 per share. Earnings per share included a $0.03 benefit for items that were not in our original guidance. Let me now comment on our capital management results, starting with our cash generation. Cash flow from operations was $1.7 billion in the quarter and $6.2 billion on a trailing 12-month basis. Capital expenditures were $1.3 billion in the quarter and $4.8 billion over the last 12 months. Free cash flow on a trailing 12-month basis was $1.5 billion. As a reminder, free cash flow includes benefits from the CHIPS Act investment tax credit, which was $220 million in third quarter and $532 million on a trailing 12 month basis. In the quarter, we paid $1.2 billion in dividends and repurchased $318 million of our stock. In September, we announced we would increase our dividend by 5%, marking our 21st consecutive year of dividend increases. This reflects our continued commitment to return free cash flow to our owners over time. In total, we returned $5.2 billion to our owners in the past 12 months. Our balance sheet remains strong with $8.8 billion of cash and short-term investments at the end of the third quarter. Total debt outstanding is $14 billion with a weighted average coupon of 3.8%. Inventory at the end of the quarter was $4.3 billion, up $190 million from the prior quarter and days were 231, up two days sequentially. For the fourth quarter, we expect TI revenue in the range of $3.7 billion to $4 billion and earnings per share to be in the range of $1.07 to $1.29. We continue to expect our effective tax rate to be about 13% in the fourth quarter. As you're looking at 2025, based on current tax law, we would expect our effective tax rate to remain about the same. In closing, we will stay focused in the areas that add value in the long term. We continue to invest in our competitive advantages, which are manufacturing and technology, a broad product portfolio, reach of our channels and diverse and long-lived positions. We will continue to strengthen these advantages through disciplined capital allocation and by focusing on the best opportunities, which we believe will enable us to continue to deliver free cash flow per share growth over the long term. With that, let me turn it back to Dave."
},
{
"speaker": "Dave Pahl",
"content": "Thanks, Rafael. Operator, you can now open the lines for questions. In order to provide as many of you as possible an opportunity to ask your questions, please limit yourself to a single question. After our response, we'll provide you an opportunity for a follow-up. Operator?"
},
{
"speaker": "Operator",
"content": "Thank you. We will now be conducting a question-and-answer session. [Operator Instructions] Our first question comes from the line of Timothy Arcuri with UBS. Please proceed with your question."
},
{
"speaker": "Timothy Arcuri",
"content": "Thanks a lot. I guess the first question is, autos grew, I think, that was a little bit of a surprise to a lot of us. Can you talk about what's going on there? You did cite China. But did orders weaken late in the quarter at all? I mean, we saw pretty much every automaker negative pre-announced. So can you talk about maybe what you're seeing in autos and maybe if you can provide a little commentary for December what the outlook is there? Is it sort of anything you'd call out in December in terms of end markets?"
},
{
"speaker": "Haviv Ilan",
"content": "Okay, Tim, let me start with that. This is Haviv. So regarding the automotive market, yes, it did grow. We said high-single digits, around between 7% and 8%. And that was really driven -- most of the growth came from our business in China. I think I've mentioned also in the second quarter, we saw strength in China and automotive drove that growth as well. It kind of recurred in the third quarter. Just to give you some high-level numbers, it grew 20% in Q2, and another 20% in Q3. I think it's not a surprise that there is momentum for EVs in China. Our content is growing there. And that's what really drove the growth in the third quarter. I expect that to, I mean that -- I think this is not the one-quarter thing. I think there is growing momentum there. Our automotive revenue in China is in an all-new-time high. So, I don't think that goes down in the near future. Now, the rest of the automotive market is different, okay? We are seeing a continued weakness over there. That revenue picked in the third quarter of 2023, and in general, trended down. If I put China aside, it had a quick correction in Q1 -- Q4 and Q1. The rest of the markets, I see a continued weakness. I think that's part of our, call it, seasonal forecast for Q4."
},
{
"speaker": "Dave Pahl",
"content": "Do you have follow-on Tim?"
},
{
"speaker": "Timothy Arcuri",
"content": "I do, yes. Rafael, so if I look at the guidance, OpEx is usually, I think, down low- to mid-single-digits for December. So if you assume even down mid-singles, you get gross margin sort of in the mid-50s. It's down like 200 basis points stripping out depreciation. So that's a pretty big decline. So I guess, are you taking down loadings in December? I do see that finished goods was up a lot. So if you can talk about that. Thanks."
},
{
"speaker": "Rafael Lizardi",
"content": "Yes. So a couple of things in your question. So let me try to address them. OpEx, nothing unusual, but we do probably expect to -- expect it to be flat to slightly up. So consider that. As far as the fourth quarter, with revenue at the midpoint decreasing, that takes a hit on margins, of course. So we would expect -- we do expect gross margins to be down and also depreciation will continue to increase. And in fact, in October, we began depreciating the building and the clean room for SM1. So that continues to put -- that's going to put even more upward pressure on depreciation in fourth quarter."
},
{
"speaker": "Dave Pahl",
"content": "Thank you. We'll go to the next caller, please."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Vivek Arya with Bank of America Securities. Please proceed with your question."
},
{
"speaker": "Vivek Arya",
"content": "Thanks for taking my question. Haviv, you -- so first, thanks for providing the end-market commentary. I think you mentioned personnel electronic demand went up, I think 30% sequentially is what I recall, it was up mid-teens in Q2 also. How do we square your strength in personnel electronics with the more kind of sluggish demand that we see for PCs and phones? Is it something outside of those areas or are those areas doing better? Just what do you attribute this strength in personal electronics? Are you thinking the market just kind of bottomed from a cyclical perspective?"
},
{
"speaker": "Haviv Ilan",
"content": "Yes. I think that's a great question. Let me just walk through what we've seen over the last, even couple of years. So I mean that revenue in the personal electronics market, it peaked in the third quarter of 2021. By the way, the third quarter is typically our peak quarter every year. There is a seasonality strength in every third quarter for PE. And it roughed in the first quarter of 2023. Since then, we have seen continuous improvement. But I will say, Vivek, that when I look at our third quarter of 2024, it's still running at a lower level than the peak. It's running about 20% lower than the 2021 peak. So there is still room to grow. And in our case, as I think I've mentioned in some of the calls, when we were short in with the supply capacity back in 2021, 2022, where we had to take some calls where it was to bias our supply towards industrial and automotive. The personal electronics has a shorter design cycles. We said we'll go attack that once the capacity and inventory are back in place. That's the case right now. So I think we are coming off of a very low trough, plus again having the right part to go back and win sockets that we couldn't sell before. So that's what I'm seeing right now. In terms of specifically into the third quarter, I think growth was across all the sectors or most of the sectors, the main ones are phones and notebook PCs. But in general, the third quarter, as I've said, is a typical strong quarter for PE."
},
{
"speaker": "Dave Pahl",
"content": "Do you have follow up, Vivek?"
},
{
"speaker": "Vivek Arya",
"content": "Yes. Thank you, Dave. So bigger picture question, Haviv, is on in the last few calls, there has been a suggestion that perhaps by calendar 2026, TI will conceptually be closed, if not more than what you were in calendar 2022. And people have kind of rightly then pushed back and said, well, that requires mid-teens sales growth in the next two years, well above the trend line. At what point do you think you will start to see those above seasonal quarters to help us get to that above-trend growth for the next two years. So I understand you're not giving guidance, but what are you seeing in the broader end markets and do you think TI is at a point where those kind of above seasonal quarters are line-of-sight or is it too early to make that judgment? Thank you."
},
{
"speaker": "Haviv Ilan",
"content": "Yes, first, just to recap on your question, Vivek. Thanks. I think you're referring to our capital management call we had in August. So I just would ask people to look at what exactly we presented there. I think you referred to a 2026 scenario -- a set of scenarios that we've presented there from flat to growth versus 2018. And we didn't say we are predicting what revenue would be, but it allows investors to kind of have a view on free cash flow per share according to the revenue scenario. And I think it allows you guys to modulate up or down revenue and know what free cash flow will do during that year. Now more specifically to your question, look, the -- we talked about three markets that are already in the midst of a cyclical recovery. I think they are not done yet, but they are pointing in the right directions. That's Personal Electronics, Enterprise Systems and Communication System for us coming from a very low trough, but showing momentum and I think that we are in the process of strengthening. Unfortunately, these markets were about 25% of our revenue in 2023 and in our case, we really need the broad industrial market and the automotive market to join, okay. So if I go to industrial first, revenue peaked in the third quarter of 2022. We've seen eight quarters of decline. We are more than 30% down versus the peak. So I don't think we -- I hope and I can't predict it. I don't think we have a lot left, okay? I think the inventory correction is still ongoing, but I do expect that to start to recover, I cannot predict the quarter because usually when we see it, we call it. I will just say we haven't seen it yet and it's been quite persistent, okay. That's on the industrial side and I can go even into the sectors, most of the sectors are showing either still searching for a bottom or hovering at a very low level, okay. So it's about time, but we haven't seen it yet. On the automotive market, I think it's more complex because this is where we see a different story between China and the rest of the market. Unfortunately, China is about 20% of our business, so it cannot move the overall automotive number for the company. But I think as I mentioned before, we are right now at a lower-single digit versus the peak kind of hovering it at minus -- sorry, not lower-single digit, I would say upper-single digit, but somewhere between 5% to 10% versus the peak on automotive. In China, we have new records being established. I think there is momentum over there. But the other markets or the other geographies, sorry, on automotive are still searching for that bottom. I do expect when it all adds up, automotive will establish a lower peak-to-trough cycle and not close to the industrial side, but I can't give you a precise time for that, Vivek."
},
{
"speaker": "Dave Pahl",
"content": "All right. Thank you, Vivek. And we'll go to the next caller, please."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of C.J. Muse with Cantor. Please proceed with your question."
},
{
"speaker": "C.J. Muse",
"content": "Yeas, good afternoon. Thank you for taking the question. I guess first question, bigger picture, I guess given the cyclical uncertainty, how are you thinking about kind of running utilization rates into Q4 and first half of 2025? And as part of that with inventory at $4.3 billion, are you looking to continue to grow that and elevate utilization or keep it where it is until you really see signs of that cyclical recovery, would love to hear your thoughts there?"
},
{
"speaker": "Rafael Lizardi",
"content": "Yes. No, happy to do that. So first, bigger picture and then I'll get into maybe some specifics, but the objective for inventories to support revenue growth as we prepare for the upturn, as Haviv described in our expectations going forward, particularly in 2025. We do expect to grow inventory in fourth quarter. So we grew a couple of hundred million in third quarter. We expect probably a few $100 million of inventory growth again in fourth quarter. But that is, we have moderated the factory loading. So factory loadings expect us to go slightly down going into the fourth quarter, but despite that, we'll still grow additional inventory. Just to comment a little more on the inventory, we have detailed plans by device at the finished goods level, at the chips level, and those plans are grounded on purchasing behavior and expected demand and this inventory is very low-risk. It sells to many, many customers and it has a long life cycle. So we feel really good, really good about that."
},
{
"speaker": "C.J. Muse",
"content": "That's great, thanks."
},
{
"speaker": "Dave Pahl",
"content": "C.J. do you have a follow-on?"
},
{
"speaker": "C.J. Muse",
"content": "I do -- I would hope to follow up on auto. You talked about that as a surprise in China. I'm curious if you could speak to Chinese OEMs taking share in Europe, that's something that we've kind of picked up and curious perhaps maybe the data points we're picking up in Europe related a little more to share loss there to some of the Chinese OEMs, are you seeing that?"
},
{
"speaker": "Rafael Lizardi",
"content": "First, I know it's a surprise -- I think not a surprise because we've seen that trend starting in Q2. So to me the automotive market in China for TI, it again peaks in that end of 2023, call it, second half of 2023. We saw a very sharp correction in Q1. I think it was mainly inventory correction and then a growth in Q2, growth in Q3, it's 20% on top of 20%. So think about it running at 45% of the opening and a new pick. I think that is mainly driven by the China market, right? If you think about -- I mean, I was just there a couple of months ago, most of the new -- I think now majority of new cars are EVs, right, or some sort of hybrid and these tend to have more content. And again, our position there is good. TI is very competitive. So I think that drives growth. Now our customer base in China is a set of OEMs, but also Tier 1s. And you guys know the OEM share in – you are the experts there, but the Tier 1s are also I think are -- they are -- they can build good systems. They are very efficient in cost. Performance is pretty good. So I think they also compete for market shares versus the worldwide Tier 1s and I think that's part of the dynamics we see in the China market. We see momentum on both."
},
{
"speaker": "C.J. Muse",
"content": "Thank you."
},
{
"speaker": "Dave Pahl",
"content": "Thanks, C.J. Next caller, please."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Ross Seymore with Deutsche Bank. Please proceed with your question."
},
{
"speaker": "Ross Seymore",
"content": "Hi guys, thanks for let me ask a question. Haviv, you talked a couple of times about China going up 20% sequentially two quarters in a row. Is there any reason that the other 80% of the business shouldn't have that sort of a cyclical rebound at some point? Is there something that's unique about China that allows it to be more volatile or is the expectation that you would have that the other 80% of your business at some point in time should do the same thing?"
},
{
"speaker": "Haviv Ilan",
"content": "Yes. First, I think at some point of time, all the horses will point in the same direction and we all are waiting for that. It's been a while, but I think that happened. Again, it's a asynchronous behavior, it's so clear to us and you can see an opposite behavior between geographies, between markets. I will say that, again, as we talked about in the previous response or my previous answer, there is a stronger EV momentum in China. On top of it, I think the China call it culture, call it environment is the design cycles are quick, inventory corrections are quick. So there is a little bit of a everything is more accelerated, I would say over there and I think that's why we're seeing shorter cycles in terms of the way up, the way down, that would be my guess. But I think we'll all be able we'll be smarter only when that thing is done or played out completely. All I can say that I've not seen this played out completely on the automotive market outside of China. But I don't think -- again, I don't think the peak-to-trough on the automotive market is going to be as pronounced is industrial simply because the secular growth over there, I believe is strong to short-term."
},
{
"speaker": "Dave Pahl",
"content": "Do you have a follow-on, Ross?"
},
{
"speaker": "Ross Seymore",
"content": "Yes, I do. One for Rafael. On the OpEx side of things, just a conceptual question, as we look into 2025, kind of what would be the puts and takes on OpEx? And I guess the punchline is, you guys have kept OpEx in certain periods of time barely growing year-over-year. In other years, inflation has been something you guys have had to endure as well. So how do we think about OpEx kind of structurally in 2025?"
},
{
"speaker": "Rafael Lizardi",
"content": "Yes. In fact, for 2025 and beyond, the way to think about it is, we continue to have a disciplined process, as you alluded to on our investments and our OpEx. But when it comes to R&D, we'll continue to invest there. So you'll see our investments grow overtime and continue to grow. Whereas in SG&A, the focus there is efficiency, so continue to drive efficiency. So there the -- it will probably grow, but at a much lower pace than R&D. And, of course, a revenue, the goal is for both of those to be under the revenue growth for the foreseeable future."
},
{
"speaker": "Dave Pahl",
"content": "Great. Thank you, Raf. And we'll go to the next caller, please."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Stacy Rasgon with Bernstein Research. Please proceed with your question."
},
{
"speaker": "Stacy Rasgon",
"content": "Hi, guys. Thanks for taking my question. I wanted to drill a little bit more into that China strength. So you're seeing it in auto. Are you seeing any signs of like China strength in analog or anywhere else in any other end market? Is it just completely focused on automotive at this point? And I guess what I'm getting at is, I'm trying to judge the propensity of some of the Chinese guys maybe to be buying more. We've got an election coming up. Nobody exactly knows what's going on with the general geopolitical environment. Just what do you see more broadly in China, both in and outside of auto?"
},
{
"speaker": "Haviv Ilan",
"content": "Yes, Stacy. I can tell you what we see and again, I -- it's helpful to speculate beyond what we see. But in general, just a reminder, as I said, during the upcycle, we had to bias our supply into the industrial and automotive markets, okay. So clearly, the -- and I think we said the company was at about 75% in industrial and automotive in 2023. China was similar, maybe even higher because we had to take some calls on the consumer PE side. So just to know where we're starting for from. So in automotive, I think as I said before, I can't tell you the reason for that, but I think part of it is the -- I think the China customers are fast-moving. I think they are gaining momentum worldwide, not only in China. The second thing is, I think it's acceptance of EVs in China and there may be some other reasons as you have mentioned, but we have not seen a clear evidence for that, okay, of a very large inventory buildup or anything like that. That's on your direct question of automotive. On the industrial side, we have not seen China recovering from the cycle yet. So we, again, we -- it has peaked somewhere in 2022, in China, included. And since then, it had a little bit of a sequential growth in Q2, but then it went down again in Q3. So kind of hovering at the bottom. That's the way I would describe it. So we are waiting for that to happen. We have seen a very strong recovery in automotive, actually with a new high, but the industrial numbers are still trending about 40% or so, maybe even higher in China versus the peak. So a lot of work for us to do in China. I don't think -- I think it's just -- I think customers, as we said in my -- as I said in my prepared remarks, are still working through some inventory over there on the industrial side."
},
{
"speaker": "Rafael Lizardi",
"content": "And maybe just to add one thing. when you look at Stacy, the other three markets that are cyclically recovering, personal electronics, comm and entertainment, all of the regions are growing and contributing to that."
},
{
"speaker": "Haviv Ilan",
"content": "Yes, in China included, right. But again, all those are very low number, if you will, in 2023."
},
{
"speaker": "Dave Pahl",
"content": "I'm sorry. Do you have a follow-on, Stacy?"
},
{
"speaker": "Stacy Rasgon",
"content": "I do. Thank you. I know you guys don't guide two quarters ahead, but just mathematically we've been sort of looking at performance versus normal seasonality. How would you guys define typical seasonality for Q1? And maybe like, what is it over the last several years and how would you define it like versus -- like pre-COVID levels?"
},
{
"speaker": "Haviv Ilan",
"content": "Yes. So maybe I'll talk about Q4, Stacy. And some people -- it depends how you define seasonality. I like the way you do it. You kind of need to take the outliers away. And I think 2020 and 2021 were the outlier during the upcycle. And typically, in the fourth quarter, we see kind of a minus 7% to even sometimes close to minus 10%. Dave, the Q1 ones, can you add what…"
},
{
"speaker": "Dave Pahl",
"content": "Yes. It's more -- it's usually more flat. It's more flattish, maybe down a little bit, but fourth quarter and first quarters definitely are seasonally weaker quarters. Second and third are obviously, the stronger quarters."
},
{
"speaker": "Stacy Rasgon",
"content": "Okay. That's helpful. Thank you guys."
},
{
"speaker": "Dave Pahl",
"content": "Next caller, please."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Thomas O'Malley with Barclays. Please proceed with your question."
},
{
"speaker": "Thomas O’Malley",
"content": "Hey, thanks for taking the question. Haviv, I just wanted to clarify some comments you made in the preamble. You kind of talked about the three markets, enterprise, PE, and comm, still correcting, but showing momentum. So not finished, but showing some progress. Are those still sequentially declining or are one or two of those actually coming off of the bottom and improving?"
},
{
"speaker": "Haviv Ilan",
"content": "No, I think all three are sequentially growing in a fast pace. So I think, just to repeat the numbers, I think PE grew 30% sequentially and Enterprise grew 20% sequentially, and Comms grew 25% sequentially. My point is that they are still not at the previous peak, okay? So to me, when I think about the momentum, I think, I expect momentum to continue to build. I think we are still running below the previous peaks that were somewhere in mid-year 2022, and I expect that momentum to continue. I think also as I mentioned before, specifically for TI, these are the markets where we were, in some cases, short in the previous upcycle and it's our job to go back and address these sockets now when we have enough supply and inventory. Okay?"
},
{
"speaker": "Thomas O’Malley",
"content": "Thank you for clarifying. Yes. And then just broadly, kind of during the pandemic, you saw a lot of growth and I think most of your peers and yourself started being more vocal about describing both auto and industrial as double-digit growers. So as this kind of correction continues, you're seeing the strength from China in your auto business and obviously that's a part of the broader business and contributes to that double-digit growth. But looking back now and as you see the recovery, would you think any differently about the growth profiles of those two businesses? You obviously have your competitors coming up in a couple of weeks kind of going to restate their long-term CAGRs as well. Do you still see that a double-digit growth profile is the right way to look at those two businesses?"
},
{
"speaker": "Haviv Ilan",
"content": "Yes. And again, the short answer is, yes, I see the same. I will say that even the current cycle on the automotive side is proving it and I think we will all see that in the short-term. And when I talk about short-term, it's five years to 10 years. I think the growth in industrial is multi-decades. I think we are on the -- in some of the, call it sectors in industrial. We're only in the very, very beginning or early innings. So I think the industrial -- and I don't know if we say double-digit, but I think TI grew 10% in the last decade 2013 to 2023. I think the market date may be a little bit lower than that, I would guess, but call it high single to maybe 10% would be a good guess. I think the automotive market for TI and also for the market grew faster. But I think it's going to be -- I don't think it's going to run multiple decades, okay? At a certain point of time, there is going to be a kind of some sort of saturation in terms of content per vehicle. I don't think we are close to that date now, specifically not in this decade. Hopefully, that helps."
},
{
"speaker": "Dave Pahl",
"content": "Thank you, Tom. And we'll go to the next caller, please."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Joe Moore with Morgan Stanley. Please proceed with your question."
},
{
"speaker": "Joseph Moore",
"content": "Great. Thank you. I wonder if you could help characterize industrial and I know you've talked about the various sub-segments underneath of that, but is that -- is there an inventory correction that's uniform other areas of strength and just any sense of inventory versus demand issues that are kind of dragging that business down."
},
{
"speaker": "Haviv Ilan",
"content": "Yes, Joe. A great question. I mean, I think we have more than 10 sectors, about 12 sectors in industrial and the overall, they all add up to a continuous decline since the third quarter of 2022. So it's the eighth quarter of decline. We are seeing -- most of the sectors I would characterize are -- have found the bottom, but are kind of hovering at that bottom, okay? And think about areas for us like building automation, the energy infrastructure, medical, kind of hovering at that bottom. On Factory Automation, we are seeing steel and it's a large sector for us. You can think about Factory Automation and motor drive, it's all these process and Factory Automation type of plants. We are still seeing a decline. So they have not found a bottom. And then, you see a couple of strength areas. Appliances, some people don't have it in industrial as we do. Appliances declined very early and we've seen some recovery there. And I would also add, in our case, we have power delivery, power delivery, think about it, the main market is silver, right? So that sits at the bottom of a rack. So we see growth over there. But these are the only two out of 12. So overall, weakness in the industrial market, hopefully that provides more color."
},
{
"speaker": "Dave Pahl",
"content": "Do you have a follow-on, Joe?"
},
{
"speaker": "Joseph Moore",
"content": "Yes, I do. That's helpful. Thank you. In terms of analog versus embedded, I know there's a that's been happening for a while that embedded has underperformed and there's a focus on kind of turning that around a narrower focus area. I wonder if you could just characterize what's different about the embedded market on a sequential basis that it's weaker?"
},
{
"speaker": "Haviv Ilan",
"content": "Yes. So strategically we are very pleased with the progress we are seeing in embedded. Embedded is more think about these higher AUPs and more visibility, I would say, on design ins, it's less broad. So when we look at the progress, when we look at momentum with customers, I think it's -- we are excited about the future and they are going through a cyclical process exactly like the analog team has done, but they are kind of a year later. So again, embedded is almost 95% industrial and automotive. They've seen growth in 2023 versus the industrial business versus the analog business that declined double-digits. So they started almost a year-after analog think about kind of middle of 2023. We've seen four quarters. I think they are also looking at a seasonal quarter in Q4, but momentum there is strong and I'm excited about the future there."
},
{
"speaker": "Joseph Moore",
"content": "Okay. Thank you."
},
{
"speaker": "Dave Pahl",
"content": "We'll go to the next caller, please."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of William Stein with Truist Securities. Please proceed with your question."
},
{
"speaker": "William Stein",
"content": "Great. Thanks for taking my question. I think earlier in the call, the question was asked that Haviv, you answered it for one or two end markets, but I'm hoping you can talk about how the pacing of orders progressed in the last couple of months? I wonder if you might have seen things accelerate to then only decelerate if there's been any sort of ups and downs that have surprised you? And then I have a follow-up, please."
},
{
"speaker": "Haviv Ilan",
"content": "Yes. I think we -- what I said about the third quarter, I think you think about it, there's not a lot of change that I see right now going into the fourth, but there is -- it's Q4, right? So there is a seasonality effect. In that sense, I don't see any change versus what we've seen in Q3. If we have -- if we would see something, I would call it out, but I cannot call out anything. Dave, you want to add anything about the order or..."
},
{
"speaker": "Dave Pahl",
"content": "Yes. Order rates, I think we're behaving normally that they increased each month in the quarter, which is very typical. So we didn't see any large drop-offs or acceleration or deceleration on that front."
},
{
"speaker": "Haviv Ilan",
"content": "And Bill, maybe just to add on that, just a reminder that we have built good service levels of inventory. As Rafael mentioned, our lead times are very low, so we get a lot of business kind of real time. As it comes, people who call it turn business or so we simply don't have a ton of visibility right now and customers also, they take part only when they need it. I don't think they are building inventory. So that's the reason that we cannot provide more color beyond what they've said."
},
{
"speaker": "William Stein",
"content": "Yes, that’s helpful. If I can have a follow-up. It actually dovetails with the follow-on, which is when you all have inventory your customers may not be all charged up about placing tons of backlog and when they have inventory, even more so, our checks recently have revealed that customers have more inventory than many suppliers thought, like they were not sort of really close to the end of the inventory digestion at end customers. And I wonder if you could either dispel that or provide any insight as TI sees it? Thank you."
},
{
"speaker": "Haviv Ilan",
"content": "Yes, I'll just answer in a high level and Dave, maybe you can chime in. But look, in general, we don't have visibility into our customer inventory levels. I do think, as we all know, I mean interest rates are high at the end of the year. I don't think there is a lot of desire to build inventory at our customers' shelves, especially when our inventory position is strong and that's where we want to be. We want to take that burden away from our customers to us that means level of service and we want to do it through not only the down cycle, but also the upcycle. Hence the preparation of capacity and inventory, as Rafael said, that's the game we want to play in the next up-cycle and that's what drives our capital allocation decisions. Dave, anything specific about the customer..."
},
{
"speaker": "Dave Pahl",
"content": "Yes, I think the points that you made that we're essentially operating from a very healthy position on inventory. That means that customers don't have to place orders and that is keeping visibility low, but we want to be able to be ready for the upturn when it comes."
},
{
"speaker": "Haviv Ilan",
"content": "Yes, many of our lead times are well below 10 weeks today. So I mean we provide -- I call it excellent customer service and when customers need the product, we have it for him."
},
{
"speaker": "Dave Pahl",
"content": "All right. Thank you, Will. We'll go to our last caller, please."
},
{
"speaker": "Operator",
"content": "Thank you. And our last question comes from the line of Tore Svanberg with Stifel. Please proceed with your question."
},
{
"speaker": "Tore Svanberg",
"content": "Yes, thank you for squeezing me in. I had a follow up question on the industrial market. Obviously, lead times are short and you have inventory. But I'm just wondering from an end-market or a sell-through perspective, is it fair to say that, that market is stabilizing? Is it getting worse, is it better? I know you called out those two segments that are perhaps starting to stabilize, but any further read on the end consumption there actually getting better or worse?"
},
{
"speaker": "Haviv Ilan",
"content": "Yes. Just to repeat, Tore, thanks for the question and just repeating what I said. I think most of the sectors are hovering because we've seen like three or four quarters hovering at the same level more or less, okay. So I would say, you call it is there an inventory correction there or not? I mean, seasonality would say that industrial would grow, for example, in Q2 or Q3 and it didn't. So you can argue that there is some inventory correction at customers and that's the reason for my prepared remarks. But at least, I do believe that they have stabilized from a revenue perspective. I will say that the only -- and these are large sectors for TI. I will say that this is not done on the factory automation and motor drive, which is kind of this automation sector for TI, that was my only other color that I've added, Tore. And I don't know, Dave, anything to add here."
},
{
"speaker": "Dave Pahl",
"content": "I think that's good."
},
{
"speaker": "Haviv Ilan",
"content": "That's good. Okay."
},
{
"speaker": "Dave Pahl",
"content": "Do you have any follow-on, Tore?"
},
{
"speaker": "Tore Svanberg",
"content": "Yes. Just one last question. So going back to the whole topic about visibility orders and so on and so forth. When you talk to your customers, especially some of your non Chinese customers, is there a sense that everyone is just waiting for rates to come down, getting through the US election because it does feel like there's like some sort of a CapEx cycle coming, but everyone just waiting on the sidelines. When you talk to some of your biggest industrial customers, do you get a sense that they're waiting for that or is this is more just about, hey, once a spending comes back with better rates and so on and so forth, we're sort of back to the race."
},
{
"speaker": "Haviv Ilan",
"content": "Short answer is no. I don't hear that at least. I don't think if they think that they would tell me anyhow. But what I think is important to remember and I think they value that because I hear it from the meetings I have that when they need it we have it, okay. And we are -- most of our portfolio is very diverse, long-lived and we let the customers know what -- where we have enough inventory to serve them as they needed and when they are more kind of, call it unique, and smaller part of our portfolio where the lead times are a little bit longer and we require more visibility. I think we are differentiated in that sense. Customers appreciate it. And hopefully, we can maintain that level of support through the next cycle and work on our market share and I think that is what customers expect and I think TI can outperform in that sense."
},
{
"speaker": "Tore Svanberg",
"content": "Very helpful. Thank you."
},
{
"speaker": "Haviv Ilan",
"content": "Okay. So let me wrap it up and with what we've said previously, at our core, we are engineers and technology is the foundation of our company, but ultimately, our objective and the best metric to measure progress and generate value for owners is the long-term growth of free cash flow per share. While we strive to achieve our objectives, we will continue to pursue our three ambitions. We will act like owners, we will own the company for decades. We will adapt and succeed in a world that's ever changing and we will be a company that we are personally proud to be proud of and would want as our neighbor. When we are successful, our employees, customers, communities, and owners all benefit. Thank you, and have a good evening."
},
{
"speaker": "Operator",
"content": "And this concludes today's conference. You may disconnect your lines at this time. Thank you for your participation."
}
] |
txn | 2,024 | 2 | [
{
"speaker": "Dave Pahl",
"content": "Welcome to the Texas Instruments Second Quarter 2024 Earnings Conference Call. I'm Dave Pahl, Head of Investor Relations, and I'm joined by our Chief Executive Officer, Haviv Ilan; and our Chief Financial Officer, Rafael Lizardi. For any of you who missed the release, you can find it on our website at ti.com/ir. This call is being broadcast live over the web and can be accessed through our website. In addition, today's call is being recorded and will be available via replay on our website. This call will include forward-looking statements that involve risks and uncertainties that could cause TI's results to differ materially from management's current expectations. We encourage you to review the notice regarding forward-looking statements contained in the earnings release published today as well as TI's most recent SEC filings for a more complete description. Today, we'll provide the following updates. First, Haviv will start with a quick overview of the quarter. Next, he'll provide insight into second quarter revenue results with some details of what we're seeing with respect to our end markets. Lastly, Rafael will cover the financial results, give an update on capital management as well as share the guidance for the third quarter of 2024. With that, let me turn it over to Haviv."
},
{
"speaker": "Haviv Ilan",
"content": "Thanks, Dave. Let me also start by welcoming everyone to the call. I'm looking forward to joining our quarterly earnings calls moving forward and sharing more details about our business strategy with the investment community. It is an opportunity for me to directly share more information about our results and our strategic progress. With that, I'll start with a quick overview of the second quarter. Revenue in the quarter came in about as expected at $3.8 billion, an increase of 4% sequentially and a decrease of 16% year-over-year. Analog revenue declined 11% year-over-year, and Embedded Processing declined 31%. Our other segment declined 22% from the year ago quarter. Now, I'll provide some insight into our second quarter revenue by end-market. Our results continue to reflect the asynchronous behavior across our end-markets that we've seen throughout this cycle. Similar to last quarter, I'll focus on sequential performance as it is more informative at this time. First, the Industrial market was down low-single digits. The Automotive market was down mid-single digits. Personal Electronics grew mid-teens with broad-based growth while demonstrating continued improvement compared to its low point in the first quarter of 2023. Next, Communication Equipment was up mid-single digits. And finally, Enterprise Systems was up about 20%. Lastly, before I pass it on to Rafael, I'd like to share a few comments regarding our capacity investments. We and our customers remain pleased with our progress of the expansion of our 300-millimeter manufacturing capacity. These investments reflect our confidence in the opportunity ahead, which remains high for several reasons. First, we have a high level of confidence in the secular growth of semiconductor content, particularly in industrial and automotive, where we have greater exposure and strong product positions. Second, geopolitically dependable low-cost 300-millimeter capacity will be increasingly critical and valuable and our investments enable us to support customer demand at scale. To share more details on our progress, which we believe is helpful for all of our shareholders to understand, I plan to hold an off-cycle capital management call with Rafael and Dave on August 20th. During the call, I will provide more granularity on our capacity investments along with the framework of revenue and free cash flow per share scenarios. With that, let me turn it over to Rafael to review profitability, capital management, and our outlook."
},
{
"speaker": "Rafael Lizardi",
"content": "Thanks, Haviv, and good afternoon, everyone. As Haviv mentioned, second-quarter revenue was $3.8 billion. Gross profit in the quarter was $2.2 billion or 58% of revenue. Sequentially, gross profit margin increased 60 basis points, primarily due to higher revenue as well as lower manufacturing unit costs due to increased factory loadings and more manufacturing internally with more wafers on 300-millimeter. Operating expenses in the quarter were $963 million, up 3% from a year ago and about as expected. On a trailing 12-month basis, operating expenses were $3.7 billion, or 23% of revenue. Operating profit was $1.2 billion in the quarter, or 33% of revenue, and was down 37% from the year-ago quarter. Net income in the second quarter was $1.1 billion, or $1.22 per share. Earnings per share included a $0.05 benefit for items that were not in our original guidance. Let me now comment on our capital management results, starting with our cash generation. Cash flow from operations was $1.6 billion in the quarter and $6.4 billion on a trailing 12-month basis. Capital expenditures were $1.1 billion in the quarter and $5 billion over the last 12 months. Free cash flow on a trailing 12-month basis was $1.5 billion. As a reminder, free cash flow includes benefits from the CHIPS Act investment tax credit, which was $312 million for second quarter. In the quarter, we paid $1.2 billion in dividends and repurchased $71 million of our stock. In total, we returned $4.9 billion to our owners in the past 12 months. Our balance sheet remains strong with $9.7 billion of cash and short-term investments at the end of the second quarter. In the quarter, we repaid $300 million of debt. Total debt outstanding is now $14 billion with a weighted-average coupon of 3.8%. Inventory at the end of the quarter was $4.1 billion, up $23 million from the prior quarter and days were 229, down 6 days sequentially. For the third quarter, we expect TI revenue in the range of $3.94 billion to $4.26 billion and earnings per share to be in the range of $1.24 to $1.48. We continue to expect our effective tax rate to be about 13%. In closing, we will stay focused in the areas that add value in the long term. We continue to invest in our competitive advantages, which are manufacturing and technology, a broad product portfolio, reach of our channels, and diverse and long-lived positions. We will continue to strengthen these advantages through disciplined capital allocation and by focusing on the best opportunities, which we believe will enable us to continue to deliver free cash flow per share growth over the long term. With that, let me turn it back to Dave."
},
{
"speaker": "Dave Pahl",
"content": "Thanks, Rafael. Operator, you can now open the lines for questions. In order to provide as many of you as possible an opportunity to ask your questions, please limit yourself to a single question. After our response, we'll provide you an opportunity for a follow-up. Operator?"
},
{
"speaker": "Operator",
"content": "Thank you. [Operator Instructions] Our first question comes from the line of Timothy Arcuri with UBS. Please proceed with your question."
},
{
"speaker": "Timothy Arcuri",
"content": "Thanks a lot. There were some comments from a geopolitical perspective. One of the candidates is talking about the China-Taiwan relationship. And I'm just asking how the geopolitical environment is sort of impacting your customers' buying decisions. I think you said last call that even some of your Chinese customers who are exporting product want geopolitically dependable capacity. I think you talked about that being kind of an increasingly big factor in autos. Can you talk about that and is that beginning to drive some share gains for you?"
},
{
"speaker": "Haviv Ilan",
"content": "Thanks, Tim. I'll take that. It's Haviv. First, geopolitical dependable capacity is not a new thing for us. We've started to see these requests coming, I think two or three years ago when tensions started to rise, but as we reflect on it now three years in, it's obvious that there is more and more attention usually at the highest levels of our customers. I'm talking about leadership of CEOs or Chief Purchasing Officers, looking at their supply chain and making sure that they are going to be immune from you know whatever is thrown at them, part of it is geopolitical tensions. And this is where TI is a great answer. We are a very unique supplier in the sense of we can provide the capacity at scale, meaning the amount of wafers and the size of our -- the capacity that we are building is very high. It is a very affordable capacity as building our parts on 300-millimeter wafers allows for a lower cost per chip and then building them internally in our assembly and test houses also provides a very good low-cost structure. And last but not least is this geopolitically dependable capacity, meaning our fabs are being built in the US, mainly in Texas and in Lehi, Utah and we provide a capacity that is at scale, affordable, and dependable. And yes, every time there is some news out there, you know, we are seeing more interest. We've seen that grown over the last several years, and in that sense, our discussions with our customers are providing us more opportunity to win positions in future platforms. I do believe we are taking a bigger share and this is part of our confidence to continue with our investments to serve that opportunity moving forward. Last but not least, you have touched China. Yes, you're right. If I take an example and just on the automotive side, our customers in China do care a lot about their export business. In that sense, our capacity is highly welcomed by them because we can compete at the market price with a very competitive offering, yet have that dependability to serve their customers not only in China but also outside of China for their export business."
},
{
"speaker": "Dave Pahl",
"content": "Follow-on, Tim?"
},
{
"speaker": "Timothy Arcuri",
"content": "I do. Yes. Rafael, can you give us an update on CHIPS Act? Do you know how much you're getting yet? And can you kind of talk about that?"
},
{
"speaker": "Rafael Lizardi",
"content": "Yes, sure, Tim. So on the grant, frankly, we're still going through the process. So we submitted the application and we're just working through the details with the CHIPS program office. But given your question, let me comment also on the ITC the Investment Tax Credit. Today, to date, we have accrued about $1.8 billion in total, that's under 25% ITC. This benefit already started flowing through the income statement as lower depreciation. In addition, in second quarter, we received, as I said in the prepared remarks, $312 million of cash benefits and that is reflected in operating and free cash flow. And we expect to receive another $200 million in 3Q and for a total of $1 billion for 2024."
},
{
"speaker": "Timothy Arcuri",
"content": "Great."
},
{
"speaker": "Dave Pahl",
"content": "Thank you, Tim. We'll go to the next caller, please."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Stacy Rasgon with Bernstein Research. Please proceed with your question."
},
{
"speaker": "Stacy Rasgon",
"content": "Hi, guys. Thanks for taking my questions. In Q2, it looked like the strength was primarily from personal electronics, given industrial and auto were down. And maybe calculators as well, I don't know other was pretty strong. I was wondering if you could give us some color on where your expectations for the growth in Q3 sequentially is coming from. Is it still primarily at personal electronics? And I guess maybe calculators or other stuff? How do I think about the end-market trends as we go forward into next quarter?"
},
{
"speaker": "Haviv Ilan",
"content": "Thanks for the question. Stacy, I'll start and I'll let Dave add some more color on Q2. So if I go back to the second quarter, yes, if you look at our results, industrial did decline at the low-single digits. Automotive continued to decline at mid-single digits. That was the third quarter in a row of that decline. Although from a year-over-year perspective, it's still doing well, meaning less than 10% of a decline. It declined about 9% in Q2. Yes, there is strength in personal electronics and I do see that market at -- you know it went down through the entire cycle. It troughed sometime in the first quarter of 2023 and we've seen that market strengthening. And again, it grew mid-teens sequentially, but close to 20% year-over-year. So there is definitely strength over there. And I would also say that on the enterprise market, yes, smaller revenue for us, but we are seeing a recovery over there, and I believe that inventory correction is behind us. Regarding the Other business, it grew thanks to our calculator business, as you mentioned, but also our DLP business, which mainly serves the personal electronics market. And Dave, maybe you can add some more color on the sectors as we talked about Q2."
},
{
"speaker": "Dave Pahl",
"content": "Yes. I think as we have seen even inside of industrial, we've had sectors behave asynchronously. So when we first began to see weakness in industrial, which really began in the third quarter, that was -- that was the peak in third quarter of 2022. That was the peak in industrial and we talked about seeing about half of the sectors or so show weakness and those early, but I'll call them earlier-stage sectors, some of them have found bottoms and begun to grow and you can see some of that bottoming process taking place. The others, we're only three or so quarters in and we've got several of them that are continuing to decline at double-digit rates. So again, as we've seen all of our markets behave asynchronously inside of the sectors, we've seen that in industrial as well. Do you have a follow-on, Stace?"
},
{
"speaker": "Stacy Rasgon",
"content": "I do actually. Maybe to re-ask the same question. So you're guiding a revenue sequentially up close to $300 million. How do I think about that $300 million growth parsing out across the end markets into Q3?"
},
{
"speaker": "Haviv Ilan",
"content": "Yes, Stacy, I'm on the calls, but still we are not going to predict or to give a guidance by market for the third quarter. I mean, it's at the midpoint of the range. We expect revenue to grow about 7%. But as you know, it's not unusual for us to see sequential growth in the third quarter. I mean, typically this is a seasonal --"
},
{
"speaker": "Stacy Rasgon",
"content": "Is it TE, is what I'm asking, is it mostly --"
},
{
"speaker": "Haviv Ilan",
"content": "Yes, typically Q3 is a quarter where if you go back to pre-COVID days, this is the quarter where customers are preparing their end equipment or the end-product for the holiday season. So it's usually a strong quarter for the company and we are seeing that a very similar behavior right now at the midpoint of our -- of the range of our forecast. I don't know, Dave, if you want to add anything."
},
{
"speaker": "Dave Pahl",
"content": "I think that's good."
},
{
"speaker": "Haviv Ilan",
"content": "Okay."
},
{
"speaker": "Dave Pahl",
"content": "Thank you, Stacy. And we'll go to the next caller."
},
{
"speaker": "Stacy Rasgon",
"content": "Thank you, guys. Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Vivek Arya with Bank of America. Please proceed with your question."
},
{
"speaker": "Vivek Arya",
"content": "Thanks for taking my question. I wanted to ask about the China market and what you're seeing in terms of not just the demand side, but are you seeing any incremental supply coming on that can create a concern from a pricing perspective? Because every time this question is asked to industries or not just TI, the answer is always that, well, the IP is not there, they don't have product breadth and whatnot, but they're still buying a lot of trailing edge equipment. So at what point Haviv does that start to become a concern from just a global capacity and global pricing perspective for Texas Instruments?"
},
{
"speaker": "Haviv Ilan",
"content": "Thanks, Vivek. Let me start with the first part of your question on how the China market did because I think it was a good quarter for our China business. Our China headquarters business grew sequentially at about 20% versus the first quarter. And we've seen the momentum across all markets. I mean, all five markets grew sequentially, I think 15% or 20%. So they all did well. And this is after seven quarters of sequential decline. So if you think about the way I look at the China market and it was exposed to all -- to all market -- to all end-markets for TI, it took seven quarters for this asynchronous cycle to go through starting with PE, Personal Electronics, then spreading to Industrial and Enterprise and just slightly to Automotive. But all of these have now corrected and Q2 was a good quarter for our business. And I believe we are now shipping to end demand, meaning customers have stopped managing their inventories over there. Now in terms of the competition in China, I don't think that's -- I mean, we've been very vocal about it. This is first not new that the competition has intensified over the last -- the past several years and I think it's growing stronger. I think it's a mistake for us to think that these guys are only doing simple parts. These are very ambitious, highly educated competitors. And our job here in TI, and that's what I try to teach the team is to compete. And I will tell you that, yes, the market is more competitive in China, but we can compete and we can win business in very attractive margins. So we are going to continue to do that. Our goal -- objective is to continue and gain market share in China."
},
{
"speaker": "Dave Pahl",
"content": "Yes. And if I just add one thing, Haviv, the growth in China that we saw was strong across all the markets, including automotive and industrial there. So --"
},
{
"speaker": "Haviv Ilan",
"content": "Correct."
},
{
"speaker": "Dave Pahl",
"content": "So, I think that's an important point. So, Vivek, you have a follow-on?"
},
{
"speaker": "Vivek Arya",
"content": "Yes. Thank you, Dave. So I know for Q3, you're not giving specific end-market commentary, but just from an industry perspective, how would you describe the supply-demand situation in industrial and automotive semis just because we see such a broad range of data points? Do you think we are past the worst in terms of inventory adjustment and supply issues for those two end markets? And if you could describe the situation in those two markets separately, that would be really, really helpful. Thank you."
},
{
"speaker": "Haviv Ilan",
"content": "Dave, I'll let you take this one."
},
{
"speaker": "Dave Pahl",
"content": "Okay. Yes, I think of what we can see, Vivek. Of course, we don't get any data feeds on customer inventory. We don't get any data feeds on customer shipments, but we can look into things like the order patterns, we can look at feeds that we get in consignment. We can see what's happening in with our inventories and our position. So as we've talked about, cancellations as an example, as a measure have continued to come down. Our lead times I described is very stable. We've got immediate availability of almost all of our products. So that does drive a lower visibility with backlog because customers can get product when they need it. And we do believe that some markets PE bottomed up back in first quarter of 2023 and has been more seasonal since then. We've seen some of the other markets that as we've shared earlier, are beginning to grow. So there's likely a bottom forming it with within some of those markets. We've got industrial and automotive that have continued to decline. Now I'd say with industrial, I mentioned earlier, some of the sectors are forming a bottom, others are continuing to decline. And automotive, where we've got three quarter behind us, right. So that's how as we look into where we are positioned today, but we don't have a strong signal that can tell us exactly to be able to answer the question that you asked."
},
{
"speaker": "Haviv Ilan",
"content": "Yes, the only one comment I will add, Vivek, in terms of the difference. So automotive so far at least just year-to-date is down mid-single digits and that is off of a very good 2023 for us, right. We grew about 17% in 2023. And I think it's just helped by the strong secular content growth that we see in automotive. And this is across the -- both combustion engines of ICE and EVs. So that's maybe the difference -- the slight difference I see between these two markets."
},
{
"speaker": "Dave Pahl",
"content": "Okay. Thank you, Vivek. We'll go to the next caller, please."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Ross Seymore with Deutsche Bank. Please proceed with your question."
},
{
"speaker": "Ross Seymore",
"content": "Hi guys. Thanks for letting me ask the question. Haviv, it's great to have you on the call. So I'll ask one for you and maybe Rafael would chime in as well. You guys have given at least Rafael in the past some mid-quarter updates or earnings call updates on capex and depreciation versus your pre-existing plan. So are you still planning to spend $5 billion a year? And is the depreciation ranges, Rafael, you gave before still apply or are we going to have some more flexibility on those metrics going forward?"
},
{
"speaker": "Haviv Ilan",
"content": "Yes. Okay, I'll start and Rafael maybe you can provide some more color. So first, again, our strategy has not changed and it continues to serve us well. As I said before, the secular growth in industrial and automotive and our position, our market position, and our product portfolio position gives us the confidence that there is a higher opportunity over there. On top of it, as we said earlier, customers do want and value geopolitically dependable capacity. So we are pleased with our progress. Our CapEx strategy provide us both with capacity for growth and flexibility. And at the end of the day, CapEx supports revenue growth and need to be prepared for different scenarios. Now we always continue to evaluate our plans and investments based on what we see on the demand environment, the dynamics, the growth opportunities in the market. And to talk more about it, we -- as I said in my prepared remarks, we see our -- we are going to have our off-cycle capital management call in a month, in four weeks, just an opportunity to share just additional insight. So we'll go through our investment plan with more granularity on what exactly we are doing per factory and then we'll provide a framework of revenue scenarios and what would free cash flow per share and CapEx do, you know, versus each and every scenario. And regarding depreciation, Rafael, I don't know if you want to add anything."
},
{
"speaker": "Rafael Lizardi",
"content": "Yes. So I'll just comment on depreciation. Ross, I'm going to narrow that depreciation range a little bit both for 2024 and 2025. So for 2024, we now expect depreciation to be between $1.5 billion and $1.6 billion. And for 2025, we now expect depreciation to be about $2 billion to $2.3 billion."
},
{
"speaker": "Dave Pahl",
"content": "Do you have a follow-on, Ross?"
},
{
"speaker": "Ross Seymore",
"content": "I do, and thanks for all those details, Haviv, and Rafael. So one for you, Rafael. If I heard you right on the gross margin rising in the second quarter, you mentioned that loadings increased. I thought that they were going to decrease to burn some inventory now that you had that at kind of the $4 billion target. So did something change there? And what's the expectations for utilization going forward?"
},
{
"speaker": "Rafael Lizardi",
"content": "Yes. So the loadings came in about as expected, but let me just tell you more about it. Second quarter loadings were up versus first quarter. And as you saw, we were essentially flat on inventory. So essentially the ins and out where pretty much offsetting. When it comes to third quarter, we expect utilization or factory loadings to be flat to slightly up. And in our base-case for our -- the EPS guidance that we have, that's what we have in there. But of course, we have time during the quarter to adjust those loading depending on what we expect for fourth quarter. On GPM specifically for third quarter, I would -- in the base-case, at the midpoint of our guidance, I would expect GPM percent to be up versus the second quarter."
},
{
"speaker": "Ross Seymore",
"content": "Thank you, Dave."
},
{
"speaker": "Dave Pahl",
"content": "Thank you, Ross, and we'll go to the next caller, please."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Chris Danley with Citibank. Please proceed with your question."
},
{
"speaker": "Chris Danley",
"content": "Hey, thanks for letting me ask a question, guys. Just to follow up on Ross' question in terms of gross margin. So depreciation is going up like 100 million bucks roughly per quarter for next year. But if utilization rates keep going up i.e., if nothing gets any worse, do you think -- is it possible that your gross margins are bottoming now? Or is there anything else that could drive them lower or maybe provide a tailwind, just give us maybe the mechanics around it for the next several quarters."
},
{
"speaker": "Rafael Lizardi",
"content": "Sure, sure. I'll be happy. And I'll keep it -- well, at the end of the day, yes, it is possible that is the case. It's all going to depend on revenue, of course. So the main driver is revenue. So as we -- and in addition to revenue, as we bring more executing our strategy to load more 300-millimeter wafers and bring in more external loadings internal, the fall-through excluding depreciation will likely trend more in the range of 75% to 85% on a year-on-year basis. Now, of course, any one quarter, even any one year, you may have puts and takes that you know utilization or factory loadings is one of those that sometimes it goes against you, sometimes it goes in favor. But in general, expect that fall-through in 75% to 85%, not counting depreciation. So you do the math, whatever revenue assumption you want to put over the next several quarters or years, do that fall-through and you can very easily model where -- and then I just gave you the depreciation, right. So you can then model what gross margins can do over the next several years."
},
{
"speaker": "Chris Danley",
"content": "Great. Thanks for the additional breadcrumbs. They're very useful. My follow-up is just on bookings. I think last quarter, you said that bookings were increasing every month. Is that still true? And do you think that for the industrial automotive space, we're at least getting close to the bottom there, or do you feel any better about either of those end markets on a relative basis?"
},
{
"speaker": "Dave Pahl",
"content": "Yes. So again, as you look at those things, revenue did increase as well as orders throughout the quarter, which is very typical as that we would see in the second quarter. And certainly, as we've got growth at the midpoint, that would not be unexpected. Again, those other sides of lead times, really on all of our products, having immediate availability and stable lead times, cancellations continuing to decline. All those things, I think point to supply and demand becoming more in balance and that availability. So -- and there was a second part of your question, Chris, that I'm not addressing. I'm not sure what it was. Can you just repeat it for me?"
},
{
"speaker": "Chris Danley",
"content": "Yes, it was just our bookings still increasing month over month. And then between the auto or the industrial end market, do you feel any better or worse about either of those?"
},
{
"speaker": "Dave Pahl",
"content": "Well, yes, again, I think that we've got half of the sectors that again we can see forming a bottom inside of industrial overall that it's been elongated. But if you look at it sector by sector, it's probably a better view overall. And in auto, this is our third quarter of decline. We're down about 13% from where the revenue peaked. It's a pretty shallow decline compared to how the other markets had behaved so far. So that's what we see. So, thank you, Chris. [Multiple Speakers]"
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Toshiya Hari with Goldman Sachs. Please proceed with your question."
},
{
"speaker": "Toshiya Hari",
"content": "Thank you. Hi, good afternoon. Thank you so much for taking the question. Haviv, maybe one for you on CapEx and how you're thinking about your long-term revenue growth. You've always had this slide in your capital management call deck where you show revenue supported. I think you have for 2026, you have $30 billion for 2030 at $45 billion. I know you're constantly evaluating your plans and you talked about presenting various scenarios on the August call. But I'm curious, is the $30 billion for 2026 and $45 billion for 2030, are those still kind of the base case scenarios for you, or has there been any change post conversations with customers?"
},
{
"speaker": "Haviv Ilan",
"content": "So, Toshiya first, I do want to leave something for August. So I think it's going to be just a better environment to go provide this information. We'll also provide supporting materials and we'll or updated presentation where you'll see, as I said, the different scenarios and how we see them. And to me, it's step-by-step. Right now when I think about how we establish our CapEx plan, we need to think about what the next peak wants to do. We'll discuss that. We'll discuss different scenarios of revenue leading to the next peak and what will CapEx do accordingly. And as a result, what free cash flow per share will be. Again, I don't want to give the whole a pitch right now, but I think it's going to be important for investors to join and hear our latest update."
},
{
"speaker": "Toshiya Hari",
"content": "Understood."
},
{
"speaker": "Dave Pahl",
"content": "Follow-on [indiscernible]"
},
{
"speaker": "Toshiya Hari",
"content": "I do. Thanks, Dave. Just a question on Embedded Processing. Revenue was down sequentially and the year-over-year decline actually accelerated. Analog, we've seen some stabilization. So I'm just curious what you're seeing in the Embedded Processing side. Is this purely volume pressure, or is there a pricing or competitive component here as well? I think operating margins for that business came in a little bit as well sequentially. So just curious. Thank you."
},
{
"speaker": "Haviv Ilan",
"content": "Yes, let me start first on the high-level embedded -- the embedded business. So when I look at the underneath beyond the numbers, it's getting stronger. Our product portfolio is improving. And when I look at the -- at this decade, the -- just the opportunity for that business to be a major contributor for TI's growth of free cash flow per share is very high. So I'm very encouraged by the progress of the business. Now regarding the cycle, cycle first, embedded as a little bit of a different structure compared to analog. It's mainly composed of industrial and automotive. So it has less exposure into a personal electronics enterprise or communication equipment. And these two markets kind of pick later, right. So if you look at the embedded business versus analog, it picked a year-after kind of middle of 2023 versus the middle of 2022 for the analog business. In addition to that, the embedded business today, although as Rafael mentioned, it's being changed, was mainly supported from foundry wafers during the upcycle and we felt more limitation over there compared to our internal supply capacity. And so, now when these supply issues are resolved, we are seeing customers just adjusting their inventory. That's what I believe is happening and therefore, embedded is seeing that sharper correction. But again, when I look at it from the from the top, embedded is strengthening and I think it will continue to serve us very well moving forward."
},
{
"speaker": "Rafael Lizardi",
"content": "Let me just add on the operating profit question or angle that you had. Just as a reminder, as Haviv said, traditionally embedded has relied on external wafers, but we now have -- we're bringing them in and we have -- the Lehi factory is disproportionately will serve embedded, and therefore, embedded has taken a disproportionate amount of the fixed-cost charges there. But just like that is put right now, it will be a tailwind. It's a headwind now, it will be a tailwind in the future as we qualify more and more parts, embedded parts as well as analog at that Lehi factory."
},
{
"speaker": "Toshiya Hari",
"content": "It's very clear. Thank you so much."
},
{
"speaker": "Dave Pahl",
"content": "Have a great day. Next caller, please."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Harlan Sur with JPMorgan. Please proceed with your question."
},
{
"speaker": "Harlan Sur",
"content": "Yes. Thank you for taking my question and great to have you on the call, Haviv. Maybe to follow up on the embedded question, right, because this business grew 3% last year versus your analog business, which was down 15%? Yes, year-to-date, it's down about as much as your peers or I would argue slightly better. You've articulated the positive strategy changes previously, right, more catalog, broad market focus. So bottom-line, again, over the past few years, it seems like you've made good improvements in this business. So as the team moves embedded more to internal manufacturing combined with the strategy shift, maybe, Haviv can you just comment on the design-win momentum? What areas are you particularly doing well in? And I'm not sure, Rafael, how should we think about the improvements in embedded margins as you move what was once mostly outsourced to internal manufacturing."
},
{
"speaker": "Haviv Ilan",
"content": "Yes. Let me start and I'll let Rafael add some more color. But again, as you mentioned, the embedded business has gone through change in the last four, five years and Amichai has done a great job to position the business such that it benefits our competitive advantages, thinking about manufacturing and technologies of shifting really from almost like 80% external to when done, maybe the opposite, 80% internally building a higher breadth of products or not less concentration of revenue per socket and us expanding our product portfolio, utilizing the reach of our market channels. Think about the large sales team of TI, think about TI.com, and the more Catalog is the product, the better fit to our strategy. So in that sense, that is moving well. In terms of design in momentum, again, it's mainly an industrial and automotive business. So very high visibility on the automotive side. But as you also know, it takes time. So I'm encouraged with the design-in momentum. Our funnel increased tremendously when I compare it to the analog side because every funnel of every supplier grows, but we've seen a disproportional growth of our design-in momentum for embedded versus previous year and also versus analog just in terms of the rates. And I will give some examples. We see good momentum in real-time control, think about EVs, onboard chargers, think about traction inverters, a very good momentum in connectivity, automotive, and beyond. Think about car entries, tire pressure monitoring, and other and body-related opportunities in the automotive market. I can continue with a -- the kind of our more application-specific products like our radar systems. We have great position and growing position in radar winning a lot of new business, both with the Tier-1s and the OEMs. This is a -- from imaging radar for the front to the corner radar to even parking assist and also in-cabin sensing, that radar is taking a bigger and bigger part in the automotive market. And many other examples on the industrial side, here the number of end equipment is really vast hundreds of end equipment, but this is where our catalog MCUs that we are really reviving the presence of TI and building a new portfolio based on our MSP family is doing very well in winning new business and across-the-board, across the markets, utilizing our channel advantage. So I can go on and on here, but again, just evidence of my excitement of what this business can do for us in the second half of this decade. Rafael?"
},
{
"speaker": "Rafael Lizardi",
"content": "Yes, I'll just add on your question on fall-throughs for embedded, of course, we don't give guidance separate for the segment. So the 75% to 85% gross margin fall-through ex-depreciation that I talked about earlier applies to both."
},
{
"speaker": "Haviv Ilan",
"content": "Yes."
},
{
"speaker": "Rafael Lizardi",
"content": "Outside of -- if we didn't have Lehi and I'll address that in a second, we didn't have that, I would say generally analog would be at the higher end of that range and better would be at the lower end. But for the next year, two or three because Lehi, all those costs are -- all those fixed costs are already there, including people, we are going to have some nice tailwind and all of the -- a good portion of that will go to embedded. But over the longer timeframe, 75% to 85% ex-depreciation is a good guide to use."
},
{
"speaker": "Dave Pahl",
"content": "Yes, follow-on Harlon?"
},
{
"speaker": "Harlan Sur",
"content": "Yes. In terms of channel reach, right, we haven't heard you guys talk about ti.com in quite some time. I think the last data point we've got was it drove about $2 billion in sales in calendar 2022 and it sort of has this additional benefit from a business planning perspective of being a really good sort of leading indicator of demand inflections. As you've sort of potentially past the bottom of sort of the current cycle here, wondering if there's been any notable movement or trends in ti.com. And maybe from a longer-term perspective, like what initiatives has the team put in place to sort of further improve the customer pull to ti.com from a mid to longer-term perspective?"
},
{
"speaker": "Haviv Ilan",
"content": "Yes. Let me start more in the mid to longer term and then let Dave add some more color on how it looks versus the cycle. So in terms of the investment in tI.com, yes, they are continuing. These are very strategic and important investments for us. We believe there is a huge opportunity to digitize what we call the last mile or that interface between us and the customers. There are many, many customers, still a long tail of customers that we can't see today. But as they move to ti.com, we can supply with them with more information, we can even provide an opportunity to place backlog electronically, directly with TI. And in that sense, the importance for us is to just know our customers better, understand the end equipment, and provide the relevant product portfolio to serve their growth and win market share, right? So that data is to us very, very important that the direct connectivity with the customer is important. To do just that, we are investing in IT systems. We are investing in warehouses or if you will, logistics to serve these customers just in time as they needed and that is part of the way customers would opt to TI and just connect directly to us. Now in terms of the short-term, Dave, maybe you can talk a little bit about what we're seeing there through the cycle."
},
{
"speaker": "Dave Pahl",
"content": "Yes. And as we would -- have expected, orders that are placed through ti.com are down significantly from its peak, just, I think just telling of where we are with availability of product. But the great thing with ti.com is customers connect through APIs and put their planning systems on that. When they do have a shortage, they can look into our inventory, they can see it, some have even automated that process and have products shipped in many cases the same day. So we think the long-term strategic value of ti.com is much higher than the transaction that will cross it here in the short-term. So, thank you, Harlan. We can go to the next caller, please."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Joe Moore with Morgan Stanley. Please proceed with your question."
},
{
"speaker": "Joseph Moore",
"content": "Great. Thank you. I wonder just as you kind of think about this longer-term strategy, you've got well over 200 days of inventory, you have relatively low factory utilization. Like do you think this means we won't have shortages down the road that people can look at the capacity that you have, the inventory that you have and they won't have the need to accumulate inventory? Is that part of the thinking? Or do you think it's just inevitable that we'll get back to that at some point?"
},
{
"speaker": "Haviv Ilan",
"content": "Again, the investment first in capacity ahead of the demand and then in inventory is done to really improve customer service, right. And we believe it's important to keep that not only now when it's kind of easy and the -- we have a market cycle at you can call it at a low-point. The test for our company would be at the next up-cycle, okay, not only in upcycle, it is -- you can model, Joe, any upcycle that you want, but we want to be supporting our customers at the highest level even if the cycle looks like a very steep one. And we model, for example, the COVID cycle as a similar one and that's what drives our investments. I think it's very, very important to sell your customers ahead of the competition at times like that because that's the opportunity to gain share and we are going to be prepared for that opportunity. Having said that, all that is done in a very thoughtful way. Inventory is being built at the right part where we have this diversity and longevity position such that we don't risk the scrap of the inventory. And I'm pleased with the progress we've made, but the test will come and I'm sure it will come one day at the next up-cycle. I don't know if you want to add anything, Dave."
},
{
"speaker": "Dave Pahl",
"content": "That's good. Joe, do you have a follow-up?"
},
{
"speaker": "Joseph Moore",
"content": "Yes. I mean, just to follow up on that, to that, to the extent that your competition is doing things more the way they traditionally have and probably will see boom-bust cycles, what happens in that next upturn if they can't get parts from three of your competitors, is there a way you can keep them from accumulating inventory of TI components, even though they shouldn't need to. I mean, that seems like it's part of kind of the industry behavior in the past. Just how focused are you on trying to dampen that?"
},
{
"speaker": "Haviv Ilan",
"content": "Yes. Well, again, I think our capacity and the inventory level that we have built are such that we tend to provide good or very high customer service levels, right. So our intention is to maintain lead times through the cycle. We -- it depends what cycle you throw, you throw at us. There is always going to be that one cycle or that steep cycle that maybe we won't be able to do it. But we have modeled the company in such a way that in most a demand situation, we would be able to maintain a good customer or hike customer service levels through the cycle, which hopefully will keep the lead times short and which I'm pretty sure we will encourage customers not to hoard inventory. That has to be proven, but that's the way we want to prepare for the future."
},
{
"speaker": "Dave Pahl",
"content": "Yes."
},
{
"speaker": "Joseph Moore",
"content": "Very helpful. Thank you."
},
{
"speaker": "Dave Pahl",
"content": "And if I added one thing, I'd just say that I spent eight years in sales, a joke I never once took a double order and so trying to control customer behavior when things get short, people want to build more inventory, right? And so that's just the behavior that I think that will be in our industry for the foreseeable future, but we can gain share in those periods of time and that's the advantage of having the capacity in place. So that said, we'll go to the next call -- or next and last caller, please."
},
{
"speaker": "Operator",
"content": "Thank you. Our last question comes from the line of Chris Caso with Wolfe Research. Please proceed with your question."
},
{
"speaker": "Chris Caso",
"content": "Thank you. Yes, thanks. Good evening. The question is on your comment -- earlier comments on China. It sounds like that rebounded fairly robustly in the first quarter. Could you give some more color on what you're seeing within China? And then do you think -- do you feel that those Chinese customers are still burning their inventory? Are you still undershipping demand there?"
},
{
"speaker": "Haviv Ilan",
"content": "Yes, thanks for the question. So first, I would say that in China, it's a -- there is a very distinct signal that customers have walked down their inventories. And we've seen that you know spreading through a time with the market. If you think about the asynchronous behavior that we have described of the different markets, we saw the same in China. The personal electronics business picked in China somewhere in 2021, enterprise and industrial sometimes in 2022, and then automotive picked sometimes in 2023. So you saw that peak spread over three years, which I think is the reason we saw such an elongated decline of seven quarters in a row and we went backwards to our history and it's been one of the longest, if not the longest cycle we have seen. But I can see clearly that it's mainly played out. Of course, we will always find pockets and a few sectors on the industrial -- in the industrial market that are still going through that, but it's very clear that once you start to shift to end demand, you will see such behavior of, in our case 20% sequential growth and that momentum is being built across the markets. All markets did very well in China, growing between 15% to 20% something percent, okay. So very robust, coherent and that's like a recovery looks like. Now we haven't seen that across the other markets. I will even tell you that areas like you know Europe and Japan are in an early phase and hopefully, it doesn't take seven quarters per geography, but China was kind of the first into the upcycle, the beginning of COVID, the first one to correct on the down and now to me, the first one kind of raising a very strong sequential growth with momentum. So that's the way I would summarize it without trying to imply that we'll see the same behavior in each and every other market."
},
{
"speaker": "Dave Pahl",
"content": "Do you have a follow-on, Chris?"
},
{
"speaker": "Chris Caso",
"content": "I do. Thanks. And just a quick follow-up and I'm sure this is another thing you'll address on the August call, but you narrowed the range for depreciation next year down a little bit. Last quarter, you talked about CapEx kind of being around this $5 billion level per year. It was down sequentially in the second quarter. Is $5 billion still a reasonable way of looking CapEx this year?"
},
{
"speaker": "Haviv Ilan",
"content": "Yes. There is no news here strategically, but Rafael, maybe do you want to guide on CapEx?"
},
{
"speaker": "Rafael Lizardi",
"content": "No, absolutely no. This year, $5 billion, what you saw in second quarter is just little puts and takes on a quarterly basis, but for 2024, $5 billion of CapEx and the depreciation numbers I gave are reflective of that."
},
{
"speaker": "Dave Pahl",
"content": "Okay."
},
{
"speaker": "Haviv Ilan",
"content": "So let me wrap up with what we've said previously. At our core, we are engineers. Our technology is the foundation of our company, but ultimately, our objective and the best metric to measure progress and generate value for owners is the long-term growth of free cash flow per share. While we strive to achieve our objective, we'll continue to pursue our three ambitions. First, we will act like owners. We will own the company for decades. We will adapt and succeed in a world that's ever-changing and we will be a company that we are personally proud to be part of and we would want as our neighbor. When we are successful, our employees, customers, communities, and owners all benefit. Thank you, and have a good evening."
},
{
"speaker": "Operator",
"content": "And this concludes today's conference and you may disconnect your lines at this time. Thank you for your participation."
}
] |
txn | 2,024 | 1 | [
{
"speaker": "Dave Pahl",
"content": "Welcome to the Texas Instruments First Quarter 2024 Earnings Conference Call. I'm Dave Pahl, Head of Investor Relations, and I'm joined by our Chief Financial Officer, Rafael Lizardi. For any of you who missed the release, you can find it on our website at ti.com/ir. This call is being broadcast live over the web and can be accessed through our website. In addition, today's call is being recorded and will be available via replay on our website. This call will include forward-looking statements that involve risks and uncertainties that could cause TI's results to differ materially from management's current expectations. We encourage you to review the notice regarding forward-looking statements contained in the earnings release published today, as well as TI's most recent SEC filings, for a more complete description. Today, we'll provide the following updates: First, I'll start with a quick overview of the quarter. Next, I will provide insight into first quarter revenue results, with some details of what we are seeing with respect to our end-markets. Lastly, Rafael will cover the financial results, give an update on capital management, as well as share the guidance for the second quarter of 2024. Starting with a quick overview of the quarter: Revenue in the quarter came in about as expected at $3.7 billion, a decrease of 10% sequentially and 16% year-over-year. Analog revenue declined 14% year-over-year, and Embedded Processing declined 22%. Our Other segment declined 33% from the year-ago quarter. Now I'll provide some insight into our first quarter revenue by end-market. Revenue declined sequentially across all of our end-markets. Our results reflect the current environment, as customers continue to reduce their inventory levels. Similar to last quarter, I'll focus on sequential performance, as it is more informative at this time. First, the industrial market was down upper-single digits. The automotive market was down mid-single digits. Personal electronics was down mid-teens. Next, communications equipment was down about 25%. And lastly, enterprise systems was down mid-teens. Rafael will now review profitability, capital management and our outlook. Rafael?"
},
{
"speaker": "Rafael Lizardi",
"content": "Thanks Dave, and good afternoon everyone. As Dave mentioned, first quarter revenue was $3.7 billion. Gross profit in the quarter was $2.1 billion, or 57% of revenue. From a year ago, gross profit decreased primarily due to lower revenue and to a lesser extent, higher manufacturing costs associated with reduced factory loadings and our planned capacity expansions. Gross profit margin decreased 820 basis points. Operating expenses in the quarter were $933 million, flat from a year ago and about as expected. On a trailing 12-month basis, operating expenses were $3.7 billion, or 22% of revenue. Operating profit was $1.3 billion in the quarter, or 35% of revenue, and was down 34% from the year-ago quarter. Net income in the first quarter was $1.1 billion or $1.20 per share. Earnings per share included a $0.10 benefit that was not in our original guidance, primarily due to the sale of a property. Let me now comment on our capital management results, starting with our cash generation. Cash flow from operations was $1 billion in the quarter and $6.3 billion on a trailing 12-month basis. Capital expenditures were $1.2 billion in the quarter and $5.3 billion over the last 12 months. Free cash flow on a trailing 12-month basis was $940 million. In the quarter, we paid $1.2 billion in dividends, and in the past 12 months, we returned $4.8 billion to our owners. Our balance sheet remains strong with $10.4 billion of cash and short-term investments at the end of the first quarter. In first quarter, we issued $3 billion in debt. Total debt outstanding is now $14.3 billion with a weighted average coupon of 3.8%. Inventory at the end of the quarter was $4.1 billion, up $84 million from the prior quarter and days were 235, up 16 days sequentially. For the second quarter we expect TI revenue in the range of $3.65 billion to $3.95 billion and earnings per share to be in the range of $1.05 to $1.25. We continue to expect our effective tax rate to be about 13%. In closing, we will stay focused in the areas that add-value in the long-term. We continue to invest in our competitive advantages, which are manufacturing and technology, a broad-product portfolio, reach of our channels, and diverse and long-lived positions. We will continue to strengthen these advantages through disciplined capital allocation and by focusing on the best opportunities, which we believe will enable us to continue to deliver free cash flow per share growth over the long-term. With that, let me turn it back to Dave."
},
{
"speaker": "Dave Pahl",
"content": "Thanks, Rafael. Operator, you can now open the lines for questions. In order to provide as many of you as possible an opportunity to ask your questions, please limit yourself to a single question. After our response, we'll provide you an opportunity for an additional follow-up. Operator."
},
{
"speaker": "Operator",
"content": "Thank you. We’ll now be conducting a question-and-answer session. [Operator Instructions] Our first question is from Timothy Arcuri with UBS. Please proceed with your question."
},
{
"speaker": "Timothy Arcuri",
"content": "Thanks a lot. Rafael, I'm wondering if you can give us an update on any CHIPS Act money that you may have gotten. I know, basically all the money for the advanced nodes has been allocated and has been announced, but there is still like $9 billion outstanding for mature nodes. So can you kind of talk about that for us?"
},
{
"speaker": "Rafael Lizardi",
"content": "Yes. No, happy to do it. First let me address the grants, which I think is what you're referring to. On that, frankly we don't have an update to give. We're still going through that process. Submitted our application late last year, we are working through the details with the CHIPS Program Office. As we said before, we believe our investments in manufacturing in both Texas and Utah are well-positioned with the objectives of the CHIPS Program Office. Now let me give you an update on the ITC, the Investment Tax Credit. To-date, we have accrued about $1.5 billion on that credit, and based on the recently released regulations, we will be receiving the ITC cash benefit throughout the year in 2024 and beyond. And starting next quarter, so in second quarter, we expect to receive about $300 million and a total of $1 billion for all of 2024. Okay, do you have a follow-up?"
},
{
"speaker": "Timothy Arcuri",
"content": "I do, yeah. I wanted to ask about factory loadings and sort of where you think inventory goes for June. If I look at your guidance, the gross margins implied pretty flat ex-depreciation. So it seems like loadings have sort of leveled-off in June. Is that right? And kind of what do you expect for inventory in June? It seems like it should start to come down a tick maybe in June. Thanks."
},
{
"speaker": "Rafael Lizardi",
"content": "Yes. Sure. Of course we give a guidance. We give a range on revenue, we give a range on EPS, and then 90 days from now, we'll discuss that more or less. But for now, I'll tell you that in first quarter, we adjusted factory loadings, as we neared our desired inventory levels. And as we said during the prepared remarks, we grew inventory about [$80-some million] (ph). And then for second quarter, we are going to adjust those loadings depending on future demand."
},
{
"speaker": "Dave Pahl",
"content": "Thank you Tim. We’ll go to next caller please."
},
{
"speaker": "Operator",
"content": "Our next question is from Stacy Rasgon with Bernstein Research. Please proceed with your question."
},
{
"speaker": "Stacy Rasgon",
"content": "Hi guys. Thanks for taking my question. I wanted to follow up on that. If and when revenues begin to recover, how do we think about what that would imply for your factory utilization given your current inventory position, as well as additional capacity coming online, which I guess sort of just naturally gives a downward bias to utilization anyways? Like I guess, how long would you need to take utilizations up? Or how much revenue growth would you need to start taking utilizations up given your positioning on inventories and capacity additions?"
},
{
"speaker": "Rafael Lizardi",
"content": "Yes. So Stacy, it's a good question, but it's a complex question and is -- at the end of the day, it is going to depend. It's going to depend on a number of factors, what kind of revenue profile you – we are faced with and not just in one quarters or two quarters but really over a longer horizon. Maybe the best thing I can tell you is don't expect a significant or even any drain on inventory because just given our business model and how we want to run the company, keeping lead time short and also the upside potential that we have with having this inventory and the capacity in place, is so much higher than the downside risk. So hopefully, that gives you some -- some good insight into how we're thinking. Do you have a follow-up?"
},
{
"speaker": "Stacy Rasgon",
"content": "I do. Thanks. I was wondering if you could talk a little bit about pricing. So I think last quarter, you'd suggested that pricing was sort of resuming historical trends, which -- I think, it suggests it was down -- I think, it was low to mid-single digits. Is there any update on what you are seeing in terms of the pricing environment? Is that still the environment that we are in? Are things better -- are things worse? Like where do you see that going as we go forward?"
},
{
"speaker": "Dave Pahl",
"content": "Yes. Stacy, I'll comment on that. And as I said last quarter, really we began seeing things change mid-last year -- in the back half of last year as we began discussions with customers for their demand in the following year and out in time, whatever those pricing windows would open up. And those are really just going back to what we've seen in the last 10 years, 20 years kind of pre-pandemic. So describe it roughly in the low to very low single-digit declines over time. And I would say, just generally that's what we are continuing to see."
},
{
"speaker": "Rafael Lizardi",
"content": "Let me add one more thing, Stacy. I want to give you a bonus answer. You always ask about OpEx. So you are not asking, but I'm going to give you OpEx. Remember that second quarter has a full three months of raises whereas first quarter only had two months of raises. So it's something for your modeling."
},
{
"speaker": "Stacy Rasgon",
"content": "Thank you."
},
{
"speaker": "Dave Pahl",
"content": "Thank you Stacy. We will go to the next caller please."
},
{
"speaker": "Operator",
"content": "Our next question is from Vivek Arya with Bank of America Securities. Please proceed with your question."
},
{
"speaker": "Vivek Arya",
"content": "Thank you for taking my question. I think in the prepared remarks, you said customers continue to reduce inventory levels, but you are also guiding Q2 sales to be up 4% sequentially. So my question is, should we think of Q2 as kind of a normal seasonal quarter? Just any more color on what you are seeing real time. Are we past the industry inventory correction? Are we kind of getting back to some semblance of -- on normalcy from a demand perspective? Any other color you could give from an end-market or geo perspective. Just -- you are the largest, right most influential vendor in the market. So I think, your perspectives would be very useful to understand where we are in the inventory and the broader demand cycle."
},
{
"speaker": "Dave Pahl",
"content": "Yes. Vivek, let me start with what we saw happen in the last quarter because I think, it's helpful. First, we saw personal electronics was the first market that went into the correction. It really is -- was the first to come out in the last few quarters, I'd describe it as behaving more seasonal. If you go to the other end of the spectrum, we have, had industrial, which has been declining sequentially from some time. And over the last few quarters, we've been talking about how there's some asynchronous behavior inside of the 12, 13 sectors that we have there. That continued inside of the quarter. So we have got some of the later-cycle sectors that are continuing to decline and declining at double-digit rates. But there are some that are beginning to -- begin to slow in the declines and even a couple that grew sequentially. So that I would just describe as being more mixed this quarter, which is certainly different than last quarter. So -- and if you look -- historically, second quarter is a seasonally strong quarter for us. So it's not unusual for us to see sequential growth sequentially. Do you have a follow-on?"
},
{
"speaker": "Vivek Arya",
"content": "Yeah, thank you Dave. Maybe if I press a little bit on that. For Q2, specifically industrial and automotive, do you think -- is your assumption that customers will continue to work down inventory? Or do you think that they have worked down most of the inventory and we are getting back to some semblance of what normal demand looks like for TI in Q2? Like what does your guidance actually imply that are we below seasonal? Are we seasonal? Or -- are we something different?"
},
{
"speaker": "Dave Pahl",
"content": "Well, again, we're not in the practice of giving guidance by end-market. And -- but even inside of last quarter, as we looked at it inside of industrial, there obviously were some customers that are nearing the end of that inventory depletion cycle. So as you know, we don't -- we try to be very cautious and not to try to predict tops or bottoms or those types of things and just report what we see and just stick to the facts. So thank you Vivek. We’ll go to the next caller please."
},
{
"speaker": "Operator",
"content": "Our next question is from Thomas O'Malley with Barclays. Please proceed with your question."
},
{
"speaker": "Thomas O'Malley",
"content": "Hi good afternoon. Thanks for taking my question. Mine is in regards to China. 2023 data came out recently, and it looks like some of the larger North American players didn't really lose share despite some concerns on the trailing edge that you would have some increased China competition. Can you talk -- has there been any change in the way that customer behavior has kind of trended over the last couple of months? And can you talk about just that competitive environment? Are you seeing more players there? Are you seeing players that you didn't see before? Any color on China would be super useful. Thank you."
},
{
"speaker": "Dave Pahl",
"content": "Sure. Yes. Thanks, Tom for that question. And I’d say, no change over the last couple of months. But I think, certainly over the last few years, there's many things that are changing in China. We've got very competent local competitors there as well as there’s subsidized capacity going in place. And when you compare that to five years or 10 years ago, is it harder to compete there? It certainly is. But again, I would not describe that as a competitive landscape that's changing overnight. And we've talked about that for some years. So China is an important market for us that -- it continues to be a growing market. And we can and will compete there to support our customers. So our competitive advantages, whether that's our manufacturing and technology, the breadth of the portfolio, the reach of the markets all [serve] (ph) us very, very well in China. Do you have a follow-on?"
},
{
"speaker": "Thomas O'Malley",
"content": "Yes. Just on auto particularly. I know that you're not guiding the out quarter, but just conversations that you've had since you last updated us with those customers? I think you just mentioned that inventories are coming down. But through the pandemic, there was a kind of change of stated ordering patterns of just-in-time to just-in-case. Do you see that kind of persisting -- or do you think that we are moving back to a situation in which customers really want to have much lower inventory on their balance sheet. Obviously, you have a unique supply chain, but just any thoughts on just the auto environment, particularly through the last several months. Thank you."
},
{
"speaker": "Dave Pahl",
"content": "Sure. Yes. Thanks again, Tom. I would say that many customers and especially those in automotive, as they went through and dealt with the disruptions that they had in supply chains actually we are very thoughtful in looking at where their supply is coming from, what things that they can do differently well beyond just carrying extra days of inventory. And when they went through that analysis, I think many found that they have a pretty significant dependence on wafers coming out of both China and Taiwan. And what they described that to us is geopolitically dependable capacity is what they're seeking. And again, we have talked about that before in our capital management updates. We believe that -- that's going to be highly sought after it is -- we are seeing that today. And so I think, we are in a position to be able to support customers, and that growth that will come from that. So thank you Tom, we will go to the next caller please."
},
{
"speaker": "Operator",
"content": "Our next question is from Ross Seymore with Deutsche Bank. Please proceed with your question."
},
{
"speaker": "Ross Seymore",
"content": "Hi guys thanks. I'm going to ask a couple of questions. I guess for the first one, Dave, I know you don't want to guide by the segments but you gave the quarter-over-quarters. Could you give us what the year-over-years were by end-market in the first quarter, please?"
},
{
"speaker": "Dave Pahl",
"content": "I can do that, yes. So the industrial market was down about 25% from a year ago. Automotive was down lower single digits. Personal electronics was actually up single digits. Comms equipment was down about 50%, and enterprise system was down mid-teens. Do you have a follow-on, Ross?"
},
{
"speaker": "Ross Seymore",
"content": "I do. Rafael, you talked a little bit about the trajectory of the grant side of the CHIPS Act -- or excuse me, the ITC side and where you are getting the money in over time. Does any of that inflows of cash have a differing impact on the income statement? Or is it just the same, it's just a matter of timing and when you're getting that $1 billion as opposed to, I think you said $500 million before?"
},
{
"speaker": "Rafael Lizardi",
"content": "Right. No, no direct impact on the income statement. That's already played in as the lower depreciation and are already flowing through the P&L and in our expectations on depreciation. Of course, having more cash, does have an impact in terms of you have more cash, you're going to have more interest income. But put that aside, that's kind of below the profit the operating profit line. So speaking of depreciation, let me give you an update on that. We've been talking about depreciation for this year, $1.5 billion to $1.8 billion. That is -- we continue to expect that -- but we're more likely to come in at the bottom half of that range. And for 2025, we continue to expect $2 billion to $2.5 billion in depreciation."
},
{
"speaker": "Dave Pahl",
"content": "Thank you Ross. We will go to the next caller please."
},
{
"speaker": "Operator",
"content": "Our next question is from Chris Danely with Citibank. Please proceed with your question."
},
{
"speaker": "Chris Danely",
"content": "Hey, thanks guys. Rafael, just another question on the balance sheet and cash. So you guys have seen the share count kind of flatten out here for the last 4 quarters or 5 quarters and then you're building cash and increasing your debt. I guess what's changed? Traditionally, you've sort of taken the share count down slowly but steadily. Any sort of changes in the long-term thinking there on cash, usage of cash, et cetera?"
},
{
"speaker": "Rafael Lizardi",
"content": "Yes. When it comes to capital management, it all depends, and it depends on circumstances. And at the moment our objective when it comes to -- you've known us for a while. We return all cash flow – [or cash] (ph) flow to the owners of the company, and we do that over time. But there are times to increase liquidity and to build up cash. So you have seen us over the last couple of years do that and steadily increase the cash on the balance sheet. We finished at $10.4 billion last quarter. And we've done that very consciously, right to protect the investments that we're making, particularly the $5 billion per year CapEx investments in manufacturing because that is the most important allocation of capital has been for the last few years and will continue to be for the next three years. So with that in mind, we've had that in mind as we have made overall capital allocation decisions, including the decisions on repurchases."
},
{
"speaker": "Dave Pahl",
"content": "Do you have a follow-on, Chris?"
},
{
"speaker": "Chris Danely",
"content": "Yes, thanks Dave. Just another question on China but more on the, I guess, the insourcing side. So some of your competitors have talked about this impacting them. Do you guys see an impact of this on TI? Would or will this alter your long-term, I guess growth expectations or thoughts on your China business? Just any color there would be very helpful. Thanks."
},
{
"speaker": "Rafael Lizardi",
"content": "Yes. So I'll start and, Dave, if you want to chime in. But as Dave alluded to earlier on the call, China is a very important market. We need to compete there, we do compete there and we compete to win there. China, there -- it's pretty clear that there's an incentive to design local semiconductor suppliers. I think, that's what you're referring to as insourcing. And today, that share, my guess -- my sense is 10% to 15% of the local content is sourced by local semiconductor suppliers. I think, the exact number is 12%, the one I saw. So that means there's another 88% that -- that is shared now between U.S. and European suppliers. And our goal is to continue that fight and maintain and gain that share, competing with local suppliers but also competing with US and European semiconductor suppliers."
},
{
"speaker": "Dave Pahl",
"content": "Yes. And maybe I'll just add in China -- in any market, we've just got to have the best parts. And when we have that -- that means we've got to be ahead of competitors, whether that's on performance, on support, availability and cost. So -- and we have customers in every region that are beginning to think about where they're sourcing products from. So customers that aren't in China are looking at our -- as they describe it, geopolitically dependable capacity. And that's about 80% of our revenue. The 20% that's in China, we have customers in China that have and support global markets. And they're coming and describing our geopolitical dependable capacity and wanting to have access to it because it is very unique. We're the only ones that are building at scale outside of China and Taiwan capacity. So customers understand that. They understand it both in China, as well as outside. So thank you for that Chris. We will go to the next caller please."
},
{
"speaker": "Operator",
"content": "Our next question is from Joe Moore with Morgan Stanley. Please proceed with your question."
},
{
"speaker": "Joe Moore",
"content": "Great. Thank you. I've asked this question before, but it keeps coming up. Can you talk about how you think about pricing kind of more strategically as you contemplate having a decent amount of capacity, more 300 millimeter capacity, more subsidization? Does that change the pricing paradigm at all? Are there markets where you might be more price-aggressive than you wouldn't be, if any of that were different?"
},
{
"speaker": "Dave Pahl",
"content": "Yes. Joe, the answer will be amazingly consistent with how you've asked it before. But we haven't changed our strategy on pricing. You know that pricing doesn't move quickly in our industry, and it -- isn't the primary reason why customers choose our products overall. So we regularly monitor pricing for all of our products. That includes all end markets and all product categories and all regions. And we price to be competitive, and we can do that because we've got a great product portfolio and we've got great access to the markets through our channels. And we've got competitive products because we build it on 300 millimeter. So hopefully, that's amazingly consistent. Do you have a follow-on?"
},
{
"speaker": "Joe Moore",
"content": "Yeah. Thank you for that. Yes, in terms of the embedded business, I know you've had a number of kind of vertical markets that you de-emphasized and things like that with kind of a focus on more of a core kind of catalog strategy in that business. Where are you in that? Do you expect that you would -- that your embedded business would sort of track the broader microcontroller business? Or just how do you think about the transitions that are happening there?"
},
{
"speaker": "Dave Pahl",
"content": "Yes. I think that we continue to make progress overall in our embedded business. The goal there is to have that business growing and contributing to our free cash flow over a long time. We think it's a great business and continue to invest. So we are very happy with that strategic progress. So I think, in the near-term, of course, we're not going to be immune to cycle-related corrections. It is a little bit later because of the constraints that we have due to embedded relying on foundry supply. And as you know, we are investing to put capacity in place. And we'll have control of that in the future and really are in a good position to gain share there. So thank you for that Joe, we will go to the next caller please."
},
{
"speaker": "Operator",
"content": "Our next question is from Tore Svanberg with Stifel. Please proceed with your question."
},
{
"speaker": "Tore Svanberg",
"content": "Yes, thank you. Dave, I had a question about the Q4 -- I mean the Q2 outlook. So I know, obviously, you can't guide by market and things like that. But from a bookings perspective, are we starting to see sort of a broad-based recovery in bookings? Or would you still say it's quite selective in all the different applications that you are targeting?"
},
{
"speaker": "Dave Pahl",
"content": "Yes. So let me speak to bookings at the top level. We saw bookings increase each month of the quarter. That is very typical that we would see in a first quarter. I don't have bookings by end market. If there's something very unusual going on, of course, that would jump out at us. So that's just not something I have here in front of me. But I would describe it as behaving as we would expect it to. And of course those bookings and other demand signals that we get from our customers are obviously [imbued] (ph) into our guidance. Do you have a follow-on, Tore?"
},
{
"speaker": "Tore Svanberg",
"content": "Yes. That's very helpful. As my follow-up, you mentioned there's a few segments within the industrial category that are starting to grow or perhaps have found the bottom from an inventory correction perspective. Can you talk about which segments those are?"
},
{
"speaker": "Dave Pahl",
"content": "Yes. Again, as we talked about over the last several quarters now that there was markets that were behaving -- or sectors that were behaving asynchronously. So there are shorter cycle investment sectors that began to roll earlier, longer-term investment cycles that were rolling later, really just the last couple of quarters into it. So it is really -- if you had to kind of divide them out, that's what they would look like. Thank for you that Tore, we will go to the next caller please. And this will be our last caller."
},
{
"speaker": "Operator",
"content": "Our last question is from Chris Caso with Wolfe Research. Please proceed with your question."
},
{
"speaker": "Chris Caso",
"content": "Yes. Thanks. Good evening. First question is related to the buybacks, and I think you addressed this in a prior question. But I guess the question is, what would be the trigger for being able to resume some degree of buybacks? We realize that the intention is to return 100% of excess free cash flow. But at what point does the cash in the balance sheet and kind of industry conditions allow you to kind of come back to what you've been doing previously?"
},
{
"speaker": "Rafael Lizardi",
"content": "Yes. Well a couple of things. For example, the data point I will give you is our free cash flow for the trailing 12 months was $940 million. And we returned in -- also in trailing 12 months, $4.8 billion. So one catalyst for a change there would be once we're past this investment phase that is consuming a good chunk of that free cash flow. Another catalyst is obviously revenue and how that behaves over a number of years. But -- so these are just some of the puts and takes that we think about when we are allocating capital."
},
{
"speaker": "Dave Pahl",
"content": "Do you have a follow-on, Chris?"
},
{
"speaker": "Chris Caso",
"content": "I do. Thanks. And I guess the question is about where TI is allocating the R&D investment going forward and how that may be changing. Over last year, it looks like auto industrial is about 70% of your revenue, and I know that's by design. But you've got some segments such as comm equipment that have been down a lot more. As we look out over the next two years or so, do you think that percentage of revenue on the segments kind of stays about where it is right now? Or based on the R&D investments you are making, do you think that changes substantially?"
},
{
"speaker": "Dave Pahl",
"content": "Yes. And it's a great question, Chris. So let me just use as a backdrop for those that hadn't looked at our capital management slide deck. And Slide 21, shows our percentage of our revenue by end-market. And the middle column there talks about what we're doing directionally from an R&D spend. So -- and we've talked about for some time that -- our belief that there is going to be secular trends and increasing semiconductors and industrial and automotive. And as a result of that, we have been taking investments up there. And the other markets though, if you look at personal electronics and communications equipment, our investments there have been and continue to be very steady because we can find great opportunities inside of those markets. And so we'll continue those investments. And then enterprise systems, we've taken up the investments there slightly. And there is just opportunities, and enterprise systems likely will be a good grower as well. It doesn't have quite the same dynamics, as industrial and automotive for us. But certainly, things that sit inside of enterprise we believe will make that an above-average grower over the next decade [plus] (ph). So with that, I'll turn it over to Rafael to wrap up."
},
{
"speaker": "Rafael Lizardi",
"content": "Okay. Thanks, Dave. Let me wrap up by emphasizing what we have said previously. At our core, we are engineers and technology is the foundation of our company. But ultimately, our objective and the best metric to measure progress and generate value for owners is the long-term growth of free cash flow per share. While we strive to achieve our objective, we will continue to pursue our three ambitions. We will act like owners who will own the company for decades. We will adapt and succeed in a world that's ever changing. And we will be a company that we're personally proud to be a part of and would [want] (ph) as our neighbor. When we're successful, our employees, customers, communities and owners all benefit. Thank you and have a good evening."
},
{
"speaker": "Operator",
"content": "This concludes today's conference. You may disconnect your lines at this time. Thank you for your participation."
}
] |
txt | 2,024 | 4 | [
{
"speaker": "Operator",
"content": "Good morning, everyone. Welcome to the Textron Q4 2024 Earnings Release Call. At this time, all participants are in a listen-only mode. Later, you will have the opportunity to ask questions during the question-and-answer session. [Operator Instructions] Now, at this time, I'll turn things over to Mr. Dave Rosenberg, Vice President, Investor Relations. Please go ahead, sir."
},
{
"speaker": "Dave Rosenberg",
"content": "Thanks, Bo, and good morning, everyone. Before we begin, I'd like to mention we will be discussing future estimates and expectations during our call today. These forward-looking statements are subject to various risk factors, which are detailed in our SEC filings and also in today's press release. On the call today, we have Scott Donnelly, Textron's Chairman and CEO; and Frank Connor, our Chief Financial Officer. Our earnings call presentation can be found in the Investor Relations section of our website. Revenues in the quarter were $3.6 billion, down from $3.9 billion in last year's fourth quarter. Segment profit in the quarter was $283 million, down $101 million from the fourth quarter of 2023. During this year's fourth quarter, adjusted income from continuing operations was $1.34 per share compared to $1.60 per share in last year's fourth quarter. Manufacturing cash flow before pension contributions totaled $306 million in the quarter, down $74 million from last year's fourth quarter. For the full year, revenues were $13.7 billion, up $19 million from last year. In 2024, segment profit was $1.2 billion, down $127 million from 2023. Adjusted income from continuing operations was $5.48 per share as compared to $5.59 per share in 2023. Manufacturing cash flow before pension contributions was $692 million, down $239 million from 2023. With that, I will turn the call over to Scott."
},
{
"speaker": "Scott Donnelly",
"content": "Thanks, David. Good morning, everyone. 2024 results were impacted by work stoppage at Aviation and difficult end markets in our Industrial segment. During the quarter, Aviation reached an agreement with the IAM on a new five-year contract. While the strike was unfortunate, we did take this opportunity to significantly improve our parts flow to the production line which we expect will reduce our out-of-station work and improve efficiency going forward. Aviation saw steady customer demand continue in the quarter, supported by our new product launches and our portfolio resulted in a year-end backlog of $7.8 billion, an increase of $676 million from 2023. In December, Aviation secured an order from Naval Air Systems Command for an additional 26 multi-engine training system, Beechcraft King Air 260s. Also in the quarter, Aviation continued to expand the global market for its versatile twin-engine large utility turboprop, the Cessna SkyCourier, achieving type certification by the Transport Canada Civil Aviation. During 2024, steady aircraft utilization within the Textron Aviation product portfolio resulted in a 6.3% growth in aftermarket revenues. At Bell, in 2024, we saw significant growth with the continued expansion of the FLRAA program, largely driving a 13.7% increase in revenues for the year. During the quarter, Bell received a follow on award for the FLRAA program as the US Army exercised Option 2, an option for two limited user test aircraft. On the commercial side, Bell continued to see steady order activity in 2024. For the year, Bell delivered 172 commercial helicopters compared to 171 in 2023. Moving to Systems, the team delivered another strong quarter with a 13.5% segment profit margin. During the quarter, Systems completed Options 3 and 4 of the Future Tactical Uncrewed Aircraft System Program with the delivery of a production representative system to the US Army in December. Also during the quarter, Systems received an award from the Naval Sea Systems Command for the next production lot of nine ship-to-shore connector crafts with a total contract value of $960 million. Systems was also awarded a contract value of up to $106 million for Mine Sweeping Payload Delivery Systems from the US Navy to support its minesweeping operations. At Industrial, the segment experienced lower revenues and operating profit in the quarter, primarily driven by the ongoing softness in specialized vehicles and markets. We are in the process of conducting a strategic review of our PowerSports product line. At eAviation, Pipistrel delivered 42 aircraft during the fourth quarter and 120 aircraft for the full year while continuing our investment in electric and hybrid aviation platforms. Despite the challenges faced in 2024 at Aviation and Industrial, the company exited the year well positioned for future growth in the Aerospace and Defense businesses with strong order activity generating total company backlog of $17.9 billion, up $4 billion from 2023. On the new product front at NBAA in October, Aviation announced a significant advancement in aviation technology with the Gen3 platform upgrades to the M2, CJ3, and CJ4 aircraft, adding Garmin Emergency Autoland along with other avionics and aircraft enhancements. During the year, we continued to make progress on the Citation Ascend and Beechcraft Denali development programs. Ascend has logged over 700 hours of flight testing, while Denali finished the year having logged over 2,500 hours of flight testing. At Bell, the US Army announced approval of Milestone B in August for the FLRAA program. Bell is now executing on the engineering and manufacturing development phase of the program and progressing towards the first prototype aircraft build. Bell's H1 and V22 military program highlights include an FMS award for the production and delivery of 12 AH-1 Zulu helicopters to Nigeria and over $1 billion in sustainment awards on the H1 and V22 programs. On the commercial side, Bell saw steady demand throughout the year, including its first 525 helicopter order for 10 units to Equinor, the Norwegian state energy company. In 2024, Textron Systems made significant progress on several key pursuits. On the US Army's Robotic Command Vehicle development program, Systems announced the delivery of two Ripsaw M3 prototype vehicles to the Army for Phase 1 of the competitive development effort, ahead of a downselect expected in the first half of 2025. As part of the XM-30 program, Team Lynx advanced to the detailed design phase that is expected to conclude with a critical design review in the first half of 2025. On the Advanced Reconnaissance Vehicle program, Systems continued its development work as one of two vendors selected to design, develop, and manufacture a 30-millimeter autocannon prototype variant for expected delivery in 2025. Moving to FTUAS, Systems has fulfilled its contractual delivery commitments as waiting -- awaiting decision on a final downselect for a production award on the competitive program by the US Army in the second half of 2025. Systems also secured the next production contract award for the Ship-to-Shore Connector and expanded maritime airside operations with the US Navy. Moving to Industrial, throughout the year, we continued to focus on our cost structure to offset challenging end markets. At eAviation, Pipistrel was granted an airworthiness exemption by the FAA for its Velis Electro Trainer, which allows US flight schools to use the aircraft in certified pilot training programs. During the year, eAviation acquired Amazilia Aerospace, the developer of digital flight controls, flight guidance, and vehicle management systems for both manned and unmanned aircraft. Looking to 2025, at Aviation, we're projecting growth driven by increased deliveries across all product lines and higher aftermarket volume with improved productivity and manufacturing efficiency. Moving to Bell, we expect revenue growth driven by the FLRAA program and higher commercial volume. At Systems, we expect low single-digit revenue growth with strong margins as we continue to pursue new program opportunities. In our Industrial segment, we are projecting lower revenues, largely driven by the suspension of powersports production at TSV and lower automotive volume at Caltex and expect cost reductions to drive improvement in segment profit margin for 2025. At eAviation, we plan to continue our investment in the development of new hybrid and electric technologies for manned and unmanned aviation platforms. With this overall backdrop, we're projecting revenues of about $14.7 billion, up 7% from 2024 for Textron's 2025 fiscal year. We're projecting adjusted EPS in the range of $6 to $6.20. Manufacturing cash flow before pension contributions is expected to be in the range of $800 million to $900 million. With that, I'll turn the call over to Frank."
},
{
"speaker": "Frank Connor",
"content": "Thank you, Scott, and good morning, everyone. Let's review how each of the segments contributed, starting with Textron Aviation. Revenues at Textron Aviation of $1.3 billion were down $242 million from the fourth quarter of 2023, reflecting lower volume and mix of $282 million, which was principally a result of production disruptions related to the strike. Segment profit was $100 million in the fourth quarter, down $93 million from a year ago, primarily due to lower volume mix and manufacturing inefficiencies, which included idle facility costs and higher costs associated with the labor disruption resulting from the strike. Backlog in the segment ended the quarter at $7.8 billion, up $219 million from the prior quarter. Moving to Bell. Revenues were $1.1 billion, up $58 million from last year's fourth quarter, reflecting higher military and support program revenues of $67 million, primarily due to higher volume on the FLRAA program, partially offset by lower volume on the V-22 program. Segment profit of $110 million was down $8 million from a year ago, primarily driven by mix as lower volume on the V-22 program offset higher volume on the FLRAA program. Backlog in the segment ended the quarter at $7.5 billion. At Textron Systems, revenues were $311 million, down $3 million from last year's fourth quarter. Segment profit of $42 million was up $7 million from last year's fourth quarter. Backlog in this segment ended the quarter at $2.6 billion. Industrial revenues were $869 million, down $92 million from last year's fourth quarter, largely reflecting lower volume. Segment profit of $48 million was down $9 million from the fourth quarter of 2023, reflecting lower volume and mix and inflation, partially offset by manufacturing efficiencies and lower selling and administrative expense, largely due to cost reduction activities. Textron eAviation segment revenues were $11 million in the fourth quarter of 2024, with a segment loss of $22 million, largely associated with research and development expense on new products. Finance segment revenues were $11 million and the profit was $5 million in the fourth quarter of 2024. Moving below segment profit, corporate expenses were $17 million. Net interest expense for the manufacturing group was $21 million. LIFO inventory provision was $80 million. And tangible asset amortization was $8 million. And the non-service components of pension and post-retirement income were $65 million. In December, we announced a strategic review of our PowerSports product line within the industrial segment that resulted in additional restructuring actions. With these actions, we recorded total pre-tax special charges of $53 million and an inventory valuation charge of $38 million in the fourth quarter. Our manufacturing cash flow before pension contributions was $306 million in the quarter. For the year, manufacturing cash flow before pension contributions totaled $692 million, down $239 million from the prior year. In the quarter, we repurchased approximately 2.8 million shares, returning $232 million in cash to shareholders. For the full year, we repurchased approximately 12.9 million shares, returning $1.1 billion in cash to shareholders. With that, I'll turn the call over to David."
},
{
"speaker": "Dave Rosenberg",
"content": "Thank you, Frank. Turning now to our 2025 outlook on Slide 7. We're expecting adjusted earnings per share to be in a range of $6 to $6.20. We're also expecting manufacturing cash flow before pension contributions to be about $800 million to $900 million. Moving to segment outlook on Slide 8 and beginning with Textron Aviation. We're expecting revenues of about $6.1 billion. Segment margin is expected to be in a range of 12% to 13%. Looking to Bell, we expect revenues of about $4 billion. We're forecasting a margin in a range of 8.5% to 9.5%. At Systems, we're estimating revenues of about $1.3 billion with a margin in a range of 12% to 13%. At Industrial, we are expecting segment revenues of about $3.2 billion and margin to be in a range of about 4.5% to 5.5%. At eAviation, we expect revenues of $45 million and a segment loss of $70 million, reflecting our continued investment in sustainable aviation solutions. At Finance, we are forecasting segment profit of about $25 million. Looking at Slide 9, we're projecting about $160 million of corporate expense. We're also projecting about $130 million of net interest expense for the manufacturing group, $165 million of LIFO inventory provision, $35 million of intangible asset amortization, and $265 million of non-service pension income. We expect a full-year effective tax rate of approximately 18%. Turning to Slide 10, R&D is expected to be about $500 million, up from $491 million last year. We're estimating CapEx will be about $425 million, up from $364 million in 2024. Our outlook assumes an average share count of about 184 million shares in 2025. That concludes our prepared remarks. So, operator, we can open the line for questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] And we'll go first this morning to Sheila Kahyaoglu of Jefferies."
},
{
"speaker": "Sheila Kahyaoglu",
"content": "Good morning, Scott, Frank, and David. Maybe, Scott, if you could start off with the Aviation guidance. Can we talk about the 2025 deliveries? I think it's implied around 190 deliveries versus 151 in 2024. Can you talk about the quarterly cadence of jet deliveries as well as maybe turboprops just given the Q4 delivery number?"
},
{
"speaker": "Scott Donnelly",
"content": "Well, I do think that the numbers obviously will ramp up through the course of the year. Sheila, we're recovering. I'd say the factors are getting back to -- towards full operation coming out of the strike. We will continue as we have been for some time, expanding our production capacity as we go through the year. And that's largely driven by parts, which I think were in fairly good shape, and ramping up the workforce. And again, I would say early signs coming out of the contract agreement, we're seeing a little more stability in the workforce, which is good, and that should enable us to see that ramp on the -- over the course of the year. As we talked about in the last call, we're probably going to see also a significant progression in terms of margins as we go through the year. We will have a lot of deliveries here in the first quarter that would have been 2024 deliveries. So obviously, they're priced at 2024 levels. So, I would expect to see both volume and margin progress through the course of the year."
},
{
"speaker": "Sheila Kahyaoglu",
"content": "Maybe if I could just follow up on the margin ramp, can you talk about that bridge as we think about the 7.8% exit rate for Q4 for Aviation, how we think about that progressing, and the contributors to that?"
},
{
"speaker": "Scott Donnelly",
"content": "Well, for sure the 7.8% is an anomaly, right? I mean we had obviously unusually low volumes with the strike affecting a third or more of the quarter, And certainly we took an inefficient current period expense with all of our overhead that wasn't burdened. We couldn't burden on volume. So, 7.8% is certainly an anomaly. I would expect, as you think about us going through the year, it will see progression. If you look at the guide, obviously we're probably 1 to 200 basis points probably below the guide and probably finishing up more like 100 basis points to 200 basis points above the guide as you progress through the year to get to that average."
},
{
"speaker": "Sheila Kahyaoglu",
"content": "Great. Thank you."
},
{
"speaker": "Scott Donnelly",
"content": "Sure."
},
{
"speaker": "Operator",
"content": "Thank you. We go next now to Peter Arment of Baird."
},
{
"speaker": "Peter Arment",
"content": "Yes. Good morning, Scott, David and Frank. Frank, good luck with your retirement. Thanks for all your help over the years."
},
{
"speaker": "Frank Connor",
"content": "Thank you."
},
{
"speaker": "Peter Arment",
"content": "Could you talk a little bit about the, Scott, just, or David, maybe you want to weigh in on just the, your outlook for cash flow for the year, just given the earnings you're projecting, which is obviously a pretty nice snapback. Just some of the moving parts, it seems, maybe it was a little lower than we were estimating, but maybe we didn't have all the inputs, but thanks?"
},
{
"speaker": "Scott Donnelly",
"content": "Well, again, it will progress through the year. The cash was obviously in Q4 lighter than we normally have. That's largely reflective of a lot of inventory that was at Aviation for jets that didn't deliver in Q4. So we'll see our normal relatively light cash in Q1 and that will grow over the course of the year, but I think we're pretty confident we'll be in that $800 million -- $900 million range, but as is normal, it will be more back-end loaded."
},
{
"speaker": "Peter Arment",
"content": "Okay. Appreciate that. And then maybe just, Scott, in general, I know Sheila talked about Aviation. And maybe you just talk about, I mean, you obviously have very strong bookings in refreshed product lines, obviously drawing a lot of new interest. Just -- maybe just if you want to highlight just what you're seeing on the demand environment, whether it's broad-based or any particular markets that are stronger than others? Thanks."
},
{
"speaker": "Scott Donnelly",
"content": "Thanks, Peter. Look, it's been pretty much across the product line. I think we feel like we're in pretty good shape. The demand and order activity across every model has been good. We saw some very strong demand, obviously in that light jet with the Gen3 announcements. So that was very, very well received by customers. So we, in particular, had a very strong quarter in sort of that CJ3, CJ4 product line. But again, it's been pretty strong in most of the portfolio. And I think we, just given where customers are and the level of activity and the level of dialog, I think we'll continue to see a sustained demand through the course of the year. Again, we're probably looking at a one-to-one book-to-bill just because we think that's about where things ought to land, given the lead times of where most availabilities are for our different products. So one-to-one is what we're baked into our basic plan."
},
{
"speaker": "Peter Arment",
"content": "Appreciate all the color. Thanks, Scott."
},
{
"speaker": "Operator",
"content": "Thank you. We go next now to Robert Stallard of Vertical Research."
},
{
"speaker": "Robert Stallard",
"content": "Thanks so much. Good morning."
},
{
"speaker": "Scott Donnelly",
"content": "Good morning, Rob."
},
{
"speaker": "Robert Stallard",
"content": "And, Frank, yeah, best of luck for your retirement. It's been quite a ride. Let's start off with Bell. I was wondering if you could talk about what the risks and opportunities could be within that 2025 guidance, both for revenues and margin."
},
{
"speaker": "Scott Donnelly",
"content": "Robert, I don't think there's a whole lot. I mean, this is all mostly backlog business. Obviously, the FLRAA program, the ramp that we have baked into there is supported by what's in the sort of the pending '25 appropriations budgets and all the guidance we're receiving from the customer. So I don't think there's risk around that. Most of the commercial business is well booked. Certainly, sustainment around V-22 and H1 is very predictable business and again, largely booked. So I think as we work our way through the course of the year, we're in -- I don't think there's a lot of risk to the downside of where we are on the Bell numbers."
},
{
"speaker": "Robert Stallard",
"content": "Okay. And then as a follow-up, I was wondering if you've seen any sign of demand changing at Aviation or Industrial since we've had the US election?"
},
{
"speaker": "Scott Donnelly",
"content": "No, no, we really didn't Robert. It's actually kind of interesting. I mean, normally, we see more of a slowdown a little bit before the election just because people don't like a lot of uncertainty. I think probably largely in part as a result of the size of the backlog and the stuff that aircraft that are available well out past that period, obviously that we didn't see quite the drop and pop that we often see around our Presidential election. So, I would say it was relatively steady and we really haven't seen any change that I'm aware of in the demand environment in terms of the industrial side."
},
{
"speaker": "Robert Stallard",
"content": "Okay. That's great. Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. We go next now to Noah Poponak at Goldman Sachs."
},
{
"speaker": "Noah Poponak",
"content": "Hey, good morning, everyone."
},
{
"speaker": "Scott Donnelly",
"content": "Good morning, Noah."
},
{
"speaker": "Frank Connor",
"content": "Good morning."
},
{
"speaker": "Noah Poponak",
"content": "Hey, just back to the cash flow guidance, I guess, it would be lower than 2023 and the conversion from net income or the free cash margin, I think a little light of where you've talked about being over time, and I would have expected you'd be recovering some inventory from '24 that would help. So is there a net negative working capital assumption still in '25, or what else are we all missing in that bridge?"
},
{
"speaker": "Frank Connor",
"content": "Yeah. There's a -- on the working capital side, there's a little bit of headwind associated with the timing of some military payments. From an inventory standpoint, obviously, we are -- we'll be ramping production through the year as we talked about. So even though we had some higher inventory levels going into the end of '24 than we would have originally anticipated, we do need to have some higher inventory levels at the end of '25 for anticipated ramp. So you won't see a lot of inventory benefit. There is some military payment timing, as I said. And then we are expecting higher capital expenditures relative to what you saw back in the '23 timeframe associated with just the growth of the business and in particular, kind of FLRAA prep activities at Bell."
},
{
"speaker": "Noah Poponak",
"content": "Okay, that makes sense. And then I just was hoping to get a little more detail on the Bell margin. That's been quite resilient as you've ramped the early stages of FLRAA rapidly, which we had all anticipated would dilute that margin. But so far it hasn't. So maybe just walk us through the pieces that would bring the Bell margin down that much in 2025?"
},
{
"speaker": "Scott Donnelly",
"content": "Well, I think if you look at the Bell through 2024, we were helped by a little bit of improvement on some of the H1 side, obviously with the Nigerian deal that allowed us to maintain some more of that H1 volume, which is better volume for us. But you still -- at a macro level, we do have V-22 coming down, H1 will start to come down. We did have strong aftermarket in 2024. I think we'll still have strong aftermarket in 2025, but it's going to be flatter from where it was in 2024. So you really see a ton of the growth coming from the FLRAA ramp and commercial OEM deliveries. And as you know, commercial OEM deliveries tend to be dilutive to our margins. They generate a lot of aftermarket, so long term, very good for the business, but the two real growth drivers in 2025 are that ramp on FLRAA and increased commercial deliveries, both of which are obviously dilutive. So as we've said, we have always expected that this margin will come down somewhat based on that mix, but we're trying to target not having that be a dilution or problem at the EPS level. So, I think we're still more or less in that range of holding the operating profit dollars. It's a little pressured year-over-year just because we sort of outperformed on 2024 and that kind of raises the bar on that 2025 target. But I still think we're going to be in that range of being able to at least hold not dollars even as we grow the revenue on lower-margin business."
},
{
"speaker": "Noah Poponak",
"content": "Okay, great. I'll add my congrats and to Frank and Dave on the retirement and the new appointments. And thanks so much for working with us over the years, Frank, and thanks for taking my questions."
},
{
"speaker": "Frank Connor",
"content": "Thanks, Noah."
},
{
"speaker": "Dave Rosenberg",
"content": "Thanks, Noah."
},
{
"speaker": "Operator",
"content": "Thank you. We go next now to Seth Seifman at JPMorgan."
},
{
"speaker": "Seth Seifman",
"content": "Hey, thanks very much, and good morning and congratulations, Frank. Just to maybe come at Bell from the other side, it was strong performance through most of the year and certainly at the high-end relative to the initial guide. But I think the guide went up in Q3 to about 10.5% to 11%, I think and came in slightly lower. Was there something that changed in Q4 at Bell that led to that shortfall?"
},
{
"speaker": "Scott Donnelly",
"content": "Well, we -- I mean, we had -- we did have some program adjustments in Q4 that weren't favorable at Bell that largely had to do around FLRAA. I mean, we did exercise the limited user test. That is a fixed-priced option that was exercised. And as we would expect, the fixed price options are not a great margin, so that did create some dilution, which when you do the program accounting did put a little bit of a drag in Q4 for us."
},
{
"speaker": "Seth Seifman",
"content": "Okay. Thanks. And maybe to follow up just at Aviation, the orders have been quite steady through the year. When we think about the composition of those orders in terms of NetJets versus retail, is that a pretty steady composition? Is it a pretty, both in terms of how it's been trending versus itself and then how it's been trending versus the level of deliveries that we're seeing?"
},
{
"speaker": "Scott Donnelly",
"content": "Well, in general, it holds about flat, right, because as you guys know, we put these into the backlog based on sort of a 12-year forward. NetJets puts orders in, generally speaking, every month. It's usually fairly linear, but not always. And so, there can be from quarter-to-quarter some variation based on how many delivers we have to make in that quarter versus how many new exercises they happen to put. So it's not a perfectly linear process, but it generates a little bit of variability from quarter-to-quarter, but over the course of the year, it's been pretty stable."
},
{
"speaker": "Seth Seifman",
"content": "Okay. Great. Thanks very much."
},
{
"speaker": "Operator",
"content": "Thank you. We go next now to Myles Walton with Wolfe Research."
},
{
"speaker": "Myles Walton",
"content": "Thanks. Good morning. On R&D, I know you started off the year with a $550 million number for R&D, it came in at $490 million. I'm curious to the underrun there. And this would be a few years in a row of declines on the R&D front. I imagine, much of it from Bell. It looks like you're looking for a stable outlook for '25 to $500 million. Is that a good number going forward? And also what was the cause of the underrun in '24?"
},
{
"speaker": "Scott Donnelly",
"content": "I think it's a good number going forward. Look, I think the Bell dynamic with the end of the FLRAA program is certainly what drove a significant change in the R&D on a year-over-year basis as that program was wrapped up. And so, I think on a go-forward basis, we'll see more normalized R&D spending at Bell, as well as across the rest of the businesses. So for sure, part of what drove the lower R&D in the year and drove some of the higher margin frankly at Bell was that we did see a step-down associated with the funding that we were having to put in net to the FLRAA program."
},
{
"speaker": "Myles Walton",
"content": "Okay. And then relative to systems, I know the decisions on FTUAS and maybe RCV are kind of sort of dictate how the year goes and maybe how '26 goes. How sensitive to this year are the outcomes on those programs for your outlook for systems top line of $1.3 billion?"
},
{
"speaker": "Scott Donnelly",
"content": "Well, I don't think there's a huge sensitivity to it. Obviously, the RCV program, we expect to be in the first half of 2025. FTUAS is probably more of the second half latter in the year. And of course, those programs have to ramp up. So in the early phases, they're not huge numbers. And particularly in the case of FTUAS because it's late in the year, there's not a huge sensitivity to them. They're certainly much more important to us from a standpoint of what growth looks like as we go into '26 and beyond. So I guess I think of them as important milestones for us in the course of 2025, but not having a huge impact on revenue and margin in the year"
},
{
"speaker": "Myles Walton",
"content": "All right. Thank you."
},
{
"speaker": "Scott Donnelly",
"content": "Sure."
},
{
"speaker": "Operator",
"content": "We'll go next now to David Strauss at Barclays."
},
{
"speaker": "David Strauss",
"content": "Thanks. Good morning, everyone."
},
{
"speaker": "Scott Donnelly",
"content": "Good morning, David."
},
{
"speaker": "David Strauss",
"content": "Scott, aviation revenues in the fourth quarter, they came in a little bit light, I assume, looks like maybe you missed relative to what you're thinking 10 to 15 jet deliveries. What happened there? Was that supply chain or was that more on kind of your own in terms of getting the factory restarted post the strike?"
},
{
"speaker": "Scott Donnelly",
"content": "Well, certainly versus our original guidance for the year, yeah, it was probably more in that mid-teens in terms of aircraft and that was largely driven by the fact that, I mean, we didn't -- we really didn't get the factory running again until really the beginning of October, so -- or I'm sorry, the beginning of November. So we've really lost a third of the quarter with having the workforce out. So, as I said earlier, I think the good news is the folks are back. It's good to have a contract agreement in place for five years. And I think the workforce is pleased with the outcome, we're fine with the outcome. Everybody is ramping up. But we're really -- we did for sure lose a third of the quarter with not having a production operation in place."
},
{
"speaker": "David Strauss",
"content": "Yeah, I was just looking at it. You took down the revenue forecast of 5.5% and you were a little short of that. I guess just following up there, how do you feel about the Aviation supply chain in terms of the ramp you're looking at in terms of deliveries for 2025?"
},
{
"speaker": "Scott Donnelly",
"content": "Look, David, I think we feel good about it. I mean, that's where we're guiding where we are. I would say that the third-party parts, supply chain pieces coming into the factory are certainly in a much better position than they were throughout the course of 2024. So that feels very good. The other critical part is obviously stability of our workforce and retention. And again, since the contract has been signed, we were very happy with the number of people that came back, even folks that had been with us for a very short period of time before the strike hung in there and came back once the agreement was put in place. And the attrition numbers we're seeing are certainly improved from where they had been through the course of the rest of 2024. So, I think the momentum is in the right direction. Now we got a lot of work in front of us here to get deliveries that were supposed to be in '24 done and ramp it up. But I'd say the early look in terms of aircraft coming out of the production lines, attack times, which clearly have to improve over the course of the year are operating as we would expect. So I think we're at this point feeling pretty good that we're going to be able to make that ramp and deliver on the guide at the $6.1 billion."
},
{
"speaker": "David Strauss",
"content": "Okay. And timing for Ascend certification, what are you looking at? And is the Aviation guide sensitive at all to that timing?"
},
{
"speaker": "Scott Donnelly",
"content": "Well, look, I mean, obviously, we're expecting it to be in the course of the year. We got to work this through the FAA. If there's not an issue or a problem, it's going well. But clearly the actual certification is an FAA action. I think we feel great about the flight testing. The program is going very well. We do have a few aircraft in the year. So, yes, it's part of our guide, but certainly not material, but we would certainly expect to get the first few aircraft delivered late this year."
},
{
"speaker": "David Strauss",
"content": "Great. Thanks very much."
},
{
"speaker": "Operator",
"content": "Thank you. We go next now to Ron Epstein of Bank of America."
},
{
"speaker": "Ron Epstein",
"content": "Hey, good morning, guys."
},
{
"speaker": "Scott Donnelly",
"content": "Good morning, Ron."
},
{
"speaker": "Ron Epstein",
"content": "Is there anything, Scott, you've seen with maybe the change in administration that could be like an added little tailwind for private Aviation. So as an example, have you heard any discussion around some form of accelerated depreciation coming back or something like that historically has been a nice catalyst for private Aviation?"
},
{
"speaker": "Scott Donnelly",
"content": "Yeah. I don't know specifically that the accelerated depreciation impact, but I would have to say, Ron, I think in general, as you know, most of our customers are small to mid-sized businesses, entrepreneurial, high net wealth, I mean, it's a broad range of customers, obviously. But I think that in general, tax policy, regulatory policy is encouraging to them and therefore, they feel-good about their businesses. Their businesses are likely to be successful in growing and that certainly is nothing but helpful in terms of how they get their head around CapEx expenditures like new aircraft. So, I would say, I wouldn't point out one particular item and it's obviously it's quite early here and we don't know, how all the tax stuff is going to work its way out. But I think in general, just the nature of our kinds of customers that they think the outlook for business is good and that's good for the prospects of private Aviation."
},
{
"speaker": "Ron Epstein",
"content": "Yeah, that makes a ton of sense. And if I can, a follow-up that change in directions just a little bit. A while ago, right, you guys did Scorpion, and I always thought that was kind of cool. And the DoD at the time didn't seem to have a big appetite for that. It does seem, however, there does maybe potentially seem to be a change in more -- maybe a push towards more commercial terms contracting, contractors taking more risk. Do you see any opportunities for you guys with maybe like a Scorpion 2.0 parenthetically, something like that with maybe the changing environment with potentially more commercial type contracting?"
},
{
"speaker": "Scott Donnelly",
"content": "Well, I don't know about a specific around a Scorpion, Ron. I will -- I would say that in this administration four years ago, eight years ago to four years ago, however you want to think about it, there was certainly a mindset that we have to find ways to go faster, right? And so our acquisition system, this was according to the OTAs and the MTAs and the Army's creation of things like Futures Command that frankly help to accelerate and drive a lot of the things that we're working on today. So again, it's very early, obviously. Everybody talks about acquisition reform and I wouldn't say I expect huge things in terms of real change to policy, but expectations that what's good for the warfighter, good for the taxpayer is to figure out how to accelerate programs. And so again, it's early, we don't have any data yet, but I'm certainly hopeful that the incoming administration and within the building is interested in figuring out how to accelerate things. Commerciality is certainly a part of that, but just frankly, how do you make the process run faster and get things out-of-the warfighter quicker. And I think we would clearly be a beneficiary of that. We have a bunch of great programs that I think the warfighter side of the military would love to see them get out into the hands in the actual combatant commands and hopefully, we'll see some of that happen."
},
{
"speaker": "Ron Epstein",
"content": "Yeah. Thanks. Thanks a lot, Scott. Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. We go next now to Gavin Parsons of UBS."
},
{
"speaker": "Gavin Parsons",
"content": "Thanks. Good morning."
},
{
"speaker": "Scott Donnelly",
"content": "Good morning."
},
{
"speaker": "Gavin Parsons",
"content": "Just maybe two questions on the Aviation margin. You mentioned still having some impact of the disrupted '24 deliveries slipping into '25. Just I was hoping you could give us some sense of how much of that excess cost you're absorbing in that 12% to 13% margin guide?"
},
{
"speaker": "Scott Donnelly",
"content": "Well, we're not. It was a big driver, Gavin, of the Q4 number because we did take and period expense, a lot of overhead, which otherwise would have been into our sort of base cost spread across aircraft deliveries. And given that we were light, we did take a pretty significant hit on period expense, but as we think about the go-forward number, we expect -- have built a plan around margin rates and normal volumes of aircraft delivery. So, I wouldn't expect to see any significant period expense thing associated back with the lower volumes in 2024."
},
{
"speaker": "Gavin Parsons",
"content": "And then anything you can give us on what you're expecting on net price and performance for '25?"
},
{
"speaker": "Scott Donnelly",
"content": "No, look, I mean, as I said, we certainly expect performance and factory efficiencies to be up significantly versus 2024 and that's a driver of a lot of where we're -- where we think we'll end-up with the margin that we have guided. In terms of price, look, price is still good in the industry, but there's also inflation out there. So as we've talked about before, I don't expect a huge spread on the net of that. I think most of our performance improvement, most of our margin improvement getting back to where we should be here in 2025 is a result of much better factory performance."
},
{
"speaker": "Gavin Parsons",
"content": "Thank you."
},
{
"speaker": "Scott Donnelly",
"content": "Sure."
},
{
"speaker": "Operator",
"content": "And we'll take our final question this morning from Pete Skibitski of Alembic Global."
},
{
"speaker": "Pete Skibitski",
"content": "Hey, good morning, guys. Congrats, Frank."
},
{
"speaker": "Scott Donnelly",
"content": "Hi, Pete."
},
{
"speaker": "Pete Skibitski",
"content": "Guys, this longer fiscal ‘25 continuing resolution, is that impacting your military programs at all?"
},
{
"speaker": "Scott Donnelly",
"content": "Pete, I have not seen it have a big impact. I mean, we hate the uncertainty of it, and I think our -- certainly our customer hates it because they're constantly in, I mean, they're trying to analogy 2026 budgets when they haven't been allowed to finalize 2025. But I think, the expectations, the customer appears to be executing to what they expect their 2025 budget to be and has sort of been appropriated and sitting on the shelf waiting for the final action. So it's very disruptive, I think. It's a horrible process, obviously, and it takes a lot of time and energy away from the customer who could be focused on other things. But the good news is most of our programs are already funded programs. They're not new starts. There are some things, as you get further into the year that will become new starts, but we certainly expect that the CR will be resolved, have an actual budget before that becomes a problem."
},
{
"speaker": "Pete Skibitski",
"content": "Got it. Okay, Thank you. Just one last one for me. Across the whole company, in terms of the new administration, is there anything on your radar in terms of new regulations or policies or the tariff issue that could be either positive or negative for the business that's on your radar? I think maybe one thing in terms of if we get tariffs towards Canada, does that impact Bell commercial at all? Is there anything on your radar that you can share with us? Thanks."
},
{
"speaker": "Scott Donnelly",
"content": "Yeah, sure. Look, Pete, I think on the positive side, again, we talked about just sort of what our expectations are for the overall business climate, less regulation, probably a better tax resolution than maybe otherwise could have happened. So I think from an overall business environment standpoint, those -- that's very positive on the tax front, on the regulatory front, on the military front. As I said, I think we have an administration coming in that has in the past been pro, how do we figure out how to accelerate, how do we go faster, which would be, again, net good for us. Look, the tariff is very much a wild card. I mean, we don't know the specifics. Clearly, we have operations in Mexico. We have, as you noted, a pretty significant operation in Canada, particularly on the Bell commercial side. A lot of the value of the dollars are things that go over from the US into Canada and then back. Assume those don't get hit. But we do have some big important suppliers like Pratt Canada, that sell a lot of engines to us in both rotor and fixed wing. And we do have our Bell, Mirabel operations on the commercial side of Bell. So, look it's an unknown and so we're not really taking position one way on the other. I think we've got to see how this plays out and again I think a lot of this is around negotiations and working on how do you deal with the free trade agreements on a go-forward basis. So we're just going to kind of hang in there and see how it plays out."
},
{
"speaker": "Pete Skibitski",
"content": "Got it. Got it. Helpful. Thanks, guys."
},
{
"speaker": "Scott Donnelly",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. And ladies and gentlemen, that will bring us to the conclusion of today's Textron Q4 2024 earnings release call. We'd like to thank you all so much for joining us today and wish you all a great remainder of your day. Just a reminder, today's call will be available for replay beginning later today by calling 1 (800) 839-5125 or (402) 220-1502. Again, thanks for joining us, everyone. We wish you all a great day. Goodbye."
}
] |
txt | 2,024 | 3 | [
{
"speaker": "Operator",
"content": "Welcome to the Textron Third Quarter 2024 Earnings Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. [Operator Instructions] This conference is being recorded for digitized replay and will be available after 10 AM Eastern Time today running through October 24, 2025. You may access the replay by dialing 866-207-1041 and entering the access code of 148-0019. I would now like to turn the conference over to David Rosenberg, Vice President, Investor Relations. Please go ahead."
},
{
"speaker": "David Rosenberg",
"content": "Thanks, Kiely, and good morning, everyone. Before we begin, I'd like to mention we will be discussing future estimates and expectations during our call today. These forward-looking statements are subject to various risk factors, which are detailed in our SEC filings and also in today's press release. On the call today, we have Scott Donnelly, Textron's Chairman and CEO, and Frank Connor, our Chief Financial Officer. Our earnings call presentation can be found in the Investor Relations section of our website. Revenues in the quarter were $3.4 billion, up from $3.3 billion in last year's third quarter. During this year's third quarter, adjusted income from continuing operations was $1.40 per share compared to $1.49 per share in last year's third quarter. Manufacturing cash flow before pension contributions totaled $147 million in the quarter compared to $205 million in the third quarter of 2023. With that, I'll turn the call over to Scott."
},
{
"speaker": "Scott Donnelly",
"content": "Thanks, David, and good morning, everyone. During the quarter, Aviation experienced a strike on the expiration of its existing labor agreement with the IAM. Work stoppage caused disruption to our aircraft production and service in our Wichita facilities. On October 20, the IAM ratified a new five-year contract ending a four-week strike. As employees return to work and production and delivery activities recover, resulting disruptions will impact our 2024 financial results. In the quarter, Aviation delivered 41 jets, up from 39 last year, and 25 commercial turboprops, down from 38 in last year's third quarter. Aftermarket revenues grew 5% for the third quarter of 2023 -- versus 2023, and our year-to-date aftermarket revenues were up 8% as compared to prior year. Aviation continued to see strong demand in the quarter, booking over $1 billion in new orders. Backlog grew $162 million, ending the third quarter at $7.6 billion. During the quarter, Aviation delivered the 400th Cessna Citation Latitude. Latitude has been the best-selling aircraft in the midsize jet segment since it was introduced into service in 2015. At NBAA this week, Aviation also announced the Gen3 updates of the Citation M2, CJ3 and CJ4, reflecting continued investments in this product portfolio. At Bell, revenues were $929 million, up $175 million over last year, and segment profit was $98 million, up $21 million as compared to the third quarter last year. During the quarter, the U.S. Army announced approval of Milestone B for the FLRAA program. This significant milestone establishes FLRAA as a program of record and transition the program to the engineering and manufacturing development phase. This phase includes continued digital modeling, detailed hardware and software design, and fabrication of hardware as Bell proceeds to critical design review and the first flight planned for 2026. As a result of Milestone B and the subsequent EMD award, Bell's backlog grew by $2.3 billion in the quarter, now totaling $6.5 billion. On the commercial side, Bell saw increased order activity in the quarter. Bell delivered 44 helicopters, up from 23 in last year's third quarter. Textron Systems revenues and profits were slightly lower compared to last year. In the quarter, Systems completed two major milestones in the Army's FTUAS program, a modular open systems approach conformance evaluation, and a prototype aircraft flight demonstration. The team will now proceed to option four of the competitive program, which includes delivery of a production representative aircraft system for Army testing and evaluation. Systems expanded its U.S. Navy Aerosonde operations with awards for two new land-based sites and three new maritime sites. Also in the quarter, Systems delivered two prototype Ripsaw M3 Robotic Vehicles to the U.S. Army for testing as part of Phase 1 of the Robotic Combat Vehicle program. The Army is expected to downselect the Phase 2 for production represented prototype in mid-2025. Moving to Industrial, the segment experienced lower revenues and operating profit in the quarter, driven by continuing softness in Specialized Vehicles end markets. Specialized Vehicles continue to take cost actions to align with lower production volumes. Moving to eAviation, the [Nuuva 300] (ph) continued integration testing, including a full system power on and flight simulation run conducted this quarter. The team is now focused on preparations for the aircraft's first hover flight, which is expected in Q4 of this year. Also during the quarter, the Nexus eVTOL program continued to progress on the wing and empennage assemblies and outfitting of the ground control station, preparation for the start of flight testing, which is expected to begin in 2025. Finally, as we announced yesterday, we're making some important executive changes at Textron. Our CFO, Frank Connor, has notified us that he intends to retire from the company on February 28, 2025. Dave Rosenberg, our current Vice President of Investor Relations, has been elected as our new Executive Vice President and Chief Financial Officer succeeding Frank. Dave has more than 24 years of experience in the aviation industry and has served in a series of finance and strategy positions at Textron Aviation, Beechcraft and its predecessor companies. In addition, Scott Hegstrom has been elected Vice President of Investor Relations, replacing Dave. Both elections are effective March 1, 2025. I want to thank Frank for his outstanding leadership and significant contributions to Textron during his 15 years and to congratulate Dave and Scott on their new appointments. With that, I'll turn the call over to Frank."
},
{
"speaker": "Frank Connor",
"content": "Thanks, Scott, and good morning, everyone. Let's review how each of the segments contributed, starting with Textron Aviation. In the third quarter of 2024, delayed aircraft deliveries along with unfavorable performance resulting from the IAM strike lowered Textron Aviation's revenues by about $50 million and segment profit by around $30 million. Revenue at Textron Aviation of $1.3 billion were essentially flat with the third quarter of 2023 with higher pricing of $36 million, mostly offset by lower volume and mix of $35 million. Segment profit was $128 million in the third quarter, down $32 million from a year ago, largely due to lower volume and mix of $29 million. Backlog in the segment ended the quarter at $7.6 billion, up $162 million from the second quarter. Moving to Bell, revenues were $929 million, up $175 million from last year, largely reflecting higher volume and mix of $148 million. Volume and mix included higher military volume of $81 million, primarily related to the FLRAA program and higher commercial volume and mix of $67 million, reflecting an increase in deliveries. Segment profit of $98 million was up $21 million from last year's third quarter, largely due to a favorable impact from performance of $17 million and favorable pricing, net of inflation, of $12 million. Backlog in the segment ended the quarter at $6.5 billion. At Textron Systems, revenues were $301 million, down $8 million from last year's third quarter, largely due to lower volume. Segment profit of $39 million was down $2 million from a year ago. Backlog in this segment ended the quarter at $1.9 billion. Industrial revenues were $840 million, down $82 million from last year's third quarter, mainly due to lower volume and mix of $86 million, principally in the Specialized Vehicles product line. Segment profit of $32 million was down $19 million from the third quarter of 2023, primarily due to lower volume and mix. Textron eAviation segment revenues were $6 million and segment loss was $18 million in the third quarter of 2024 compared with a segment loss of $19 million in the third quarter of 2023. Finance segment revenues were $12 million and profit was $5 million. Moving below segment profit, corporate expenses were $20 million, net interest expense from the manufacturing group was $22 million, LIFO inventory provision was $49 million, intangible asset amortization was $9 million, and the non-service components of pension and post-retirement income were $66 million. In the quarter, we repurchased approximately 2.4 million shares, returning $215 million in cash to shareholders. Year-to-date, we have repurchased approximately 10.1 million shares, returning $890 million in cash to shareholders. Textron is adjusting its full year outlook to include the expected impact of the aviation strike on its financial results. Textron now expects 2024 adjusted earnings per share from continuing operations to be in a range of $5.40 to $5.60 per share, down from its previous outlook of $6.20 to $6.40 per share. Manufacturing cash flow before pension contributions is now expected to be in a range of $650 million to $750 million as compared to its previous outlook of $900 million to $1 billion, with planned pension contributions of about $50 million. Looking to Aviation, we now expect total year revenue of about $5.5 billion, with an expected segment margin of around 11%. At Bell, while total year revenue outlook is unchanged, we expect an improved segment margin in the range of 10.5% to 11%. At Systems, the revenue outlook is unchanged, with a segment margin estimated at the top end or slightly above our original guidance range of 11% to 12%. Looking to Industrial, we now expect revenues to be about $3.5 billion, with an expected segment margin of around 4%. At eAviation, we now expect revenue to be about $35 million, with segment margin unchanged at a loss of around $75 million. At Finance, we now expect revenue to be about $50 million, with segment margin of around $30 million. Below segment profit, we now expect corporate expenses to be around $135 million, interest expense to be about $85 million and a tax rate of 17.5%. That concludes our prepared remarks. So, operator, we can open the line for questions."
},
{
"speaker": "Operator",
"content": "Thank you. [Operator Instructions] And we'll go to the line of David Strauss with Barclays."
},
{
"speaker": "David Strauss",
"content": "Good morning. Thanks, and congrats, Frank and Dave."
},
{
"speaker": "Frank Connor",
"content": "Thank you."
},
{
"speaker": "David Strauss",
"content": "Scott, could you just maybe touch on, how things are going at Aviation in terms of restarting production and kind of what have you assumed in the updated forecast for Aviation, I think, and get $5.5 billion in revenue in terms of jet deliveries? Thanks."
},
{
"speaker": "Scott Donnelly",
"content": "Sure, David. So, look, I mean, obviously, we got the ratification last weekend, which was very important. Under the terms of the contract, the workforce has up to five days to come back in. So, we are starting to ramp and get things back in place. I think I talked to Ron yesterday, we probably had about 60% of the workforce was back in yesterday. We expect that to continue to ramp and clearly expect to be at full representation on Monday. So, when we factor in the numbers, we kind of think about that. That's why the $0.5 billion revenue drop, it's not really four weeks, it's more like a five-week strike, and then we've got to get all the ramping and get the line back up and running here as we get into fourth quarter. I guess I'd say, David, the good news is that's what we're focused on, right? We have a five-year deal in place that's good for employees, it's good for us. Our total focus right now is getting things ramped up. We've spent, obviously, a lot of time here over the last four or five weeks continuing to work with our supply chains, make sure that parts are coming in and suppliers who have been late to PO are getting back to current. So, our complete focus right now is getting everybody back in the door and getting the factory up and running and hopefully more efficient than it's been over the past few years as we get better part full."
},
{
"speaker": "David Strauss",
"content": "Okay. Thanks for that, color. And Frank, in terms of the lower forecast for free cash flow for the year, it looks like, maybe you're losing about $125 million from lower earnings. CapEx, I think, is a little bit lower than you had previously forecast. What accounts for -- it looks like, $200 million of -- the additional $200 million hit on the free cash flow side?"
},
{
"speaker": "Frank Connor",
"content": "Yeah, we're going to have some inventory headwinds associated with kind of the slower kind of ramp up here and the impact of the production. As Scott said, it's kind of a five-week impact. We want to get healthy from a supply chain standpoint. So, we certainly looked at kind of mitigating the cash impact of strike, but we also want to make sure that we were healthy as we come out of this. So that's really the impact and we'll then have that inventory obviously to burn through and sell in '25."
},
{
"speaker": "David Strauss",
"content": "Thanks very much."
},
{
"speaker": "Operator",
"content": "We'll go next to the line of Sheila Kahyaoglu with Jefferies."
},
{
"speaker": "Sheila Kahyaoglu",
"content": "Good morning, Scott, Frank and Dave, and congratulations, Frank, of course. So, just going back to the EPS cut of $0.80, I think Industrial is about $0.30, that's a headwind, but Bell is the $0.10 offset. How do we think about, I guess, Aviation into 2024 exiting Q4, and then also Industrial, just given a 4% margin to exit the year?"
},
{
"speaker": "Scott Donnelly",
"content": "So, on the Industrial front, Sheila, we've been -- we've seen softness all year. We've talked about that each quarter. So, I think as we've revised the guidance, beyond just giving color, we're trying to give you guys some specific in each one of the segments. And so, I think our expectation right now is that those softnesses in that end market are going to continue. As we've talked about in previous quarters, we're just cutting way back on production volume. We don't want to put stuff out in the channel. I don't think deal is one thing is in the channel until we get better perspective and view on where things are going in terms of interest rates and their end market. So, I think this was just -- we're just kind of firming up our view on the total guide on that segment. The bigger issue for us, obviously, is we've got to get the Aviation business ramped back up again here. As Frank talked about, given the sort of delays in some of these deliveries, we're going to certainly carry out more inventory through the end of the year of work in process than we would normally have coming out of the Q4. But I guess, it's important to note these sales aren't lost, right? I mean, these are pushed and we're going to ultimately deliver these aircrafts. So, as we think about 2025, we clearly expect we're going to see revenue progression over what our original 2024 guide was. We're continuing to ramp. And I think now with the contract behind us, we're optimistic about seeing more stability in the workforce, clearly a better position on supplier parts. And it's tough to recover all that in one quarter, but I think we'll have good momentum as we go into 2025."
},
{
"speaker": "Sheila Kahyaoglu",
"content": "And just on the contract, how do we think about the headwind in 2025 as we factor in the wage increase?"
},
{
"speaker": "Scott Donnelly",
"content": "Well, that was largely baked into our plans. The deal was a little bit more than we expected, but it's -- direct labor is about 10% of our costs. So, I mean our focus at this point will be making sure we can drive the right productivity and efficiency to compensate for that. But I think it's a fair deal. It's good for our employees. And our view is we want these to be the best jobs in town. We think this is a hugely important workforce. We need good people. We need to retain them, and we'd like to be that best job. And I think this makes us the best job in town. So, it's a good trade for us."
},
{
"speaker": "Sheila Kahyaoglu",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "We'll go next to the line of Robert Stallard with Vertical Research."
},
{
"speaker": "Robert Stallard",
"content": "Thanks so much. Good morning."
},
{
"speaker": "Scott Donnelly",
"content": "Good morning."
},
{
"speaker": "Frank Connor",
"content": "Good morning."
},
{
"speaker": "Robert Stallard",
"content": "Just want to follow-up on David's question really and the recovery plan. It sounds like you've taken a fairly proactive approach to managing the supply chain that you haven't turned anyone off. In fact, you just kept things going and you've built up this inventory. Is that a fair analysis?"
},
{
"speaker": "Scott Donnelly",
"content": "Yeah. Look, I mean, in part shortages, while it has improved over the last few years, has still been problematic, I think, for everybody in the industry. It's gotten to be a smaller number of part numbers that are a problem, but they're still a problem. And that was continuing to drive a lot of out-of-station work and just significant inefficiencies in the factory. So, our view was, look, nobody wins a strike. A strike is not a good thing, but we certainly, during the period of the strike, were committed to go continue to work with those suppliers and try to resolve that problem. So, again, from our perspective, this is all about how you move forward and expecting we'll get the workforce back in, which is now happening, that we would put ourselves in a better situation in terms of parts and back shops and these things so that we can be more efficient going forward. So, yeah, that's going to cost a little bit of inventory, but all that inventory is going to turn into airplanes. So, I'm not particularly worried about that."
},
{
"speaker": "Robert Stallard",
"content": "Okay. And then, as a follow-up on Industrial, you mentioned that Specialty Vehicles have been having some demand challenges. What about at Kautex? Have you seen any softening on the European auto front?"
},
{
"speaker": "Scott Donnelly",
"content": "Well, for sure, we have. I mean, auto is down around the world. European is probably the most challenged market, so the volumes are somewhat below where we would like them to be, but frankly, that team does a really good job of managing through and dealing with that and offsetting with productivity and pricing. And so, I think the Kautex guys actually have been performing quite well."
},
{
"speaker": "Robert Stallard",
"content": "Okay. That's great. Thank you."
},
{
"speaker": "Operator",
"content": "And next, we'll go to the line of Peter Arment with Baird."
},
{
"speaker": "Peter Arment",
"content": "Yeah. Thanks. Good morning, Scott. Congrats, Frank and Dave. Hey, Scott, maybe just to talk about, just on the heels of NBAA, you guys obviously saw some nice bookings this quarter. Can you talk maybe just about what you're seeing on the demand environment? It still seems obviously very favorable for a lot of your models."
},
{
"speaker": "Scott Donnelly",
"content": "Yeah, Peter, I think it has. I mean, we had over $1 billion here in Q3. As you know, Q3 is usually historically one of the lighter ones, right? The summer, July, August is kind of usually quieter. I think it was a good quarter of order activity. We're very encouraged, the refreshes that the team is putting out in both M2, CJ3, the new CJ4. Of course, we have the Ascend, which we announced too long. That's coming along very well. So, the number of updates, which are pretty significant in terms of capability of the aircraft and safety, particularly with launching Autoland across all those single pilot jet platforms is driving strong demand. So, I think the end market continues to feel good. Order activity is -- flow is good. So, I think we're still feeling good about where the industry is."
},
{
"speaker": "Peter Arment",
"content": "Yeah. And just as a follow-up, on pricing, I guess, net of inflation, you guys have done pretty well all year. What's the latest there, I just -- I assume, given that the demand environment is healthy?"
},
{
"speaker": "Scott Donnelly",
"content": "Yeah. Pricing is still good, Peter, in the marketplace, but as we've talked about, I think the price inflation number is compressing, right? I mean, so I would not expect to see big contributions in necessarily price over inflation. What we really got to be doing is driving productivity and efficiency in the factories to continue to maintain that momentum. So, the pricing dynamic is good, that's not a problem, but you had these pretty significant price inflation spreads. And again, that will -- as we talked about before, that will be coming down, but we're not banking on that to drive the kind of margin and performance that we need to see going forward. We've really got to drive good fashion productivity and efficiencies on that volume."
},
{
"speaker": "Frank Connor",
"content": "The only thing I'd add on that is for this quarter and next quarter with the lower volume, which is where price comes through and essentially inflation across all aspects of the cost structure, not just the aircraft, but SG&A and other things, that puts pressure on price versus net of inflation. So, for this quarter, it's net zero price, but that is certainly impacted by the lower volume associated with the strike and that will have an impact on the price versus inflation on a net basis in the fourth quarter as well."
},
{
"speaker": "Peter Arment",
"content": "Appreciate all the color. Thanks, guys."
},
{
"speaker": "Operator",
"content": "We'll go next to the line of Noah Poponak with Goldman Sachs."
},
{
"speaker": "Noah Poponak",
"content": "Hey. Good morning, everybody."
},
{
"speaker": "Frank Connor",
"content": "Good morning."
},
{
"speaker": "Scott Donnelly",
"content": "Good morning, Noah."
},
{
"speaker": "Noah Poponak",
"content": "Frank, congrats on the retirement. Thanks for all the help and the relationship over the years. And David, congrats on the move to the CFO."
},
{
"speaker": "David Rosenberg",
"content": "Thanks."
},
{
"speaker": "Noah Poponak",
"content": "How many Cessna jet deliveries are we expecting in the fourth quarter given the abnormal backdrop with the strike and the recovery?"
},
{
"speaker": "Scott Donnelly",
"content": "Well, Noah, I mean, we've never given a number of jets. So, I think we'll probably just stick to revenue at this stage of the game. But I mean, it's $0.5 billion of revenue obviously adjustment, which is pretty significant, but yeah, I think that accounts for what's turning out to be really a kind of a five-week strike duration and then just the inefficiencies and just the time of getting it ramped back up and going."
},
{
"speaker": "Noah Poponak",
"content": "Okay. And, Scott, I guess, in 2025, should we anticipate that Jan 1, when you're starting a year, you're pretty much recovered and it's a clean run rate production line, or could there be disruption that bleeds into the beginning of the year? And then, should we expect the aircraft that slip out of '24 to add what you previously had planned for '25, or does it kind of smooth out over a longer period of time?"
},
{
"speaker": "Scott Donnelly",
"content": "Well, so first of all, we certainly expect by January 1, we're running at normal productivity and a smooth rate. I mean, we're here in kind of late October, we've got November, December here to get things ramped and operating smoothly. So, I certainly expect by the start of the year, the factory will be stable and doing well. I guess, it will -- I mean, we're kind of probably not ready to guide 2025 yet, but as I said, no, I do think if you look at what we're doing in production ramp and our expectations in terms of where we're going to be in 2025, while the 2024 is obviously an issue and impacted, we certainly expect to see good healthy revenue growth in '25 above what we had originally guided in '24."
},
{
"speaker": "Noah Poponak",
"content": "Okay. And then, just lastly on the margin, at Aviation, should we all just continue to contemplate the incremental margin framework you've referenced in the past, or is cost now different enough, or is there still a lot of opportunity on the productivity front? How should we be thinking about that over the medium term?"
},
{
"speaker": "Scott Donnelly",
"content": "Look, we still think about this business as converting at 20%-plus in terms of revenue given the kind of the mix of gross margin across the business. So that's still, I think, an appropriate long-term guide."
},
{
"speaker": "Noah Poponak",
"content": "Okay. Thank you."
},
{
"speaker": "Operator",
"content": "Next, we'll go to the line of Myles Walton with Wolfe Research."
},
{
"speaker": "Myles Walton",
"content": "Thanks. Good morning. I was wondering if you could talk to Systems, and you mentioned the two contracts that are being decided next year, FTUAS and the Robotic Combat Vehicle. Is an outcome on those basically going to dictate whether or not Systems can start a real growth profile? It's been obviously flattish here for a long, long time. And how critical are those two programs?"
},
{
"speaker": "Scott Donnelly",
"content": "Yeah, absolutely. Look, I mean, these are programs that we've been investing for a long time to position ourselves. They are key factors of driving growth for the business in the future. There's other programs, obviously. In fact, I think, frankly, if you look at 2024, that business is performing extraordinarily well. We did take a hit at the beginning of the year, which we did not anticipate around Machado getting pulled out of service. Other businesses within systems over the course of the year have grown to help to offset that. And as we said, even with that hit, which was not trivial to us, the businesses are hitting their original guide in terms of revenue, and they're going to be on the high side of their margin. So, I think the Systems team is performing very well. But yeah, absolutely, those programs like FTUAS and like RCV and of course, there's ARV in the year out and such are key drivers of growth in the future."
},
{
"speaker": "Myles Walton",
"content": "Okay. And just one quick one. Is the 525 still on track for 4Q cert, or is that slipping into '25?"
},
{
"speaker": "Scott Donnelly",
"content": "We're actually just down there yesterday. Look, the flight test program is continuing. I hate to put dates out there because we don't certify that, right? I mean, it's -- I'd say the relationship and the work going on with FAA is good. Flight test program is going well. Whether it gets this year, if I were to guess, I would probably say it would slip into 2025 just because of just the sheer amount of documentation and paperwork and number of approvals that need to flow through -- before the official TC gets put on there. So, we continue to do the work on the flight test and all the work that we have to do on our side. And of course, we're already moving a lot of resource into various kits and capabilities that need to be added on to the aircraft over its life cycle. So -- and that work will go on in parallel with this certification process."
},
{
"speaker": "Myles Walton",
"content": "All right. Thanks for the color."
},
{
"speaker": "Operator",
"content": "Thank you. And we'll go next to the line of Seth Seifman for -- with JPMorgan."
},
{
"speaker": "Seth Seifman",
"content": "Hey. Thanks very much, and good morning."
},
{
"speaker": "Scott Donnelly",
"content": "Good morning."
},
{
"speaker": "Seth Seifman",
"content": "And congratulations, Frank and Dave. Wanted to ask about the margin in Aviation. And so, ex the strike, it looks like it was kind of in the mid-11% range, which was kind of below the guidance range for the year. I know there's variability quarter to quarter and you talked about Q2 being exceptionally strong, but just anything to point out there with regard to why we saw kind of a step down there versus what we've become accustomed to seeing in recent quarters?"
},
{
"speaker": "Scott Donnelly",
"content": "Well, look, I mean the strikes are a bit messy, right, when you go back and you look at idle facility and impacts and total year volumes and assumed overhead rates and liquidation rates. So, part of what you're seeing in the quarter and the year is you've got to factor in a lot of significantly lower volume all of a sudden with a lot of cost, which some of which is not variable. And so that's part of why you see that drag in the -- in both Q3 as well as in our updated guidance for the full year."
},
{
"speaker": "Seth Seifman",
"content": "Okay. Got it. And then, I guess, maybe thinking about the margin at Bell and profitability coming in ahead of expectations this year, as FLRAA continues to grow, is this something where you can kind of continue to maybe see some improvement here, given performance elsewhere, or should we still be thinking about maybe profit dollar growth but margin rate declines?"
},
{
"speaker": "Scott Donnelly",
"content": "Yeah, look, we're still trying to drive the profit dollar growth. The FLRAA program is growing and will continue to grow next year fairly significantly, which is great obviously, but that is, as you know, had a lower margin mix. But the commercial market is strong, so that's helpful to us. The win in Nigeria, which is actually going to grow the H1 original equipment volumes here over the next couple of two, three years is obviously helpful. So, there are some things in there mix wise that are helping. But again, I still think given the significant growth of the FLRAA program, our focus really is how do we continue to be accretive and make sure that we're growing the margin dollars in these subsequent years."
},
{
"speaker": "Seth Seifman",
"content": "Excellent. Thanks very much."
},
{
"speaker": "Operator",
"content": "And we'll go next to the line of Doug Harned with Bernstein."
},
{
"speaker": "Doug Harned",
"content": "Good morning. Thank you. And also congrats to Frank and Dave. If you look forward from here, say over the next five years, and thinking about what you're going to be investing in on the Aviation side with respect to R&D and CapEx, how do you see that profile evolving? And are there specific areas where you really intend to be focusing there?"
},
{
"speaker": "Scott Donnelly",
"content": "Well, look, I mean, I think that I don't see us making a big change. I think what we've been doing for the last number of years and I would expect we continue to do in the future is a nice mix of upgrade programs to our existing portfolio, which, as we talked about earlier, drives healthy growth and is very well received, I'd say, on the customer front, with an occasional new product clean sheet that drops in. So that piece of formula that has worked for us, and I think we'll continue to make that. From an R&D perspective, we've talked about kind of making this at or a slight tailwind in terms of on a percent of sales basis. Part of our margin challenge towards the end of the year is we've -- you assume that you're -- what you're doing on the R&D front is fairly fixed over the course of the year. So, if you lose a big chunk of revenue, obviously, on a strike, that kind of hurts you a little bit, but I mean, that's an unusual circumstance, obviously. So, I think we'll see fairly stable R&D, and we'll raise appropriately when we have the right programs to invest, but I'd say, generally speaking, we view that it should be a tailwind in terms of percent of sales for the business while making the right investments to keep growing the business."
},
{
"speaker": "Doug Harned",
"content": "And then separately, when we go into 2025 and if we put the strike aside for the moment, you said that during the strike you've been able to make some progress with respect to the supply chain. It seemed that really the limiting factor for you in Aviation is not demand, it is really -- it may be really just the supply chain. So, if you've been able to narrow some -- the issues within the supply chain, can you describe where the bottlenecks are now, the principal bottlenecks? And if there's a point you see where you think you can get back to a world where the limiting factor is no longer dealing with the supplier issues?"
},
{
"speaker": "Scott Donnelly",
"content": "Well, I think the limiting factor -- I mean, there has been some critical supply things. It's been our own resourcing and staffing and the ramp, but as I said, I think when I think about how you look at 2025, despite the interruptions that we've had here in 2024, I think our plans in terms of expanding capacity and delivering more product, increasing our revenue that, that thesis is still on track. You'll see that in 2025 despite the fact that we have an interruption in production here in 2024. So, we have had a ramp plan that was coordinated with suppliers and our own internal resourcing and staffing. And I think that's still in place and that's why you should expect that we'll see revenue growth in '25 above the '24 original guidance."
},
{
"speaker": "Doug Harned",
"content": "Very good. Thank you."
},
{
"speaker": "Operator",
"content": "We'll go next to the line of Jason Gursky with Citi."
},
{
"speaker": "Jason Gursky",
"content": "Hey, good morning. Frank, congrats on -- and good luck with the next phase. And, Dave, congratulations. Well deserved. I look forward to working with you more closely in that role. Scott, couple of quick questions for you. You mentioned labor productivity earlier as a way to offset maybe some of the higher costs associated with the strike. I'm just curious if you can make some bigger picture generalized comments about labor productivity maybe now versus where we were prior to the pandemic and kind of the things that you are doing to drive labor productivity back to maybe where we were if it was better back then, and how much longer do you think it takes for labor productivity to kind of return to historic levels?"
},
{
"speaker": "Scott Donnelly",
"content": "Well, look, there were two major contributors to the inefficiencies, which certainly manifest themselves largely in productivity in the factory. Part of it was certainly supplier parts. When you're looking at running a production line, you've got lots of holes in your part bin, you start doing stuff that's out of sequence and having to rework things and swap things between aircraft and there's a lot of disruption that comes from that. As I said, I think while it won't be perfect, what we did work through the strike period to try to get the on time to PO and supplier delivery to where we have many, many, many fewer of these instances where we don't have the part available at the time that we need to consume that part in the various stages of the production line. The other, frankly, is just sheer labor, right? I mean, like most companies, coming out of COVID, we saw a lot of turnover. We have a lot of hiring of new people, so there's been a lot of training, and clearly that drives a lot of inefficiencies. It's not just that new person, it's our senior people who participate in helping to train and develop these new people. So, I do think that the labor contract and getting that behind us, and yeah, it's a significant GWI, but it makes these jobs even more attractive in that market, which we think is -- makes us as an employer more attractive and hopefully stronger on the retention side. So, stabilizing that, not just adding the numbers of people, but getting it towards a stable number, and it's the same people that are coming in, is a huge part of that. So, I think the parts thing, I feel much better about. We worked out really hard over the last month or so to get that in a much healthier place. And again, I think with the GWIs that are out there, these are the best jobs in town. And I think that will help us not just attract, but also retain that hourly workforce that builds these aircraft, which is critical to driving that efficiency and productivity in our factory."
},
{
"speaker": "Jason Gursky",
"content": "Okay. Great. That's helpful. And then, the second question was, just more of a maybe a philosophical one. If you could waive a magic wand, and always have this be the case, I know this is difficult to control, but kind of months of backlog in the Aviation business, what is the North Star for you all? What do you -- where would you like to try to manage the business to on a pretty consistent basis over the longer term?"
},
{
"speaker": "Scott Donnelly",
"content": "Well, look, if you look at, it's a little bit different across different products in our product portfolio, but I would say, generally speaking, being out there 18, 24 months is a very healthy place for us to be for a couple of reasons. One, many of our customers already own aircraft and their ability to remarket their aircraft and manage and have a -- know what their timeline is and when a window of time to go sell their aircraft is important. And it also gives us the right amount of time to specify aircraft and interiors and go through a very smooth process where we know when that aircraft hit the line, what is that aircraft, right? What's the configuration? A lot of stuff is standard, obviously, but there are customizations that happen towards the latter part of the process. And having that all set and well understood, being able to signal and have a consistent volume and delivery dates with our suppliers, I mean, it really helps to make a business where it can run smoothly when you can see out that 18 to 24 months on volumes and product mix and product configuration."
},
{
"speaker": "Jason Gursky",
"content": "Great. That's helpful. Appreciate it, guys."
},
{
"speaker": "Operator",
"content": "And we'll go next to the line of Gavin Parsons with UBS."
},
{
"speaker": "Gavin Parsons",
"content": "Thanks. Good morning. And Frank and Dave, congrats."
},
{
"speaker": "Frank Connor",
"content": "Thanks."
},
{
"speaker": "Gavin Parsons",
"content": "Just wanted to ask a couple of margin questions. On Industrial, are you still seeing some benefit of the restructuring, or is that largely already in place at this point?"
},
{
"speaker": "Scott Donnelly",
"content": "Well, I mean, I think, clearly, we've been restructuring through the course of the year, but I'd say there's more restructuring to come, for sure. I think the end markets, and particularly in a couple of segments of the business, are continuing to be soft, and I think they're going to be soft for a little while. So, we'll continue to do what we think is appropriate to restructure and maximize our performance in each of those business segments."
},
{
"speaker": "Gavin Parsons",
"content": "Got it. And on Aviation, can you just remind us how the performance accounting line works? If you have cost on aircraft this year that deliver next year, do we expect some margin headwind there?"
},
{
"speaker": "Scott Donnelly",
"content": "The performance line is -- there's a lot of stuff in performance line. I don't know if I could walk through it. I mean, clearly, this quarter and for the full year, you've got unusual things in there, right? I mean, factory inefficiency, period expensing, idle factory costs, which is not a normal thing for us, obviously, manufacturing variances go through that, there's a lot of moving parts in that so-called performance line."
},
{
"speaker": "Gavin Parsons",
"content": "Understood. Thank you."
},
{
"speaker": "Operator",
"content": "And we'll go next to the line of Pete Skibitski of Alembic. Please go ahead."
},
{
"speaker": "Pete Skibitski",
"content": "Hey, good morning, guys."
},
{
"speaker": "Scott Donnelly",
"content": "Good morning."
},
{
"speaker": "Pete Skibitski",
"content": "I was wondering if we go back to FLRAA now that you had the Milestone B approval, I just wonder if you could put a finer point on the revenue line since it's so substantial. I think last I recall, you were thinking about $900 million in revenue this year. And Scott, you're talking about substantial increase next year. Is there any way to put a finer point on that?"
},
{
"speaker": "Scott Donnelly",
"content": "Pete, I think $900 million is probably around the right number this year. It's probably going to be $100 million to $200 million higher than that next year, just based on what's in the budget. So, I mean, I'm a little bit -- I always try to be a little careful here, Pete. I mean, these things are appropriated, right? They're not appropriated yet. I mean, we don't actually have a budget. So -- but I -- if you look at what's in the appropriations process, I guess, once they pass the budget, I would expect that we'll see some additional ramp as we go into next year. So -- and I think there's talk to the Army, there's full support for this. I mean, obviously, the criticality of getting through CDR is huge. And so, I think the customer is just as committed as we are to keep driving this thing forward, and that will -- that only happens with some increased funding next year, and I think everybody is on board with that."
},
{
"speaker": "Pete Skibitski",
"content": "Okay. No, I appreciate it. And then just the decision to in-source the cabin from Spirit, what's the right way to think about sort of the technical and the schedule risk there? Obviously, it's probably easier than if you were kind of midstream in production, but can you give us a sense of how you guys are viewing that decision?"
},
{
"speaker": "Scott Donnelly",
"content": "Well, look, I think that the -- as you kind of know, Peter, given the status of where that was, right, kind of just starting EMD, made it a fairly low risk, easy process to execute. The Spirit team was highly collaborative and worked very, very closely with us in that process, and it's done. So, we're focused on going forward. We're executing to that. And so far, so good."
},
{
"speaker": "Pete Skibitski",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. We have no further questions in queue at this time. And today's conference is being recorded for digitized replay and will be available after 10 AM Easter Time today through October 24, 2025. You may access the replay by dialing 866-207-1041 and entering the access code of 148-0019. This does conclude the conference for today. Thank you for your participation. You may now disconnect."
}
] |
txt | 2,024 | 2 | [
{
"speaker": "Operator",
"content": "Ladies and gentlemen, thank you for standing by. Welcome to the Textron Second Quarter 2024 Earnings Release Conference Call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. [Operator Instructions] As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Vice President, Investor Relations, Mr. David Rosenberg. Please go ahead."
},
{
"speaker": "David Rosenberg",
"content": "Thanks, Greg, and good morning, everyone. Before we begin, I'd like to mention we will be discussing future estimates and expectations during our call today. These forward-looking statements are subject to various risk factors, which are detailed in our SEC filings and also in today's press release. On the call today, we have Scott Donnelly, Textron's Chairman and CEO, and Frank Connor, our Chief Financial Officer. Our earnings call presentation can be found in the Investor Relations section of our website. Revenues in the quarter were $3.5 billion, up from $3.4 billion in last year's second quarter. During this year's second quarter, adjusted income from continuing operations was $1.54 per share, compared to $1.46 per share in last year's second quarter. Manufacturing cash flow before pension contributions totaled $320 million in the quarter, compared to $242 million in the second quarter of 2023. With that, I'll turn the call over to Scott."
},
{
"speaker": "Scott Donnelly",
"content": "Thanks, David, and good morning, everyone. Aviation has higher segment revenues of $1.5 billion, generating a profit of $195 million, up $24 million from the second quarter of 2023. We delivered 44 commercial turboprops, up from 37 last year and 42 jets down from 44 in last year's second quarter, while aftermarket revenues grew 13%. Aviation continued to see strong demand across all product lines. Backlog ended the quarter at $7.5 billion, up $118 million from the first quarter of this year. In the quarter, Aviation began deliveries of the King Air 260 under the multi-engine training systems contract for the US Navy. To-date, we've been awarded 35 aircraft to a possible 64 on the program. Also during the quarter, Aviation certified a third variant of the Cessna SkyCourier, the combi version allows operators to transport passengers and cargo simultaneously. Combined with the previously certified passenger and cargo variants, this latest variant continues to demonstrate the versatility of the aircraft to our customers. In June, Aviation completed the first flight of Cessna Citation Ascend. The aircraft is the first conforming production flight test aircraft and represents a significant milestone for the program. To-date, we have completed over 400 hours of flight testing. The Bell revenues and profit in the quarter were up as compared to the second quarter of last year. On the commercial side, Bell delivered 32 helicopters, down from 35 in last year's second quarter. Moving to military. Bell completed the FLRAA preliminary design review, while also continuing to release engineering drawings and place orders for long new material as the program continues to ramp. In the quarter, Bell was now selected as one of two companies for the next phase of DARPA's Speed and Runway Independent Technologies X-Plane program to create a prototype high speed vertical takeoff and landing aircraft for the US military. This program builds on Bell's success as the leader in tiltrotor technology. Textron Systems realized higher revenues. We're continuing to pursue new program opportunities in the quarter. Systems was awarded Options 3 and 4 for the FTUAS program in the second quarter. This award includes the delivery of an Aerosonde Hybrid Quad System to the U.S. Army for test evaluation. As part of the army's robotic combat vehicle competition, we announced a collaboration with Kodiak Robotics. Kodiak will integrate its industry-leading autonomous system into a Textron Systems purpose-built uncrewed military vehicle to demonstrate the autonomous operations later in 2024. Moving to industrial. We experienced lower revenues and operating profit in the quarter. As expected, we continue to see softer demand in our consumer and automotive end markets. We continue to execute on our cost reduction plan to position the cost structure for lower volume environment. As a result, we saw sequential margin improvement in Q2 and expect to see this improvement in the second half of 2024. Moving to Aviation. During the quarter, we completed the acquisition of Amazilia Aerospace. The Amazilia team has expertise in digital flight controls, flight guidance and vehicle management systems for manned and unmanned aircraft. We plan on integrating their products and capabilities into our new platforms, such as the Nuuva and Surveyor. Nuuva program reached a significant milestone with the completion of vehicle one assembly. The prototype vehicle has entered ground testing, which supports anticipated hover flight later this year. With that, I'll turn the call over to Frank."
},
{
"speaker": "Frank Connor",
"content": "Thanks, Scott, and good morning, everyone. Let's review how each of the segments contributed starting with Textron Aviation. Revenues at Textron Aviation of $1.5 billion were up $113 million from the second quarter of 2023, reflecting higher pricing of $57 million and higher volume and mix of $56 million. Segment profit was $195 million in the second quarter, up $24 million from a year ago, due to higher volume and mix of $35 million and favorable pricing net of inflation of $22 million, partially offset by an unfavorable impact from performance of $33 million. Backlog in the segment ended the quarter at $7.5 billion, up $118 million from the first quarter. Moving to Bell. Revenues were $794 million, up $93 million from last year, primarily due to higher military volume of $104 million as we continue to ramp the FLRAA program. Segment profit of $82 million was up $17 million from last year's second quarter, largely due to a favorable impact from performance of $39 million, which included lower research and development costs, partially offset by mix. Backlog in the segment ended the quarter at $4.2 billion. At Textron Systems, revenues were $323 million, up $17 million from last year's second quarter, largely due to higher volume of $14 million. Segment profit of $35 million was down $2 million from a year ago. Backlog in the segment ended the quarter at $1.7 billion. Industrial revenues were $914 million, down $112 million from last year's second quarter, mainly due to lower volume and mix of $119 million. Segment profit of $42 million was down $37 million from the second quarter of 2023, primarily due to lower volume and mix. Textron eAviation segment revenues were $9 million, and segment loss was $18 million in the second quarter of 2024, compared to a segment loss of $12 million in the second quarter of 2023. Finance segment revenues were $12 million, and profit was $7 million. Moving below segment profit. Corporate expenses were $17 million. Net interest expense for the manufacturing group was $20 million. LIFO inventory provision was $27 million. Intangible asset amortization was $9 million. Special charges related to the previously announced restructuring were $13 million, and the non-service components of pension and post-retirement income were $66 million. In the quarter, we repurchased approximately 4.1 million shares, returning $358 million in cash to shareholders. Year-to-date, we have repurchased approximately 7.7 million shares, returning $675 million in cash to shareholders. That concludes our prepared remarks. Greg, we can open the line for questions."
},
{
"speaker": "Operator",
"content": "Okay. [Operator Instructions] Your first question comes from the line of Peter Arment from Baird. Please go ahead."
},
{
"speaker": "Peter Arment",
"content": "Yeah. Good morning, Scott and Frank. Nice results. Scott, your book-to-bill over 1 in Aviation. Maybe you could just give us a little color, what you're seeing in the market environment and any color on pricing and what aftermarket also did in the quarter?"
},
{
"speaker": "Scott Donnelly",
"content": "Sure, Peter. Yeah. Look, I think the end market continues to be robust. We're seeing strong demand in jets, turboprops. It's pretty much across all models and across the whole family of products, which is great. A strong response to a lot of the upgrades that we've done here recently in terms of existing models. And obviously, we'll expect as we go to the back half of the year to see continued strength in new launches like the Ascend and such. So I would say, again, as much as we've seen for the last couple of years, we're still sort of targeting that one-to-one area, but robust demand, which is great. Aircraft are flying. So we continue to see strength in the service business as well. 13% is particularly strong in the quarter, but we feel good about where that's been performing. So, yeah, across I think the whole portfolio is feeling pretty good in terms of the end market."
},
{
"speaker": "Peter Arment",
"content": "Yeah. That's great. And then, just a quick one for Frank. Your CapEx, I think, you're $140 million for the first half of the year. I think your guidance is $425 million. So what is -- are you coming in at a slower pace or than kind of the guidance or plans to step up and outside of maybe FLRAA, what are the main drivers of the step-up? Thanks."
},
{
"speaker": "Frank Connor",
"content": "Well, we'll continue to see growth in the second half of the year. Obviously, as reflected in those numbers, we're a little slower in the first half than we expected. We tend to be a bit back end loaded in CapEx though. So we will see growth in the second half. There's probably a little opportunity in that kind of full year number given the pace, but for now, that's a number we'll stick with."
},
{
"speaker": "Peter Arment",
"content": "Appreciate the color. Thanks, guys."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of David Strauss from Barclays. Please go ahead."
},
{
"speaker": "David Strauss",
"content": "Thanks. Good morning."
},
{
"speaker": "Scott Donnelly",
"content": "Good morning, David."
},
{
"speaker": "David Strauss",
"content": "Scott -- good morning. Scott, can you just give us an update on supply chain at both Aviation and Bell?"
},
{
"speaker": "Scott Donnelly",
"content": "Sure, David. Look, it's still problematic. There's fewer problems probably than we used to have, but there are still parts that are from suppliers that continue to give us some heartache with late deliveries and that does create some of these issues around holding the factory and reworked and [indiscernible] sequence kind of things. But what we've been managing through that, unfortunately now for a number of years, it does continue to drew -- drag on our performance in the aviation business and particularly the performance numbers continue to see factory inefficiencies that we would like to get resolved. But I think the team all-in-all is working through that. We're still able to drive higher revenue and higher profit margins. So I think all-in-all, the business is performing well despite, it's still a tough environment. I think you see most companies reporting and continue to see some challenges in the supply chain, still a lot of new people, a lot of training inefficiencies and things like that, but we're working our way through it. Same thing at Bell. We have a number of deliveries that we missed where we're missing some key components. We're working with those suppliers. And as I said, the number of them are getting smaller, but in this industry, every part is important. So we're continuing to have to work our way around, some late deliveries of parts coming in. But as I said, I think all-in-all, our teams operational are fighting through that and getting most of their deliveries done and continue to drive good margins. So we'll keep our heads down and keep fighting through that through the course of the year, I think."
},
{
"speaker": "David Strauss",
"content": "Okay. Thanks for that. And your first half jet deliveries are relatively flat year-over-year. Are you still expecting higher, higher jet deliveries for the year? And could you maybe comment on latitude and specifically the deliveries were lighter year-over-year there, which is a bit surprising. Thanks."
},
{
"speaker": "Scott Donnelly",
"content": "Look, I think we'll -- we are still expecting to have higher unit deliveries in '24 than we had in '23. I would say for sure, David, we're a little behind where we would like to be on a couple of these models. Latitude is one in particular. We had a few deliveries towards the end of the quarter that we didn't get out. They've now gone. But we're working those lines hard in addressing some of the issues. Latitude specifically had one item that we had to kind of manage our way through and I do think we'll see improved performance on that line through the balance of the year. So bottom line is that we will still -- we will have higher unit deliveries and I think overall good mix and performance of the business. Despite all that, we'll show strong margin performance on a year-over-year basis."
},
{
"speaker": "David Strauss",
"content": "Great. Thanks very much."
},
{
"speaker": "Scott Donnelly",
"content": "Sure."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Sheila Kahyaoglu from Jefferies. Please go ahead."
},
{
"speaker": "Sheila Kahyaoglu",
"content": "Good morning, guys. Thank you so much. Scott, maybe to start on Aviation. Aviation profitability has been really good, 13.2 in the quarter, I think 150 basis points of net price. So how do we think about the puts and takes as we go into the second half? And is this sort of low teens a new level for Aviation profitability?"
},
{
"speaker": "Scott Donnelly",
"content": "Look, Sheila, I do think the team is performing well, right? I mean, we've got revenues up, margin is up, backlog is up. So we feel pretty good about where the business is. As I said in my answer to David's question, it's not always easy. We're still dealing with challenges in supply chain and things of that nature. But I do think that we'll see continued strong margins on a year-over-year basis as we go through the balance of the year. And again, we're feeling good about where the business is. I wish it was easier, it's not, but the guys are working through it. And I do think that we'll see strong margins. I think we still feel good about our guide. We still think this is probably a $6 billion business this year. I think we'll be well within the guide on the margin front. As we said earlier in the year, I think the price inflation spread, you'll see that getting smaller as the year goes on. But again, I think that will be in part offset by the fact that we'll continue to drive better we'll continue to drive better efficiencies and performance of the factory."
},
{
"speaker": "Sheila Kahyaoglu",
"content": "Great. And then maybe one on Bell and just the military portfolio there outside of FLRAA. How do you think about V-22 and opportunities there elsewhere in the military side?"
},
{
"speaker": "Scott Donnelly",
"content": "So I think the balance of the military business outside of FLRAA is doing well, right? I mean, we did add the H-1s from Nigeria, so that's 12 aircraft. We're able to start ramping that. Here this year, we saw some benefit of that in the quarter as that program starts to ramp up. V-22 production is still going along. Obviously, the five aircraft that were in FY '24 have now been added. So we look at that as adding a little bit of base. Nacelle Improvement Program continues to go. I think we'll see broader adaptation of our acceptance of that here as we go into the future. So I think there's work going on in the FY '25 budget and beyond that will provide some upgrade opportunities on V-22 as well as H-1. So the announcements around SIEPU. So I do think while the production unit volumes obviously will continue to ramp down, we will see some good flow of upgrade and modernization efforts on both the H-1 and the V-22 lines that will help to make that, to keep that solid as we start to ramp and really more -- move towards the production mode of the FLRAA program."
},
{
"speaker": "Sheila Kahyaoglu",
"content": "Great. Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Myles Walton from Wolfe Research. Please go ahead."
},
{
"speaker": "Myles Walton",
"content": "Thanks. Good morning. I was wondering, Scott, if you could talk about the aftermarket growth, you mentioned 13%, which is a pretty good acceleration given utilization is decelerating. Was there anything or is there anything that's driving that, whether that's non-typical on the military side or mandates or anything of that nature?"
},
{
"speaker": "Scott Donnelly",
"content": "Well, I think all-in all, Myles, we're continuing to see good growth in the aftermarket business. Demand continues to be strong. Aircraft are flying. We did have a strong military quarter, in particular as we build the spares pool around the METS program for the Navy contract, but it's just in general, strong on the aftermarket side. Demand is there. Again, people are flying, so consumption is up, people are doing shop visits. So I think we feel in a -- and we're in a very good place in terms of the aftermarket overall."
},
{
"speaker": "Myles Walton",
"content": "Okay. And then I guess on the performance disclosure, the $33 million drag, I know this can get a little bit apples to oranges comparison, but does that imply that performance actually deteriorated sequentially or didn't improve as much as you had in your baseline plan?"
},
{
"speaker": "Scott Donnelly",
"content": "Yeah. Myles, look, the performance category is a messy one as you know, right? So there's a lot of stuff in there. For sure, some of it is just some of those inefficiencies that we talked about, right? I mean, we're still not at our standard costs where we would like to be. So part of that number for sure reflects some manufacturing variance. But as you know, there's also a lot of other stuff in there, right? I mean, the business continues to grow. So if you look at on a year-over-year basis, SG&A, IRAD, these numbers, which are in line on a percent of sales basis, but those actual dollar values on a year-over-year basis also go through that performance line. So there's natural growth in SG&A, there's natural growth in IRAD. Look, there was a legal settlement in there this quarter. So there's always lots of $3 million, $4 million, $5 million things that go through there, most of which you would kind of expect in a business that's growing and continuing to invest."
},
{
"speaker": "Myles Walton",
"content": "Okay. Got it. Thanks so much."
},
{
"speaker": "Scott Donnelly",
"content": "Sure."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Doug Harned from Bernstein. Please go ahead."
},
{
"speaker": "Doug Harned",
"content": "Good morning. Thank you."
},
{
"speaker": "Scott Donnelly",
"content": "Good morning."
},
{
"speaker": "Doug Harned",
"content": "On the Ascend, you introduced the Ascend at EBACE and I thought that was interesting. Europe is only about, I think about 7% of aviation revenues. How are you looking at international markets, particularly Europe, Asia. Do you see those for aviation as potentially offering a bigger share of your total revenues?"
},
{
"speaker": "Scott Donnelly",
"content": "So Doug, I don't know if it will change dramatically that overall share of revenue. The Jet business obviously has always been more North American centric. South America has usually been our second biggest market than Europe, third behind that. So specifically, as you look at Ascend, I think we'll see a similar spread of share, much as we saw over many years with the XLS family. This really -- the Ascend in essence takes that historical product, which has been a homerun for us, probably the most popular business yet in the world and modernizes it, gives us great new cockpits, a little bit of thrust pump in the engine side, a much better cabin with a flat floor and larger windows. I mean there's everything -- I think customers will love everything about that aircraft from crews to passengers, performance. But I would expect we will see sort of the same kind of share because it really is the product that is hugely strong in that mid-sized biz jet market, but that is still largely a North American market and then secondarily South American and then European. So I would expect we'll see that same kind of share position across all those key segments with the Ascend as we used to see with the XLS family."
},
{
"speaker": "Doug Harned",
"content": "And then on SkyCourier, I mean, SkyCourier seems to be, you're sort of expanding the envelope in which it can serve. How do you ultimately see that market in terms of scale? And how large could that -- the SkyCourier fleet ultimately be?"
},
{
"speaker": "Scott Donnelly",
"content": "Well, I think it's going to be a very big market. I mean, if you look at the acceptance of that product, I mean, right now, we're just trying to make them as fast as we can make them. The demand has been really strong. And I mean, it's been great to see, Doug, it's everything from the pure cargo version. I mean, this thing is a beast in terms of moving cargo around the world. We're seeing a lot of acceptance on sort of small regional airlines, 19 PAX seating and then obviously, what we did here most recently with the combi is you have a lot of markets where they need to move PAX, but they also need to move cargo and that's exactly what the combi was aimed at. So right now, I think both domestic, international markets, cargo PAX, now the combi, the issue for us with SkyCourier is just continue to ramp up on the production volumes. The demand is there across all those segments and in a lot of different geographies."
},
{
"speaker": "Doug Harned",
"content": "Okay. Very good. Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Seth Seifman from J.P. Morgan. Please go ahead."
},
{
"speaker": "Seth Seifman",
"content": "Hey. Thanks very much, and good morning."
},
{
"speaker": "Scott Donnelly",
"content": "Good morning, Seth."
},
{
"speaker": "Seth Seifman",
"content": "I was wondering if you could talk a little bit more about the potential where the margin can go in the Industrial segment in the second half, kind of how much of the benefit of the cost cutting program that you felt like we saw in the second quarter and how much is still on the come?"
},
{
"speaker": "Scott Donnelly",
"content": "Well, Seth, I mean, I don't know if I'll give an exact number, but we certainly continue to -- we expect to see it continue to grow as we move through the year. We're not expecting a miraculous turnaround in the end market demand. We're watching that very closely. So if you look at the numbers Frank kind of went through, we've done about a third of the restructuring costs incurred here in Q2, we'll see another big chunk of that for the most part in the back half of this year as we continue to take cost out of the business to align with that volume. But I think when you look at that, it's probably going to generate, we're probably still running 100 basis points or something below where we should be. And I think the cost actions that we're taking will square that away. So it's -- the strategy right now is keep taking the cost actions. Don't assume that you see some miraculous turnaround in terms of that end consumer demand and just keep driving sequentially improved margins."
},
{
"speaker": "Seth Seifman",
"content": "Okay. Great. And then maybe just as a quick follow-up. Very good order activity year-to-date in aviation. Is there anything you'd say to distinguish where the order activity is coming from with regard to either fleet customers versus individual customers?"
},
{
"speaker": "Scott Donnelly",
"content": "Now we're still seeing the spread is strong pretty much across all the customer base and both jet and turboprops. So it's pretty well across all characteristics, no matter how you want to kind of slice and dice, it's looking to be continually -- continue strong demand."
},
{
"speaker": "Seth Seifman",
"content": "Excellent. Well, thanks very much."
},
{
"speaker": "Scott Donnelly",
"content": "Sure."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Noah Poponak from Goldman Sachs. Please go ahead."
},
{
"speaker": "Noah Poponak",
"content": "Hey. Good morning, everyone."
},
{
"speaker": "Scott Donnelly",
"content": "Good morning, Noah."
},
{
"speaker": "Frank Connor",
"content": "Good morning, Noah."
},
{
"speaker": "Noah Poponak",
"content": "The business jet output just remains, I guess, low relative to how strong demand is and where the backlog is. Are lead times getting long enough that it's an issue for some customers and you're losing some sales on that or do you sort of just not care about that because you're managing to price and the margins are good and you're okay on that front?"
},
{
"speaker": "Scott Donnelly",
"content": "Well, I mean, I think largely, Noah, this is an industry phenomenon, right? I mean, if you're out there -- if you had a dramatically different lead time, you might be disadvantaged, but I think everybody is dealing with the same issue. So we're still out there. Obviously, with a book-to-bill above one, we're selling, but we're delivering aircraft, but we're continuing to take orders into that -- into those out years. So it's -- I'd say right now, it's pretty well-balanced. And I don't think we're at a competitive advantage or disadvantage right now in terms of availability. We're all out competing. But in the timeline, obviously, based on the backlog that's out there year-and-a-half, two years in many cases."
},
{
"speaker": "Noah Poponak",
"content": "Okay. The additional H-1 orders at Bell, can you speak to roughly what that adds annually and how far out in the future that will go?"
},
{
"speaker": "Scott Donnelly",
"content": "No, I don't think so. I mean the Nigerian order was 12 aircraft, like the upgrade programs like SIEPU, that will go on for quite a number of years, but I mean, those aren't all appropriated. So I don't think I would get into -- to that. It's the same, I would say on the V-22 program, right, we think there's missile improvement opportunities. There's a number of other things that are in dialogue with our V-22 customers on enhancements. Everybody knows that aircraft is going to be around for a very, very long time. And so like any military platform, you would expect ongoing investment upgrades, enhancements, but these are all dialogues and programs that will flow over the year. So I don't think I would necessarily start to get into a multiyear forecast on those."
},
{
"speaker": "Noah Poponak",
"content": "Okay. And then just last one, does it make sense to walk through the math on the shadow decommission just so that's modeled correctly, how much comes out? What does it do to the margins? Did that affect the second quarter? Any clarity you can provide there?"
},
{
"speaker": "Scott Donnelly",
"content": "So look, I mean from a modeling standpoint, Noah, this is about a $50 million business or something like that, right? So I mean, we're -- we've already obviously worked our way through most of what the revenue is going to be this year as we wound down from Q1 to Q2. So I'd say it's fairly de minimis as we go through the balance of the year. Again, I think this is one where if you look at that team from our original guide absorbed that loss of the shadow, which kind of came out of nowhere, obviously from our perspective. And we've seen enough growth in all of the other business within systems to try to try to make up for that revenue and obviously continue to hold a good margin business. So I think the team has largely got shadow, unfortunately, it's largely behind us and the team managed their way through that and has positioned us to at least continue to operate the business well. And again, most importantly probably in systems focus on those new programs like the FTUAS, RCVs, the ARV, XM30, I mean there's a lot of stuff going on that business that has opportunity. But I would say largely what you model is we sort of have absorbed the loss of the shadow program."
},
{
"speaker": "Noah Poponak",
"content": "Okay. Yeah. That looked mathematically a little tough to do at least in the very near-term. So, yeah, that's impressive. Okay. Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Cai von Rumohr from Cowen & Company. Please go ahead."
},
{
"speaker": "Cai von Rumohr",
"content": "Yes. Thanks so much. So, Scott, you guys have been kind of warning about margins. Don't get ahead of yourself because the inefficiencies that you experienced in the second half of last year are going to flow through inventory into the P&L and that will restrain margins. It looks like that didn't really occur. I know although I know mix was a plus. And as presumably your efficiencies are improving, even if not as much as we'd hoped. Should we be looking for a good improvement in the second half from diminishing flow through of kind of inefficiencies so that even though I assume the mix is negative given you got more latitudes, but so you could basically sustain this 13% type margin?"
},
{
"speaker": "Scott Donnelly",
"content": "Well, look, I think that the 13% is extremely strong, right? I'm not sure I would say that we're going to maintain 13% as we go through the balance of the year. But I think it's going to be solidly in that sort of that mid-12s kind of range. So for sure, we will have some -- as I said earlier, probably less price inflation spread than we had. And part of that frankly is some mix. We do have a lot of latitude deliveries, a number of which are heavy on the fractional side in particularly Q3. And as you know, those have lower margin than a retail latitude. So there's, look, there's always some headwinds, but there's also good things that are going on. So I think this business is well within the guide that we put out there despite the ongoing inefficiencies. And at a mid-12%’s margin, we feel like this -- our business is performing well, generating strong margin, generating good revenue growth, generating continued strong backlog. So I think the guide that we had out there, which I think we're clearly still on track to deliver is -- shows that business in a very good place."
},
{
"speaker": "Cai von Rumohr",
"content": "Terrific. And then secondly, you continue to be aggressive actually even more aggressive in terms of share repurchase. You bought $358 million, 4.1 million shares. So you're basically whacking away at a 5% rate. What should we expect in terms of the Repo in the second half?"
},
{
"speaker": "Scott Donnelly",
"content": "I think we'll continue to focus on that Repo, Cai. What we're generating, we're getting good strong cash flow. We feel very good about where the business is on a cash standpoint. What we do some small acquisitions of Amazilia relatively small dollars that adds some real capability to the eAviation business. Frankly, technology that will help us not just the aviation, but I think also at Textron Aviation as well as future opportunities at Bell. So, but these are small dollars. Clearly, the bulk of the strong cash flow generation that we have right now. We're allocated to the buyback and I think we'll continue to do that."
},
{
"speaker": "Cai von Rumohr",
"content": "Thank you very much."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Ron Epstein from Bank of America. Please go ahead."
},
{
"speaker": "Ronald Epstein",
"content": "Yeah. Hello. Can you hear me?"
},
{
"speaker": "Scott Donnelly",
"content": "Good morning, Ron. We can hear you."
},
{
"speaker": "Ronald Epstein",
"content": "Yeah. Great. Perfect. Sorry. Yeah. Maybe just a couple of quick ones. Could you do a bigger version of SkyCourier? Like is there any demand for that from your customers?"
},
{
"speaker": "Scott Donnelly",
"content": "Ron, I don't know that we need to do a bigger version of it. It's a big aircraft. It's just -- next to one of those guys. But I mean the -- from a -- just from a regulatory standpoint, I mean where it fits -- first of all, fits really, really well in that short haul cargo market. Obviously, we work very closely with FedEx and particularly on designing that aircraft. So it was really designed to be in that (3) LD-3 container kind of space where it fits really, really well. And then on the PAX side, from a regulatory standpoint, you hit that 19 PAX line and this thing comfortably takes care of 19 passengers. So I think to do anything bigger than that, now you sort of start to step up into the ATR world and things like that. And I don't think that's really our space. I think the -- where there was a huge gap in the market was really when you went from our caravan, which obviously has been a homerun in that smaller cargo and PAX market and then up into that sort of light air transport kind of slide, we felt like SkyCourier is in the sweet spot of that. So, and we're seeing that from a market demand standpoint."
},
{
"speaker": "Ronald Epstein",
"content": "Got it. And then on Aviation, I mean, how do I frame this? It seems like we're in a unique environment where for you guys, I don't want to put words in your mouth, but everybody that you have no white tails. Everything going down lines is owned. Have you ever experienced that before, if that's okay?"
},
{
"speaker": "Scott Donnelly",
"content": "Well, I think you have to probably go back to 2007, Ron, to be there. But look, this is a business and we talked about this for years, right, Ron? This shouldn't be a white tail business, right? I mean it wasn't in most of its -- most of the history of business jets was not a white tail business. I think what happened sort of financial crisis, post-financial crisis wasn't how that business should operate. This business should operate off of a, depending on the model types, anywhere from 12 months, 18 months to two year, kind of a backlog so that you know when an aircraft is rolling down that line, where it's going. And that's where we are and I think that's where the industry should stay. And again, this is not a new idea, right? This is how this industry worked for decades and certainly good to have it back where it's supposed to be."
},
{
"speaker": "Ronald Epstein",
"content": "Yeah. That's great. And then if I can, just one last quick one. Just curious, you mentioned that aviation, some of the technology investments you might make inorganically could flow back to out just broader Textron Aviation. Can you highlight anything that you're learning in that business that could actually help outside of the aviation, just broader aviation?"
},
{
"speaker": "Scott Donnelly",
"content": "Sure. Look, the nature of what we're doing, particularly with unmanned things like Nuuva and when you look at the levels of automation that we believe need to be in things like Nexus, these are very highly automated fly-by-wire, digital flight control, almost autonomous, even if there's not a person -- even if there is a person in a cockpit like in the Nexus case, it's still in essence, the capability of the aircraft is inherently autonomous. So when you look at the Amazilia guys, this is an expertise that they had. But we've done this. We've done a lot of fly-by-wire on V-22, for instance. Obviously, the V-280 is all fly-by-wire, the 525 is the first commercial helicopter in the world is fly-by-wire. So we have capability in the company to do this. But I think as we go forward, not just for these things like Nexus and like Nuuva, but future families of products or enhancements upgrades to products is going to see more and more levels of fly-by-wire, digital control, quasi autonomous capability, but it needs to be at a much lower price point than what you've seen in these high end, very expensive systems. And so that's the technology that we're using, developing and working both through the acquisition and the implementation on things like Nuuva and Nexus are fundamental technology that -- well I believe you'll start to see in the lower price point on both fixed wing and rotorcraft markets in the future."
},
{
"speaker": "Ronald Epstein",
"content": "Okay, cool. Thank you very much."
},
{
"speaker": "Scott Donnelly",
"content": "Sure."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Kristine Liwag from Morgan Stanley. Please go ahead."
},
{
"speaker": "Kristine Liwag",
"content": "Hey, good morning, everyone. Scott and Frank, I mean, the strength in aviation is clear. Scott, you mentioned on Ron's question that, look, we're kind of almost back at that pre-financial crisis levels regarding the backlog. If you take out the performance headwind that you highlighted in the quarter, margins at aviation would have been 15.5%. I mean, this is also back to pre-financial crisis levels margin. So I guess when the performance headwinds tail off and the backlog continues to hold secure, is the mid-teens margin kind of the new normal in aviation?"
},
{
"speaker": "Scott Donnelly",
"content": "Well, Kristine, I guess what I would say is, look, some of the -- some of those performance items for sure are associated with these factory inefficiencies and we do expect over time for those things to get better. As we get better, the supply chain deliveries as our workforce becomes more seasoned again. So I do think there will continue to be underlying improvements going forward in those areas. But as I also said, some of these things around performance are also just fundamentally associated with the growth of the business, right? We are going to see more sales commissions when we have more sales. And we are going to see R&D, again, not necessarily a headwind from a percent of sales standpoint, but you're going to see higher R&D numbers as we continue to invest in the business. So, but look, I think the bottom-line answer to your question, Kristine, is we're not going to put a number out there right now, but clearly, over the last few years, we continue to see improvements in the margin performance of this business. And I think it's reasonable to expect that we'll continue to see that going forward."
},
{
"speaker": "Kristine Liwag",
"content": "Thank you. That's really helpful context. And then maybe pivoting to a defense question. The European defense budget seems to be moving higher, a little faster and steeper than the U.S. defense budget. I guess, how do you think about opportunities for European sales? It hasn't been a huge part of your portfolio historically. But with the leverage of the business pretty low, what's also your interest in expanding European capabilities either organically or inorganically?"
},
{
"speaker": "Scott Donnelly",
"content": "Well, I mean, we do have a number of sales campaigns that go on in Europe. It's not, as you noted, has not been a huge part of our business in the past. I do think as you look at farm military sales opportunity, things like the FLRAA program, clearly that's a big part of where the army is focused is looking at partner countries around the world. And just as we saw for many, many decades, things like the Black Hawk become really important parts of those businesses from an international sales perspective, including Europe. We obviously will expect that to happen over time. And there's also some organic things. So again, if you look at rotorcraft again, I guess right now we've we did announce sort of a teeming relationship with Leonardo around pursuit of the European next generation rotorcraft opportunity. So that's kind of organic, but that would be a product that's tailored to that European market. So I do think there are opportunities out there and we are pursuing those and we'll compete for those going forward."
},
{
"speaker": "Kristine Liwag",
"content": "Great. Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of George Shapiro from Shapiro Research. Please go ahead."
},
{
"speaker": "George Shapiro",
"content": "Hi, good morning."
},
{
"speaker": "Scott Donnelly",
"content": "Good morning, George."
},
{
"speaker": "George Shapiro",
"content": "Scott, year-to-date orders have been about $3 billion in aviation, about the same as last year's first half. Do you think you can reach the $1.86 billion of orders that you had in last year's third quarter, which was particularly strong?"
},
{
"speaker": "Scott Donnelly",
"content": "George, I don't know. I mean we're -- as we kind of guided, we think this is going to end up as a one-to-one year. That's still our view. So if you look at order activities last year, they were stronger than that. But I do think we're -- again, our expectation is we're in sort of a more normalized world here where one-to-one is a good book-to-bill target. And we are coming through the first half of the year strong, which is great. I mean, I'd love to see that continue obviously, but I don't think necessarily $1.6 billion in the quarter is probably pretty sporty."
},
{
"speaker": "George Shapiro",
"content": "Okay. And then maybe one for you, Frank, the inventories year-to-date are up like $467 million, obviously less in the second quarter with bedded deliveries, but still up $110 million in the second quarter. I mean, for the end of the year, do you expect that inventory level to come down to close to where it was at the end of last year's -- at the end of last year or we're going to stay $100 -- a couple of $100 million above it? Thanks."
},
{
"speaker": "Frank Connor",
"content": "So we'll certainly expect to liquidate inventory in the back half of the year. Yeah. But in order to kind of grow the business for next year, we need inventory in order to sell products. So we expect we'll see some inventory growth on a year-over-year basis at year end, but not at the levels you've seen to date. I'd say overall, obviously, that offsets from working capital in other areas. So we think working capital is kind of flattish type number for the year. But obviously, there are offsets and payables and other things associated with that, but we do need some inventory growth in order to grow the business."
},
{
"speaker": "George Shapiro",
"content": "And one last one. Industrial, in the first quarter, you pretty much said was primarily weak because of special vehicles. This quarter, you kind of said -- you didn't say that. So do we assume that both Kautex and special vehicles were relatively weak in this quarter?"
},
{
"speaker": "Frank Connor",
"content": "Well, Kautex was down on a year-over-year basis, but it wasn't particularly weak. It was just -- we had a very strong second quarter last year, frankly, both in specialized vehicles and Kautex. So you had a really tough compare from both a volume standpoint as well as a margin standpoint. But Kautex on a sequential basis was up quarter-over-quarter, but it was down a bit on a year-over-year basis, but specialized vehicle was down kind of more on a year-over-year basis, coming off a very strong second quarter last year."
},
{
"speaker": "George Shapiro",
"content": "Okay. Thanks very much."
},
{
"speaker": "Scott Donnelly",
"content": "Yeah."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Peter Skibitski from Alembic Global. Please go ahead."
},
{
"speaker": "Peter Skibitski",
"content": "Hey, good morning, guys."
},
{
"speaker": "Scott Donnelly",
"content": "Good morning, Peter."
},
{
"speaker": "Peter Skibitski",
"content": "Hey, Scott. As we think about some of the softness in the consumer that you're experiencing at TSV, maybe to your Kautex comments as well, less so, but you guys aren't seeing that extend to any of your aviation customers at all. And I -- not even on the pistons or the turboprops. And I'm asking in particular, because it seems like deliveries on your lighter jets at aviation that Citation in the first half were a little bit lighter year-over-year versus the larger jets. So I just want to understand how you're seeing the health of your customers there. Obviously, they have bigger balance sheets, but I just want to get a sense."
},
{
"speaker": "Scott Donnelly",
"content": "Yeah, Peter. I'd say when you look at our lighter aircraft, I mean M2, CJ3, CJ4, we're seeing strong demand. So book-to-bill in those guys is good. Even pistons, I mean, for the most part, we're just trying to make them faster, right? I mean, now the piston aircraft training demand remains very high, right? It's very hard to find a 172 anywhere. So I think the piston side of the business is good. The light jet side of the business is good. So it's that again, these are people with stronger balance sheets, obviously and looking out over time and there's backlog. So you can get one for a year or 18 months, whatever it may be even in the lighter jet side of things. So we continue to see good order flow there. It's that discretionary, sort of point-of-sale kind of consumer, you generally financed kind of market that's just -- that's down. As I said, we're aligning costs around that. As Frank said, it's tough, particularly this quarter. We had a really strong quarter for a lot of those kind of products a year ago. It's softer now. And so we've made necessary cost and production volume alignments to match that. But no, we're absolutely not seeing that behavior when you look at light jets or Bell 505s, Bell 407, I mean the market for those even that sort of the lower price point jets and rotorcraft continue to do very well."
},
{
"speaker": "Peter Skibitski",
"content": "Okay. Interesting. Last one for me, just on GBSD. It looks like sentinel (ph), it looks like it passed its [indiscernible] review. Any change that you guys expect in the program profile for you guys?"
},
{
"speaker": "Scott Donnelly",
"content": "No, I don't. We're continuing to work very closely with Northrop. I think the program is progressing well. We've had a number of things that have added scope to what we originally had bid on the program. So I think we have a great relationship with these guys. That piece of the program is going well. As you guys know, I mean just in the media that a lot of the cost issues around the infrastructure as opposed to the missile itself have been a big issue. So for sure, there are scheduled challenges, which I think are well-documented, Northrop talks about them, their customer talks about them, but we continue to -- I think, to execute well on the program, see scope increases on the program and are continuing to make good progress on the -- on our piece of the -- of the overall weapon system."
},
{
"speaker": "Peter Skibitski",
"content": "Okay. Thank you."
},
{
"speaker": "Scott Donnelly",
"content": "Sure."
},
{
"speaker": "Operator",
"content": "And your final question today comes from the line of Gavin Parsons from UBS. Please go ahead."
},
{
"speaker": "Gavin Parsons",
"content": "Thank you. Good morning."
},
{
"speaker": "Scott Donnelly",
"content": "Good morning."
},
{
"speaker": "Gavin Parsons",
"content": "It sounded like aviation guide in-line with the initial thoughts, industrial margin maybe a little below, but can you just kind of go around the horn a little bit and update what's tracking above or below to allow you to stay in the guidance range?"
},
{
"speaker": "Scott Donnelly",
"content": "Yeah. I think you actually did a pretty good job there. I think the aviation guys are well within -- in their guide and having a great year. I think that Bell Systems will probably come in a little bit above their guide. Strong performance in both those business. And as we've talked about, we'll probably be a little below the guide on the industrial segment just because of lower volume, particularly in that consumer space. But net, I think we feel pretty good about where things are and most businesses are performing really well."
},
{
"speaker": "Gavin Parsons",
"content": "Okay. Appreciate it. And then maybe just on pricing on orders, it seems like you're still getting maybe mid-single digits on deliveries. Is it a similar level what's going into the backlog today?"
},
{
"speaker": "Scott Donnelly",
"content": "Yeah. Well, I mean, we're probably not going to give price forecasting, but I would certainly say price continues to be strong in the marketplace, so."
},
{
"speaker": "Gavin Parsons",
"content": "Okay. Thank you."
},
{
"speaker": "Scott Donnelly",
"content": "Okay."
},
{
"speaker": "Operator",
"content": "Ladies and gentlemen, this conference will be available for replay after 10 a.m. Eastern Time today through July 18, 2025. You may access the AT&T Executive replay system at any time by dialing 1866-207-1041 and entering the access code 4306608. International participants dial 402-970-0847. Those numbers once again are 1866-207-1041 or 402-970-0847 with the access code 4306608. That does conclude your conference for today. Thank you for your participation and for using AT&T teleconference. You may now disconnect."
}
] |
txt | 2,024 | 1 | [
{
"speaker": "Operator",
"content": "Thank you for standing by. Welcome to the Textron First Quarter 2024 Earnings Call. [Operator Instructions] This conference is being recorded for digitized replay and will be available after 10 a.m. Eastern Time today through April 25, 2025. You may access the replay by dialing (866) 207-1041 and enter the access code 8546032."
},
{
"speaker": "",
"content": "I would now like to turn the conference over to David Rosenberg, Vice President, Investor Relations. Please go ahead."
},
{
"speaker": "David Rosenberg",
"content": "Thanks, Leah, and good morning, everyone. Before we begin, I'd like to mention we will be discussing future estimates and expectations during our call today. These forward-looking statements are subject to various risk factors, which are detailed in our SEC filings and also in today's press release. On the call today, we have Scott Donnelly, Textron's Chairman and CEO; and Frank Connor, our Chief Financial Officer."
},
{
"speaker": "",
"content": "Our earnings call presentation can be found in the Investor Relations section of our website. Revenue in the quarter were $3.1 billion, up from $3 billion in last year's first quarter. Segment profit in the quarter was $290 million, up $31 million from the first quarter of 2023. During this year's first quarter, adjusted income from continuing operations was $1.20 per share compared to $1.05 per share in last year's first quarter. Manufacturing cash flow before pension contributions reflected a use of cash of $81 million in the quarter compared to $104 million of cash provided in last year's first quarter."
},
{
"speaker": "",
"content": "With that, I'll turn the call over to Scott."
},
{
"speaker": "Scott Donnelly",
"content": "Thanks, David, and good morning, everyone. In the first quarter, we saw higher segment profit at Aviation, Bell and Systems. At Aviation in the quarter, we delivered 36 jets, up from 35 last year, 20 commercial turboprops, down from 34 last year's first quarter. Aviation continues to see strong demand across our product lines that resulted in backlog growth of $177 million and in the first quarter at $7.3 billion. Textron innovations fleet utilization remained strong in the quarter, contributing to aftermarket revenue growth of 6% as compared to last year's first quarter."
},
{
"speaker": "",
"content": "Throughout Q1, we saw continued improvements in our supply chain and hours attained in the factory, supporting delivery growth throughout the remainder of the year. At Bell, revenues in the quarter were up driven by higher military volume, reflecting the continued ramp of the FLRAA program. On the FLRAA program, we continue to progress through preliminary design reviews and expect to complete milestone B, which allows for the entrance into the engineering and manufacturing development phase of the program later this summer."
},
{
"speaker": "",
"content": "Also during the quarter, Bell received an award for the production delivery in Nigeria of 12 AH-1Z helicopters. V-22, the recently enacted FY '24 budget includes 5 additional aircraft scheduled for delivery in 2027. On the commercial side of Bell, we delivered 18 helicopters down from 22 in last year's first quarter. During the quarter, we continued to progress toward FAA certification on the 525 expected later this year."
},
{
"speaker": "",
"content": "Bell recently received its first order for 10 525 helicopters from Equinor, Norwegian state energy company."
},
{
"speaker": "",
"content": "Moving to Textron Systems, revenue was flat and margin was up versus last year's first quarter. During the quarter, we received notification from our government customer of the termination of the shadow program. We're currently working with the Army on winding this program down. This decision reflects the Army's transition from shadow to the Future Tactical UAS system to fulfill the need of organic intelligence, surveillance and reconnaissance. Earlier this month, we received notification that we were awarded options 3 and 4 of the FTUAS program, and we remain one of two competitors for this next-generation program. Also in the quarter, systems was down selected with one other competitor to design, develop and manufacture a 30-millimeter Autocannon Advanced Reconnaissance Vehicle prototype for the U.S. Marine Corps."
},
{
"speaker": "",
"content": "This 2-year effort will develop an innovative combat vehicle that provides mobile protective firepower for the marines. In addition, the Army's FY '25 budget request funds the design of the XM30 ground combat vehicle in preparation for the prototype build and testing portion of Phase 3 and 4 in the program's development. Moving to Industrial. We saw lower revenues in the quarter, largely driven by lower volume and mix and specialized vehicles. Kautex revenues were flat in the quarter. We are encouraged by recent trends in the hybrid space where industry is experiencing increased customer demand and OEM investments in hybrid platforms."
},
{
"speaker": "",
"content": "Aviation, Pipistrel delivered 30 aircraft in the quarter, up from 13 in 2023. Also during the quarter, Pipistrel was granted an airworthiness exemption by the FAA for its Velis Electro trainer which will allow U.S. flight schools to use this all electric aircraft in their pilot training programs. With that, I'll turn the call over to Frank."
},
{
"speaker": "Frank Connor",
"content": "Thanks, Scott, and good morning, everyone. Let's review how each of the segments contributed, starting with Textron Aviation."
},
{
"speaker": "",
"content": "Revenues at Textron Aviation of $1.2 billion were up $39 million from the first quarter of 2023, reflecting higher pricing of $48 million and lower volume and mix of $9 million. Segment profit was $143 million in the first quarter, up $18 million from a year ago, reflecting a favorable impact from pricing net of inflation of $14 million. Backlog in the segment ended the quarter at $7.3 billion."
},
{
"speaker": "",
"content": "Moving to Bell. Revenues were $727 million, up $106 million from last year's first quarter, reflecting higher military volume of $95 million, primarily related to the FLRAA program. This was partially offset by lower volume on the V-22 and H-1 programs. Segment profit of $80 million was up $20 million from a year ago, primarily driven by a favorable impact from performance of $30 million which includes $13 million of lower research and development costs."
},
{
"speaker": "",
"content": "Backlog in the segment ended the quarter at $4.5 billion. At Textron Systems, revenues were $306 million, flat with last year's first quarter. Segment profit was $38 million, up $4 million from last year's first quarter. Backlog in the segment ended the quarter at $1.8 billion. Industrial revenues were $892 million, down $40 million from last year's first quarter, largely reflecting lower volume and mix of $51 million, principally in the Specialized Vehicles product line, partially offset by higher pricing of $16 million in the segment."
},
{
"speaker": "",
"content": "Segment profit of $29 million was down $12 million from the first quarter of 2023, primarily due to lower volume and mix at specialized vehicles. Textron eAviation segment revenues were $7 million and segment loss was $18 million in the first quarter of 2024 compared with a segment loss of $9 million in the first quarter of 2023, primarily related to higher research and development costs. Finance segment revenues were $15 million and profit was $18 million."
},
{
"speaker": "",
"content": "Moving below segment profit. Corporate expenses were $62 million. Net interest expense was $15 million. LIFO inventory provision was $20 million. Intangible asset amortization was $8 million and the non-service component of pension and postretirement income was $66 million. In the first quarter of 2024, we incurred $14 million in special charges under the 2023 restructuring plan, largely related to head count reductions to improve the cost structures of the Textron Systems and Bell segments in light of the cancellations of the shadow and FARA programs in the quarter."
},
{
"speaker": "",
"content": "We expect to incur additional severance costs in the second quarter in the range of $25 million to $30 million largely related to head count reductions in the Industrial segment. As a result, Textron has expanded its 2023 restructuring plan from a previously announced range of $115 million to $135 million in pretax special charges to a range of $165 million to $170 million. In the quarter, we repurchased approximately 3.6 million shares, returning $317 million in cash to shareholders."
},
{
"speaker": "",
"content": "To wrap up with guidance, we are reiterating our expected full year adjusted earnings per share to be in a range of $6.20 to $6.40 per share. We also expect full year manufacturing cash flow before pension contributions of $900 million to $1 billion."
},
{
"speaker": "",
"content": "That concludes our prepared remarks. So Leah, we can open up the line for questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] And we'll start with David Strauss with Barclays."
},
{
"speaker": "David Strauss",
"content": "Scott, maybe if you could just dig in a little bit in the -- on the deliveries in the quarter. I think the mix was pretty strong but relatively flat year-over-year and you build a lot of inventory. So maybe just how the supply chain is doing? Did you want to deliver more airplanes than you ended up doing? And how do we think about how much deliveries could grow this year off of 168 last year?"
},
{
"speaker": "Scott Donnelly",
"content": "Sure. David, look I think that we certainly expect to see nice growth on a year-over-year basis. The supply chain does continue to improve the number of hours that we're able to get in the factory in terms of labor hours that are productive hours post training and whatnot does continue to improve. So I think we feel pretty good about how things progressed through the quarter."
},
{
"speaker": "",
"content": "Look, we always have a few aircraft that we would like to have gotten delivered. We definitely had some things that got late in the quarter or just didn't get to where they could transfer in time. But for sure, the trend in terms of productivity and efficiency and throughput in the factory improved as we worked our way through the quarter. So a little bit lighter than we probably would have liked but not a big number. And I think again, the momentum is good, and we certainly are still feeling very good about our guide in terms of a nice increase in volume on a year-over-year basis."
},
{
"speaker": "Operator",
"content": "Next, we go to the line of Robert Stallard with Vertical Research."
},
{
"speaker": "Robert Stallard",
"content": "Thanks Scott, maybe we'll start with Industrial, a bit of softness there in Q1. I know this is a tough division to forecast given its short-cycle nature. But are we finally seeing the U.S. consumer rolling over here."
},
{
"speaker": "Scott Donnelly",
"content": "Well, look, I think we talked last year Robert towards end of the year and in our guide that we expected to see the sort of high-end consumer dollars, sort of recreational personal transportation, stuff soften and we're seeing that. It's probably even a little bit softer than we would have expected. I think the automotive segment is pretty stable, which is fine. There are certainly some pieces in the vehicle business that are doing fine, but those high-dollar discretionary items have certainly softened."
},
{
"speaker": "",
"content": "As you know, those are often financed. Finance costs are certainly higher than they have been. So we expected it to be softer, our PTV business, which has been a great business for us. It was a little bit softer than we would have expected, and that's part of what we'll have to do some additional restructuring on top of our initial plan to dial that in and avoid a situation where we put too much inventory out in the field."
},
{
"speaker": "Robert Stallard",
"content": "Right. And then maybe one for Frank. On the revised restructuring plan, do you -- how do you expect the cash impact of that to flow through? And do you expect the savings to be roughly equivalent to the restructuring charge?"
},
{
"speaker": "Frank Connor",
"content": "Yes. I think the savings will be ultimately in the area of $185 million or so kind of on a run rate basis and that we'll realize a fair amount of that by the end of 2024, but that will roll into '25 as well. The incremental cash is about $20 million in '24 for the additional restructuring, and we'll just absorb that into our cash guidance and overall cash for the restructuring for '24 is in the area of $60 million to $65 million. So -- but additional $20 million versus where we had been."
},
{
"speaker": "Operator",
"content": "Next, we move on to Sheila Kahyaoglu with Jefferies."
},
{
"speaker": "Sheila Kahyaoglu",
"content": "Can we start off with maybe Bell, Scott, if we look at margins, they expanded up 130 basis points of Bell to 11% despite maybe $180 million of large contribution on the top line. So how do we think about the moving pieces to profitability for the year to get to 9.5% to 10.5%?"
},
{
"speaker": "Scott Donnelly",
"content": "Well, I think we'll probably still end up in that range, Sheila. We had a strong Q1, obviously. We did have, as we noted there, a settlement on initial property-related lawsuit that gave us a little bit of a boost in the quarter. But I would say the team is performing well. As you know, we did restructuring actions to try to deal with the loss of the FARA program. We were able in a number of cases to take some of the appropriate engineering count and move that over to the FARA program, which helped us ramp that program up."
},
{
"speaker": "",
"content": "But we also had to take some cost actions, both in the -- as a result of the loss of the FARA program as well as some of the lower production quantities. Obviously, it will certainly help us as we start to see some flow of the Nigerian H1 where that gets that line back up and going again, the extra 5 on V-22, which is above the original program of record is certainly a nice add, and we'll start to see some of that flow through in the latter part of the year. So I think Bell had a strong quarter. We're continuing to focus very much on cost to deal with the mix issues there. But we'll clearly end up towards the high side of the guidance on Bell, I think they're performing well."
},
{
"speaker": "Sheila Kahyaoglu",
"content": "Great. And then if I could ask one on Aviation, orders held up pretty well, book-to-bill above 1x. Maybe if you could provide any color on what you're seeing from your customers. One of your competitors noted interest rates are potentially prohibiting orders? If you could just comment on that?"
},
{
"speaker": "Scott Donnelly",
"content": "Sheila, we continue to see real good strength across pretty much all the product lines in the business. So we're feeling pretty good about the order flow a lot of these aircraft are going to deliver a couple of years from now. So from a financing standpoint, I don't know, we don't -- I guess here is as much about that, but the order activity was staying pretty strong, very positive."
},
{
"speaker": "Operator",
"content": "Next, we go to Myles Walton with Wolfe Research."
},
{
"speaker": "Myles Walton",
"content": "Scott, I was wondering if you could touch on the supply chain within Bell. Obviously, the 1Q seasonally light usually for the commercial helos but down year-on-year. And then also the comment you made on the 525 certification at year-end. I know that, I wonder if your business heads had been quoted is getting more confident on that into the year-end. Could you also comment on your confidence level of that certification?"
},
{
"speaker": "Scott Donnelly",
"content": "Sure. Look, the Bell supply chain continues to I would say, improve. We always have a number of parts that are sort of problem children. We're continuing to work that. But in general, I think we are able to manage our way through that. And I don't think there's anything new or surprising that would have, in any way, affect our guide as we think about Bell commercial volumes through the course of the year."
},
{
"speaker": "",
"content": "We did have a very strong Q4, obviously, on the commercial deliveries and so a little lighter maybe than we expected in Q1, but I think we're in good shape. And order activity there also remains very healthy. So I think Bell is in a good place. 525 flight test is going very well. The FAA flight testing portion, we're well into that. We have a few more performance flight test and then we go through sort of what they call FNR, which is about 150 hours of just durability reliability flying."
},
{
"speaker": "",
"content": "And obviously, as you guys know, we've been flying that aircraft for a long time. It's proven to be very durable, reliable aircraft. So I don't think we'll have any issues going through there. So we'll we should wrap up flight testing year as we get to midyear. And as you know, there's a fair bit of paperwork processing and final documents and all that kind of stuff that have to go before the final certification. But I'd say at this point, we feel pretty good about where it is."
},
{
"speaker": "Myles Walton",
"content": "And if it were certified, what would be sort of the production rate that you target over the next few years?"
},
{
"speaker": "Scott Donnelly",
"content": "Yes. We haven't released a production rate on the 525."
},
{
"speaker": "Operator",
"content": "And our next question comes from Peter Arment with Baird."
},
{
"speaker": "Peter Arment",
"content": "Scott, nice results. Did you quantify what the settlement was in the Bell that affected the margins this quarter?"
},
{
"speaker": "Scott Donnelly",
"content": "No, we didn't. I mean, it's not a huge number, Peter, but it's not that helped the margin rate a little bit in the quarter."
},
{
"speaker": "Peter Arment",
"content": "Okay. Okay. So I just want to clarify that. And then just a quick one for you, Frank. We expected that you would have higher corporate expenses in Q1. Just wondering, just from a modeling perspective calibrate the rest of The Street. Are we thinking more evenly spread for the balance of the year for your $160 million target?"
},
{
"speaker": "Frank Connor",
"content": "Yes. As you know, that bounces around depending on where the share price is, but kind of we expected, it certainly will not be as volatile or may not be as volatile for the rest of the year. So we'll see. But yes, we're still sticking with the same target for the full year."
},
{
"speaker": "Operator",
"content": "Next, we have a question from Cai von Rumohr with TD Cowen."
},
{
"speaker": "Cai Von Rumohr",
"content": "Yes. So your competitors, Gulfstream and Embraer basically had higher biz jet deliveries and we're kind of closer to where they expected to be. And yet you guys continue to struggle. Is part of that related to geography that you guys are in Wichita and you have to fight with Spirit to get people because they're trying to ramp to. And that, therefore, this is going to be a longer slog than maybe others are going to see?"
},
{
"speaker": "Scott Donnelly",
"content": "Cai, I mean I thought we feel pretty good about our deliveries. We always would like to get another couple of jets here and there, but I think we're doing pretty good and feeling good about where we are. On the labor front, where we expect it to be. So I don't see a problem with our labor situation in which [indiscernible] I think everybody has been challenged by higher turnover rates just in terms of the amount of churn."
},
{
"speaker": "",
"content": "And that's really been one of the biggest impacts to us on the productivity efficiency side is the number of people that come in and rotate back out, but I think most companies in all industries, frankly, are seeing that. But no, I don't think we have a -- we certainly don't feel like we have a macro unsolvable problem. It's improved significantly. The number of employees is where we needed to be."
},
{
"speaker": "",
"content": "And I expect we'll -- as I said, we will continue to see a ramp on deliveries as we go through the year."
},
{
"speaker": "Cai Von Rumohr",
"content": "Great. And sort of maybe going back to Myles' question. So energy prices are up 525 is clearly targeting that market. You've got an order for 10, do delivery start relatively early next year? So could we start to see some pretty good build on that program?"
},
{
"speaker": "Scott Donnelly",
"content": "Well, we're already ramping up the production side of the program to start to meet deliveries, but I suspect those deliveries will be in the late '25 sort of time frame. I think we're in a very good place in terms of the cycle, as you alluded to. Obviously, Equinor is an energy company, and those are for oil and gas offshore applications, and we have several other customers who were in, I'd say, positive latter stage negotiations that are primarily aimed at the oil and gas market right now. So it's certainly a favorable time to be getting these things through certification. And I think it fits a nice place in that end market."
},
{
"speaker": "Operator",
"content": "Next, we go to Seth Seifman with JPMorgan."
},
{
"speaker": "Seth Seifman",
"content": "Thanks very much. Good morning, everyone. I guess, Scott, you called out the contribution to EBIT growth from pricing at Aviation, and we'll see more about the other components in the queue. It looks like the compares for pricing get somewhat tougher from here, should we think about I know you probably have some visibility into the backlog here. Should we think about the $14 million of year-on-year pricing being a relatively high level compared to what we're likely to see for the rest of the year given that those compares get harder?"
},
{
"speaker": "Scott Donnelly",
"content": "Yes. I think it kind of is pretty stable through the course of the year. I mean we do have obviously very good visibility to the pricing side of things because they're all in the backlog. Obviously, what's important to us is to maintain that spread of net pricing over inflation. And so that's really most of the work as we go through the course of the year is just managing the inflation numbers around supply base and things like that. So -- but I would expect to see positive price over inflation through the course of the year."
},
{
"speaker": "Seth Seifman",
"content": "Okay. Okay. And then just a follow-up, I think you talked earlier about potentially some upside at Bell. I talked about being in good shape at Aviation. I mean when we think about where industrial came in, in the first quarter and where the guidance is, it looks like they're going to probably have a tough time getting to that guidance and then maintaining the overall guidance for the company of Aviation and Bell to fill in those gaps? Or that..."
},
{
"speaker": "Scott Donnelly",
"content": "I think that -- yes, I think look, the industrial business, we would anticipate the revenue being a little bit lower than probably our original guide. I think we'll probably hold in the margin range. But I think we have sufficient upside in terms of the performance and how we're doing on the aviation and the Bell front that -- which is why we're comfortable holding our guide for the overall company."
},
{
"speaker": "Operator",
"content": "Sorry about that. We will next go to the line of Noah Poponak with Goldman Sachs."
},
{
"speaker": "Noah Poponak",
"content": "Scott, Frank. Just staying on the Aviation margin, I mean, it's a pretty good incremental in the quarter. I think it was a little bit of an easier compare. We kind of a sense what units and price are doing. I think you've had cost input inflation, but you've also cited just kind of supply chain and some internal operating performance, maybe that's been a hurdle. Is that behind you now? Is that no longer an issue as you move through 2024? And is that a tailwind year-over-year?"
},
{
"speaker": "Scott Donnelly",
"content": "I think you'll still see some pressure in second quarter. No. Remember, a lot of these aircraft are inventories, a lot of that cost is inventory. So it usually takes the first half of the year to bleed out in the performance levels and productivity levels that we saw in the back half of the previous year in 2023 in this case. So I still think we see some pressure for that."
},
{
"speaker": "",
"content": "But I'd say the good news is that when we look at the metrics in the factory and the efficiencies, productivity and things of that nature, we are starting to see some of the benefits that we expect to see in a more stable production environment, less supplier disruption, fewer onboarding, so less impact on the training. There's a lot of things the business is doing to try to address some of those issues. So I do think that we'll have margin rates that do continue to improve over the course of the year, but you're still going to have some drag of that inventory release, particularly as you get through Q2."
},
{
"speaker": "Noah Poponak",
"content": "Okay. That makes sense. And then I guess just a follow-up on the Bell margin. I know the FLRAA is still ramping and it will kind of exit the year at a different revenue run rate than it achieved in the first quarter. But it's also ramped a decent amount. And I think this year, you'll get pretty close to what the run rate is in the sort of medium term. And this Bell margin just keeps outperforming. I mean the amount of margin compression that was discussed out there in the market, I guess, in the medium term? Is that kind of off the table? Or I guess, how do you see this dollar margin hanging in '24, '25 or '26, just in the medium term as you continue to ramp FLRAA?"
},
{
"speaker": "Scott Donnelly",
"content": "Well, look, I mean, I think again, the team is performing well. We're doing everything we can on the cost front to deal with the lower production levels, things like the Nigerian order, the additional 5 V-22, these things are all helpful. I guess I would also note and you may have seen, if you look at the FY '25 budget request, one of the allocations of sort of the elimination of FARA and where that money in the out years goes, there is over $200 million of FY '25 money on FLRAA above what was originally in the [ FIDAE ]. So I do think that we're going to -- we're ramping quite nicely on FLRAA."
},
{
"speaker": "",
"content": "We'll actually probably see that increase in terms of the number of revenues on FLRAA as we get into 2025 above what we might have originally expected on the [ FIDAE ]. So that's another couple of hundred million dollar probably revenue step as we get into next year. So look, we'll continue to stay very focused on the cost side and executing and perform against all these programs. And as I said, I think that will drive us to the higher side of the revenue guide -- part of the -- I'm sorry, the margin guide for this year, and we'll certainly get back to you on the FY '25 guide sometime in January, February."
},
{
"speaker": "Noah Poponak",
"content": "Okay. And Frank, I guess, a decent amount or a lot of the items below segment manufacturing segment EBIT were pretty different in the quarter compared to what the full year implied on a quarterly run rate. If I look at what Aviation did finance did tax rate, corporate interest, even. Is it worth updating those on a full year basis? Or are they all just kind of still looking like the land in the range of what you had originally embedded in the earnings guidance?"
},
{
"speaker": "Frank Connor",
"content": "Well, I think that finance will be in the range of what we had thought. We talked about corporate expense was kind of significantly higher this first quarter due to share price performance. But we'll kind of stick with that type of range. I think interest expense relative to, I don't know what -- we didn't really guide interest expense, but our -- I guess, we're probably a little better on interest expense, excuse me, relative to the $90 million depending on what interest rates do for the year."
},
{
"speaker": "",
"content": "Our investment in cash is a little better than we had thought given the continuing higher interest rates, so there's probably a benefit there. But the other stuff is kind of in the range of what we had talked about."
},
{
"speaker": "Operator",
"content": "Next, we have a question from Doug Harned with Bernstein."
},
{
"speaker": "Douglas Harned",
"content": "I wanted to go back to your discussion around pricing at aviation. This has been a great story with continuing to be able to get pricing ahead of inflation. But when you look at this, and I'd say outside of what you have in the order book right now. When you try and plan longer term, is this something you can expect to continue? Or do you have to look at this as eventually pricing is going to come back and kind of converge with inflation rates?"
},
{
"speaker": "Scott Donnelly",
"content": "Jeez, I don't know. I mean, obviously, I would say at a macro level, generally speaking, over very long periods of time, price inflation probably end up pretty close. I think we certainly went through a number of years in this industry where the prices were where the products were way under price. I mean it just doesn't make sense."
},
{
"speaker": "",
"content": "So I mean, we had a significant catch up in price. I think got them back to much closer to where they should be. And obviously, our expectation is you're going to continue to see inflation on a go-forward basis, and we expect to see pricing increasing on a go-forward basis. And then we're seeing that. I mean pricing in the market is solid. And beyond that, I'm not sure how to forecast over a long period of time. But we still think demand is strong and the price environment is also doing well. As I said, I think when we guided, we talked about the fact that you wouldn't see as significant a price -- absolute price increase, as you saw in the last couple of years, but you also see some inflation starting to come down as well. So anyway for us, what's important is that we have net pricing positive over inflation."
},
{
"speaker": "Douglas Harned",
"content": "Okay. And then just switching over to Bell for a moment on -- again, on margins. You've talked in the past, and I think as one would expect, initially, FLRAA is dilutive. But when you look at that trajectory now that you're moving forward, you're headed toward [ Milestone B ], I would expect long term, this is a very accretive program once you're in full rate production. Can you give us a sense of how you expect kind of the time line of FLRAA's contribution to margins to proceed?"
},
{
"speaker": "Scott Donnelly",
"content": "Well, I mean, I think that -- as you described, that's kind of what you would nominally expect for any of these large defense contract programs, FLRAA is a very big program, right? So the EMD phase of this thing goes out through into 2030. Now you'll start to see, I would suspect initial production lots. We have LRIP deliveries that happen out in 2028, but you'll start to see some of the follow-on production lots be negotiated out in that time frame. But certainly, the next several years is very much dominated by the EMD program."
},
{
"speaker": "Douglas Harned",
"content": "Okay. And that would be dilutive in that period."
},
{
"speaker": "Scott Donnelly",
"content": "Yes. Correct."
},
{
"speaker": "Operator",
"content": "Next, we go to the line of Jason Gursky with Citigroup."
},
{
"speaker": "Jason Gursky",
"content": "Good morning, everybody. I was wondering if you could spend a little bit time on eAviation. Maybe provide us a little bit of an update on how things are going in that business and the development that you've got going on there? And kind of what the -- the next couple of years look like for you all on product development revenue and how EBIT is going to trend for us here over the next few years given that backdrop?"
},
{
"speaker": "Scott Donnelly",
"content": "Sure. So look, I think there's obviously a couple of pieces that are in here, right? There's the Pivotal business, which I think is doing well. We're seeing -- we saw a significant increase in the number of deliveries here in Q1. I think demand for those products is strong. So we feel pretty good about where that is."
},
{
"speaker": "",
"content": "As I mentioned, we did get an FAA exemption on the ability to do flight training on the Bell's electro, which is fundamentally a training aircraft. So I think that will help us pick up volume as we can now sell those and use those for training in the U.S. domestic market. It's already been accepted, and we've seen nice growth in the international markets. We have a couple of new products that are in that in that product line, I think we'll do well. So I think we feel very good about how the Pipistrel guys are doing and how that's performing."
},
{
"speaker": "",
"content": "On the R&D, which is really the dominant piece of what's driving the financials in that segment, we have the Nexus program, which is progressing well. We're doing the full integration and testing of the first craft. We'll probably see -- we're already sort of doing ground testing and evaluation already. We'll probably see flight test later on this year on the Nexus front. That program is also, I'd say, progressing well. Most of the supplier selections are done. Parts coming in, we're starting to build the first airframe with an expectation that we would probably fly that sometime next year."
},
{
"speaker": "",
"content": "So that's really what drives the financial side. Now I would say that we're -- the level of investment that we're making right now into those programs is probably going to level off. So we saw -- as we've guided, we saw a significant increase from '22 to '23 and now '23 to '24 and those -- that level of spending is probably going to level out going forward. So we'll start to see some EBIT increased contribution on the Pipistrel product sales side. So I think that's clearly a segment that the investments in Nexus and in the newer program, we're going to continue to have us in a loss position, but it probably stabilizes going out the next few years."
},
{
"speaker": "Jason Gursky",
"content": "And as you think about the size of the market that you're going after, you're putting investment dollars against what you expect to be volumes. And so I'm just kind of curious, when do you expect the payback period to start on these investments that you're making?"
},
{
"speaker": "Scott Donnelly",
"content": "Okay. So I think this is very much an unknown. I mean, there's plenty of studies out there and a lot of other noise in this industry that when you look at the eVTOL side of things, that it's a mega market. The exact timing of that, I think, is still a little bit to be determined. There's still plenty of work to do on the technical front from our perspective, technical work, regulatory work to make sure that there's viable products to meet that mission. So again, I think there's plenty of independent third-party data out there that has perspectives about how huge that market could be."
},
{
"speaker": "",
"content": "Keep in mind as our spending here is relatively modest. I think we're taking advantage of a lot of cost and cost structure and talent and capability that we already have in the company. So if the market proves to be what third parties would say the market would prove to be, it's going to be a massive return on investment."
},
{
"speaker": "Operator",
"content": "Next, we go to George Shapiro with Shapiro Research."
},
{
"speaker": "George Shapiro",
"content": "Scott, the incremental margin in Aviation, as people were talking about was, I mean, like 46%. And I recognize that revenue differences are small, so the numbers can get somewhat distorted. But given that you said inflation will probably pretty much be somewhat similar to the price benefit that you got this quarter. Why won't those incrementals for the rest of the year run somewhat higher than kind of your objective of 20%?"
},
{
"speaker": "Scott Donnelly",
"content": "Well, George, look, I mean I think when we look at the cost and what's going to come out of inventory and what the margin rates are going to look like, it's, I do think you're right. We did have a higher conversion on Q1, but that's certainly, I think, certainly higher than we would expect for the course of the year. So I think at this point, as we look at it, our expectations in terms of what inflation is going to look like, what plant performance is going to look like, which, as I said, is for sure improving through the course of the year as we get towards the high side of guide there, it's that 20% kind of range, which is generally what we've guided as a long-term measurement for the business. And I think that's where we'll be."
},
{
"speaker": "George Shapiro",
"content": "Okay. And one quick one for you, Frank. You bought a lot of stock in the first quarter, like 1.8% of the outstanding I guess it was pretty opportunistic? Or do we expect that you might buy more than 5% for this year?"
},
{
"speaker": "Frank Connor",
"content": "Well, we talked about kind of 5% was in our guidance, but we also talked about the fact that we have a strong liquidity position, and we're going to return excess capital. So I think that kind of -- we did a fair amount in the first quarter. We'll continue to buy from here. We'll probably be on the higher side of that 5% for the year."
},
{
"speaker": "Operator",
"content": "Next, we go to the line of Ron Epstein with Bank of America."
},
{
"speaker": "Ronald Epstein",
"content": "Just maybe circling back on the defense business in the supplemental that just got passed yesterday. Is there stuff in there for you guys? I mean have you looked -- obviously you've look at it, but can you give us a sense of potentially what's in there for Systems or Bell?"
},
{
"speaker": "Scott Donnelly",
"content": "No, there's not. I mean we really haven't been in the in the guns and bullet business. So most of that stuff is not replenishments of things that we have. I do think there's opportunities in Ukraine over time when you look at things that are possibilities for Bell on some other things and systems, but not something that's directly tied to these supplementals."
},
{
"speaker": "Ronald Epstein",
"content": "Got it. Got it. And then kind of back to aviation. Broadly, how is this supply chain doing in that? One of the things I've heard oddly enough is like window screens, windshields for airplanes or there's a shortage of those. I mean is there other stuff like that, that's just kind of random stuff to just kind of short in supply."
},
{
"speaker": "Scott Donnelly",
"content": "Well, look, Ron, as we said, it's the randomness is part of what drives us crazy, right? It's -- and they change over time. But you're absolutely right. Windshields have been a problem now for several years. And it's, I'd say, probably getting better, but it's been a big problem. It's been a problem for us in terms of production builds. And frankly, it's been a big problem for us in terms of our customers."
},
{
"speaker": "",
"content": "If somebody has a damaged windscreen and it's been an area of a lot of dissatisfaction in the industry, not just for the OEMs like us but also for our ability to provide spares in service. So it is -- certainly has been and remains one of the top problem items by category."
},
{
"speaker": "Ronald Epstein",
"content": "Yes. When I heard that I was astonished, but yes, I guess the current suppliers shut down the other supplier, whatever."
},
{
"speaker": "Operator",
"content": "Next, we go to Kristine Liwag with Morgan Stanley."
},
{
"speaker": "Kristine Liwag",
"content": "Scott, earlier you mentioned on industrial, how you're seeing incremental weakness in the high-end consumer. Can you talk about the customer profile of those buyers? And if there are similarities to the customer profile for products like M2 or pistons or Couriers in aviation?"
},
{
"speaker": "Scott Donnelly",
"content": "So I don't know exactly in terms of categorization of that customer per se. But I think that if you look at demand for all the way down to piston. The system 172, demand remains very strong, and we expect to have strong deliveries even over last year, but availability, the demand environment is very strong for that kind of stuff."
},
{
"speaker": "",
"content": "And too strong. I mean these are products that we see strength in terms of demand across the product line. I don't think they're the same customer maybe or the same consumer perhaps. But I think if you look -- now certainly, what we're seeing and we look at other companies. If you're in the business of doing boats, RVs, recreational vehicles, PTVs, that consumer has clearly slowed down. They slowed down last year, and we did make some adjustments based on that, but we've seen further slowing on that. But yes, I don't know how to categorize whether it's the same customer or not, but certainly those product categories have slowed down and everything from pistons up into light jets has not. And of course, that's a much bigger, much more important business to us, which is good, I suppose."
},
{
"speaker": "Operator",
"content": "Next, we go over to Gavin Parsons with UBS."
},
{
"speaker": "Gavin Parsons",
"content": "I just want to confirm if I heard the restructuring savings are expected at $185 million, given I think the initial plan was $75 million. And just what's driving the better number there?"
},
{
"speaker": "Frank Connor",
"content": "Yes. That's a full kind of run rate when we get through it all. And it's really driven by the addition of head count reductions. The unanticipated Shadow, FARA and then the additional actions at Industrial are really focused on head count where the original restructuring had some asset impairment in it. And so we're getting a much bigger run rate savings as a result of those reductions to kind of rightsize those activities."
},
{
"speaker": "Gavin Parsons",
"content": "Got it. Okay. What is the transition from shadow to FTUAS look like in terms of kind of revenue and margins over what time frame?"
},
{
"speaker": "Scott Donnelly",
"content": "Well, look, I think that's still a little bit to be determined when the Army canceled the Shadow program. They did say they wanted to move more aggressively on FTUAS, we have seen that in the awards now of option 3 and 4, which is good. There aren't, I don't think, formally published dates, but the dates that we hear about in terms of when they'll put an RFP out on The Street for the ultimate EMD production decisions, sounds like they're probably pulling that forward to where that RFP could come out as early as even late this year, which would lead to an early '25 calendar year award, which should be great. So the exact size and scope and therefore, the revenue and the margin is -- we just don't have visibility to that at this point."
},
{
"speaker": "Operator",
"content": "This conference is being recorded for digitized replay and will be available after 10 a.m. Eastern Time today through April 25, 2025. You may access the replay by dialing (866) 207-1041 and enter the access code 8546032. This does conclude our conference for today. Thank you for your participation. You may now disconnect."
}
] |
tyl | 2,024 | 4 | [
{
"speaker": "Operator",
"content": "Fourth quarter 2024 conference call. Your host for today's call is Lynn Moore, President and CEO of Tyler Technologies, Inc. At this time, all participants are in listen-only mode. Later, we will conduct a question and answer session, and instructions will follow at that time. In order to address your questions and stay within the allotted time, please limit your question to one question per person. You may get back into the queue for a follow-up. As a reminder, this conference is being recorded today, February 13, 2025. I would now like to turn the call over to Hala Elsherbini, Tyler's Senior Director of Investor Relations. Please go ahead."
},
{
"speaker": "Hala Elsherbini",
"content": "Thank you, Calvin, and welcome to our call. With me today is Lynn Moore, our President and Chief Executive Officer, and Brian Miller, our Chief Financial Officer. After I give the safe harbor statement, Lynn will have some initial comments on our quarter, and then Brian will review the details of our results and provide our annual guidance for 2025. Lynn will end with some additional comments, and then we'll take your questions. During this call, management may make statements that provide information other than historical information and may include projections concerning the company's future results, future prospects, revenues, expenses, and profits. Such statements are considered forward-looking statements under the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995 and are subject to certain risks and uncertainties which could cause actual results to differ materially from those projections. We refer you to our Form 10-Ks and other SEC filings for more information on those risks. Also, in our earnings release, we have included non-GAAP measures that we believe facilitate understanding of our results and comparisons with peers in the software industry. A reconciliation of GAAP to non-GAAP measures is provided in our earnings. We have also posted on the investor section of our website under the financials tab a schedule with supplemental information including information about quarterly recurring revenues and bookings. On the events and presentations tab, we've posted an earnings summary slide deck to supplement our prepared remarks. Please note that all loan comparisons we make on the call today will relate to the corresponding period of last year unless we specify otherwise."
},
{
"speaker": "Lynn Moore",
"content": "Thanks, Hala. Our fourth quarter results provided a solid finish to an exceptional year of growth and profitability as we executed on our key objectives across financial, operational, and strategic initiatives. We exceeded our expectations across our key financial metrics, with recurring revenue growth of nearly 15% driven by SaaS revenue growth of 23%, our sixteenth consecutive quarter of SaaS revenue growth of 20% or more. SaaS adoption continued to accelerate with both new and existing clients. With 97% of our new software contract value in the cloud, transaction revenues set a new quarterly high, growing nearly 21%. Our non-GAAP operating margin expanded to 24.4%, benefiting from the mix shift to higher SaaS revenues. In addition, free cash flow of $216 million significantly exceeded our expectations, reaching a new high for a fourth quarter. In 2023, we passed a cloud revenue inflection point where long-term recurring SaaS revenues surpassed on-premise license and maintenance revenues. At our 2023 Investor Day, we unveiled our Tyler 2030 vision and multiyear strategic direction, including drivers of revenue growth and margin expansion. We also laid out our 2025 and 2030 targets, key metrics around revenues, margins, and cash flow. We're pleased with our progress in 2024 toward those goals. As planned, we closed our Dallas data center midyear and are on track to close our main data center at the end of 2025. We delivered SaaS revenue growth that exceeded our 20% growth target, and transaction revenues were well above plan. We made significant progress with our cloud operations initiatives, delivering better than expected operating margin expansion through version consolidation, releasing cloud-optimized products. These proof points give us confidence in achieving our 2025 targets as well as our long-range goals of organic recurring revenue CAGR of 10% to 12%, sustainable margin expansion, with non-GAAP operating margins of 30% or more, and expanded free cash flow of $1 billion with free cash flow margins in the high 20s. The public sector market remains strong, with robust demand supported by healthy budgets, especially at the state and local levels, which comprise approximately 95% of our total revenue. The public sector's drive towards digital modernization continues to accelerate as aging mission-critical systems reach end of life, cybersecurity threats continue to increase, and governments at all levels face a growing demand for an improved citizen experience and seek operational efficiencies to enable them to do more with limited resources. While the new federal department of government efficiency or Doge is still in its early days, we don't envision its effort having a significant impact on funding or demand for our software and services, which power what are generally essential functions. In fact, we view an increased focus on government efficiency at any level as an opportunity rather than a risk for Tyler, and we believe that technology is ultimately the greatest driver of improved efficiency. The elevated market activity we've discussed for the past few quarters, along with excellent execution by our sales teams, is reflected in our new software bookings this quarter with new SaaS contract value of approximately $141 million, up 37% over last year. Our market-leading position and competitive strengths, including our deep domain expertise, broad portfolio solutions, and most importantly, our client base, serve as the foundation for our long-term strategic focus on four key growth pillars: executing on our cloud-first strategy, leveraging our unmatched installed base, expanding into new markets, and growing our differentiated payments business. Our cloud transition is anchored by our unifying principles toward a single release stream to better scale, innovate, and deliver an enhanced client experience. We've made significant progress with our cloud optimization efforts, with cloud-optimized releases launched across many of our flagship products, driving an accelerated pace of on-premise client migrations to the cloud, with more flips of larger clients taking place. For the quarter, we inked a total of 106 flips of on-premises clients. The total contract value from flips signed this quarter grew 58% over last year's fourth quarter, and the average ARR of flips signed in the quarter was nearly 32%. As we previously discussed, we are executing multiple cloud transitions across our product solutions, each with its own nuanced roadmap and timeline. We're pleased with the current trajectory of flips from on-premises to cloud deployments and currently envision flips peaking in 2027 and 2028 as we work towards migrating more than 80% of our on-premises clients to Tyler's next-generation cloud. We continue to lead with cloud across all product solutions, and during the quarter, we saw increased momentum from clients selecting multiple integrated solutions from Tyler. Our largest SaaS deal this quarter was an $11.4 million multi-suite contract with the city of Kenosha, Wisconsin, for enterprise ERP, enterprise permitting licensing, enterprise asset management, municipal justice, and enterprise assessment and tax solutions, which adds $1.3 million ARR, leveraged our expanding footprint and strong client references in Wisconsin, combined with our unique ability to offer multiple integrated solutions from a single platform. This is what we refer to as a total Tyler client engagement. Notable multiproduct SaaS contracts include Hernando County, Florida, and the city of Warner Robins, Georgia, for enterprise ERP, enterprise permitting licensing, and enterprise asset management solutions, adding almost $1.3 million in ARR. We're also pleased to see growing adoption of our AI-driven priority-based budgeting solution, which we acquired with ResourceX in the fall of 2023. Priority-based budgeting enables informed decision-making and efficiencies by linking financial resources to strategic funding priorities and goals. There were three key wins for the solution in Q4, with large clients, including LA County, California, Kansas City, Missouri, and Johnson County, Kansas, adding a total of nearly $1.8 million ARR. We're excited to partner with these clients as they implement their data-driven applications, leveraging our deep domain expertise and industry-leading best practices. We continue to drive higher cloud adoption for our public safety solutions, with both new competitive wins and a growing number of flips. Notable SaaS wins included the Southwest Regional Communications Center, a Texas 911 consortium in the Dallas Fort Worth area, and Peoria, Illinois, which dispatches for ten different agencies, each contracting for our full enterprise public safety suite. We also continue to build momentum at the state level with our public safety solutions. We signed three enterprise public safety deals with state agencies in the quarter, including SaaS contracts with the Iowa Department of Public Safety, which was a competitive effort leveraging our digital solutions division state enterprise relationship and contract vehicle, and also the Michigan State Police. We also signed a license deal with the Nebraska State Patrol. We now count nine state police agencies as enterprise public safety clients. In our state and federal business, we signed an eight-year contract with the state of Maine for a resident engagement portal, adding $2.2 million in ARR. This competitive win leveraged our strong state relationship as a trusted partner, offering deep public sector domain expertise and strong references from other successful implementations of our resident engagement platform. At the core of our growth strategy, leveraging our unmatched install base through cross-sell and upsell initiatives, we added to our growing footprint in outdoor recreation, signing a multi-year SaaS arrangement with the South Carolina State Parks under our state enterprise master agreement. Additionally, we signed a contract with the Colorado Department of Corrections for an inventory warehouse management solution, leveraging our Colorado State Enterprise relationship, to add $612,000 ARR. Driving transaction revenue growth through our integrated payments business is another key element of our growth strategy. Our payment strategy is centered on a high-value unified platform that seamlessly integrates with our software solutions and proprietary back-office services, creating opportunities for higher margins. Demand for our differentiated payment solutions continues to be strong, and in the fourth quarter, we signed 244 new payment deals across Tyler software clients, representing approximately $8.1 million in projected ARR. For the year, we signed 995 new payments deals. In our state enterprise business, we secured a two-year extension for our digital government and payment processing services with the state of Utah, representing approximately $11.5 million in ARR. Now I'd like to provide Brian to provide more detail on the results for the quarter and our annual guidance for 2025."
},
{
"speaker": "Brian Miller",
"content": "Thanks, Lynn. Total revenues for the quarter were $541.1 million, up 12.5% and organically grew 12.4%. Subscriptions revenue increased 21.9% and organically rose 21.8%. Within subscription, SaaS revenues grew 23% to $173.4 million and grew organically 22.8%. Keep in mind that there's often a lag from the signing of a new SaaS deal or flip to the start of revenue recognition that can vary from one to several quarters. Because of this, as well as the timing of SaaS renewals and related price increases, SaaS revenue growth both year over year and sequentially may fluctuate from quarter to quarter. Transaction revenues grew 20.9% to $175.4 million, driven by new transaction services, higher transaction volumes from both new and existing clients, including the August go-live of the California Department of Parks and Recreation, and e-filing growth. While Q4 is historically a seasonally lighter quarter for transaction-based revenues, we are seeing slightly less seasonality than in previous years, as we continue to diversify our mix of revenue, including digital titling services that are less seasonal, and outdoor recreation services that have different peak periods from state to state. As Lynn noted, we had a very good quarter for bookings in Q4, with a marginal benefit from field timing associated with the year-end deadline for allocating ARPA funds. SaaS deals comprised approximately 97% of our new software contract value, compared to 89% last year. During the quarter, we added 150 new SaaS arrangements and signed 106 best flips of existing on-premises clients, with a total contract value of approximately $194 million, up 42%. In Q4 of last year, we added 156 new SaaS arrangements and had 92 flips with a total contract value of approximately $137 million. The average ARR from new SaaS contracts increased 63%. The average ARR associated with our Q4 flips increased 32% over last year, as we continue to see larger clients flip to the cloud. Our total annualized recurring revenue was approximately $1.86 billion, up 14.9%. We entered 2024 expecting margin expansion operating margin. After experiencing the margin trough from our cloud transition in 2023, and we have exceeded our expectations. Our non-GAAP operating margin in the fourth quarter was 24.4%, up 210 basis points from last year. The margin expansion reflects the impact of our cloud efficiency initiatives along with effective operating expense management. As we discussed on previous calls, merchant and interchange fees from our payments business under the gross revenue model have a meaningful impact on our overall margins as they are included in both revenues and cost of revenues. We incurred merchant fees of approximately $41 million in Q4, compared to $35 million last year. Because of strong earnings and effective working capital management, both cash flows from operations and free cash flow reached new highs for our fourth quarter at $224.8 million and $216 million respectively, with free cash flow up 60.7%. Cash flow in the quarter was positively impacted by two significant items. The first was a $29 million prepayment in October of six years of SaaS fees related to our new enterprise justice contract with the state of Kentucky. The second was the timing of funds that we routinely collect and disperse through Tyler disbursement platform, formerly Rapid. At year-end, approximately $25 million of cash was held by Tyler that was subsequently dispersed under these contracts. We ended the quarter with $600 million of convertible debt outstanding and cash and investments of approximately $779 million, and net leverage is zero. Now I'd like to turn to our annual guidance for 2025. We expect total revenues will be between $2.30 billion and $2.34 billion. The midpoint of our guidance implies organic growth of approximately 8.5%. We expect GAAP diluted EPS will be between $7.31 and $7.56 and may vary significantly due to the impact of discrete tax items on the GAAP effective tax rate. We expect non-GAAP diluted EPS will be between $10.90 and $11.15. Our estimated non-GAAP tax rate for 2025 is expected to be 22.5%. We expect our free cash flow margin will be between 24% and 26%, including an estimated impact of approximately $27 million of incremental cash taxes related to section 174. We expect research and development expense will be in the range of $177 million to $182 million. Other details of our guidance are included in our earnings release and in the Q4 earnings deck posted on our website. I'd like to add some additional color around our guidance. Subscription revenues in total are expected to grow between 15% and 18%, and within subscriptions, SaaS revenue is expected to grow between 21% and 24%. Transaction revenues are expected to grow between 10% and 12%, with merchant fees down 7% to 9%. Our expected transactions growth is below the 2024 growth rate and will be impacted by the wind-down of our payments processing contract with the state of Texas, which currently expires at the end of August 2025, and was awarded to another payment vendor after a competitive procurement process. The Texas contract is a standalone, somewhat commoditized payments arrangement and differs in a number of respects from our core payment strategy, which is centered on providing differentiated payment solutions integrated with our software solutions, enterprise portals, and proprietary back-office services that add value to our clients and provide opportunities for premium pricing. For background, the payment relationship with Texas was not an organically developed relationship but was part of a state enterprise agreement that NIC purchased from BearingPoint following their bankruptcy in 2009. That contract was split in 2017, with NIC retaining the payment services, and it was subsequently extended through August of 2025. We knew that the rebid would be highly competitive and price-sensitive, and margins under the existing contract were already very low. There were no issues with the quality of our services, and we believe that price was the significant factor in the award. The Texas payments contract is a gross contract with 2024 revenues of approximately $44 million, merchant fees of approximately $39 million, and a gross margin of approximately 10%. We currently expect that 2025 revenues from Texas payments will be approximately $29 million at a similar gross margin. While we expect to continue to provide payment services to Texas through August, it is possible that some services may transition prior to then. Excluding emergencies that are absorbed under the gross revenue model, expected transactions growth in 2025 would be approximately 17%, and total growth would be approximately 10%. Given the narrow margins of the gross model Texas contract, we will see a positive impact on margins as these services end. Maintenance revenue is expected to decline 4% to 6%, reflecting the ongoing shift in our new software business mix to SaaS, as well as the acceleration of flips in 2024 and 2025. Professional services revenue is expected to be flat to down 3% as our cloud transition drives efficiencies in implementations and allows us to limit the growth of these lower-margin revenues. License revenues are expected to decline 18% to 20% with very few license sales to new clients. Hardware and other is also expected to decline 18% to 20% as 2024 benefited from elevated hardware sales tied to the use of ARPA funds. Research and development expenses are expected to grow more than 50% due to three main factors: The first, representing approximately 30 percentage points of the growth, is a redeployment to R&D of development resources previously focused on support activities and expense and cost of revenues. As we continue to transition to a SaaS-only model, this redeployment will continue over the next few years as product lines complete their transition to SaaS-only. Secondly, certain capitalized software development projects either concluded in 2024 or will conclude in 2025, resulting in more development costs being expensed and accounting for approximately eight percentage points of the R&D growth. The remaining growth represents our incremental funding of R&D initiatives, including investments in AI. Now I'd like to turn the call back over to Lynn."
},
{
"speaker": "Lynn Moore",
"content": "Thanks, Brian. 2024 was another successful year in advancing our cloud-first strategy. We delivered growth and consistent operating margin improvement, tracking towards our 2030 objectives. Our sales organization continues to execute at a very high level, which was reflected in our bookings growth. Our unified go-to-market strategy is creating substantial expansion opportunities with both new and existing clients. Our inside sales team has performed exceptionally well, representing a high-growth sales channel. We're investing across our sales channels and adding additional sales resources, including a new dedicated state sales team that will be in place this year. We've also aligned incentive compensation and commissions across Tyler in a way that has reduced barriers and facilitated more cross-sell. We take very seriously our responsibility to be good stewards of the capital that our shareholders entrust us, which we have exhibited through our long history of disciplined financial management and prudent capital allocation. That continued to be the case in 2024. In a high-interest rate environment, we fortified our balance sheet by paying off the remaining term debt associated with the NIC acquisition, reducing our net leverage to zero at year-end. Additionally, we enhanced our financial flexibility by replacing our $500 million unsecured revolving credit facility with a new facility extending maturity to 2029, increasing the size to $700 million with improving terms. Our disciplined acquisition strategy focuses on opportunities that complement our existing portfolio, expand our addressable market, and add technologies that can be leveraged across our product portfolio. We remain patient acquirers and are well-positioned to continue to make tuck-in acquisitions while maintaining the flexibility to pursue compelling larger opportunities. But we did not make any acquisitions in 2024. I want to highlight our recent acquisition of MyGov, closed January 31st. MyGov is a leading provider of integrated community development and asset management solutions to small and mid-sized municipalities and currently serves approximately 150 clients, with a high concentration in Texas. MyGov strengthens our public administration offering and expands our local market footprint with an integrated platform that complements our extensive enterprise portfolio. We're thrilled to welcome the MyGov team and clients to Tyler. AI continues to garner significant attention in the software space, and interest in AI from the public sector is growing. Building on our momentum and commitment to innovation, we are taking a deliberate and strategic approach to our AI strategy centered on three core pillars: productivity, decision-making, and service delivery. We're separating the hype from reality by leveraging our unmatched strengths of decades of public sector experience, 13,000 clients producing critical data every day, and deep collaboration with leading AI vendors like AWS, Microsoft, and Google. We expect that by the end of this year, every flagship product roadmap will have clear AI-driven features, and we plan to preview our AI strategy to clients at our Tyler Connect user conference in May, demonstrating our commitment to innovation and empowering clients with dramatically enhanced productivity and performance. I'd like to highlight some recently announced additions and changes to our senior leadership team that support our commitment to long-term growth and leadership development. As we enter the next phase of our cloud-first transition, we took a significant strategic step toward further enhancing our client experience with the creation at the end of 2024 of a new chief client officer role. Our appointment of industry leader Andrew Call to that position is critical to strengthening our long-term client relationships, maximizing the value of our installed base, and driving expansion through cross-sell and upsell opportunities. Andrew will oversee our client-centric approach across Tyler's vast public sector client base. He brings extensive technology leadership experience, having served as CEO of Backbox Software, the global category leader in the network security automation market, where he led cloud transformation and business model evolution. In his previous positions, he held multiple client success roles and served as chief customer officer at SailPoint, overseeing global customer success and partner enablement. Andrew's deep technology background and track record of driving innovation and client engagement positions us well for success as we scale our cloud initiatives and create a single unified experience for clients with multiple Tyler products. Our chief marketing officer, Samantha Crosby, has announced her intent to retire this June. In her 16 years with Tyler, Samantha's visionary leadership in developing our unified brand strategy and her contributions across marketing and communications have been instrumental in our growth and success. Until June, we will continue to tap into Samantha's immense experience during her transitional senior marketing adviser role, and we extend our heartfelt appreciation to Samantha for her dedicated service. In January, we named Eric Flanders as chief marketing officer, succeeding Samantha. Since joining Tyler's marketing team in 2023, Eric has significantly enhanced our digital marketing operations, technology and data practices, and demand generation strategies. Prior to joining Tyler, Eric gained extensive experience as an innovative leader in progressively responsible global marketing management roles with Texas Instruments. Abby Diaz, previously our chief legal officer, has been elevated to the newly created position of chief administrative officer. In this expanded role, she will continue to oversee our legal team, adding responsibilities for internal audit, data privacy, corporate governance and responsibility, and corporate communication. This transition strengthens alignment across these critical functions and fosters an integrated approach to governance, compliance, and communications. Associate general counsel, Bill Van Essel, has been promoted to chief legal officer and assumes direct leadership of the legal team. Bill joined Tyler in 2021 through the acquisition of NIC, where he served as general counsel. Lastly, I'm pleased to highlight that Tyler has recently been recognized by multiple leading publications for our commitment to excellence, innovation, and workplace culture, including Forbes' American Dream Employers and Best Large Employers 2025 list. In December, we were named AWS State or Local Government Partner of the Year, and most recently, we were named to the 2025 GovTech 100 list for the ninth consecutive year. As we enter 2025, I'd like to repeat what I said to our Tyler team in our recent town hall: that I'm not just excited about Tyler's future, but I've never been more confident in our future. We're experiencing success in growing our high-value SaaS and differentiated transaction revenues while reducing the mix of lower-margin revenues like professional services and commodity payments. As our 2025 guidance illustrates, we're well on track to meet or exceed the 2025 targets we communicated at our 2023 Investor Day, and we remain confident in realizing our Tyler 2030 vision. I look forward to reporting on our progress during the coming year. Now I'd like to open up the line for Q&A."
},
{
"speaker": "Operator",
"content": "We'll now begin the question and answer session. To answer a question into the question queue, if you are using a speakerphone, please pick up your handset and press the star key and the number one. To withdraw your request, press the star key and the number one. As a reminder, please limit your question to one question so we may have more time for progress. We will pause momentarily to assemble our roster. Your first question comes from the line of Alexei Gogolev, JPMorgan. Please go ahead."
},
{
"speaker": "Alexei Gogolev",
"content": "Good morning, everyone, and congratulations on the amazing results. Lynn, could I first start with your payment comments and comments that Brian made? It's clearly appears that you're prioritizing profitability within payments. As you mentioned, you're moving away from commoditized products. Could you perhaps elaborate on the announcements made by Fiserv at their recent earnings call around the expansion of their payments partnership with Tyler? What does that imply longer term for your partnerships with other third parties? And do you think that expansion of the Fiserv partnership could benefit your margin outlook?"
},
{
"speaker": "Lynn Moore",
"content": "Thanks, Alexei. So that was there's a lot in there. I'm gonna I'll try to hit all the points. If not, I'm sure Brian or someone else will catch up. I think our strategy at Tyler has always been to not really pursue commodity payments. And I think when you look back, you know, pre-Tyler's acquisition of NIC, I think the viewpoint there was more sort of any payments deal was a good deal, and that's not really what we're pursuing. We don't really want to pursue those pure payment contracts. It's commoditized pricing. It's low margin. It's not sticky. They come up for rebid. It's a race to the bottom. We want to be there where we have a differentiated offering that we connect to our back-office systems, that we do reporting, that we can drive higher margins and drive higher revenue. So I think that's sort of been where we've been the last couple of years, and I don't think that's changed. As Brian mentioned in the comments, we inherited the contract. We were happy to have the Texas contract. It showed it was showed our relationship with Texas. It showed our ability to do payment processing. But again, there was no additional add-on or stickiness that we were bringing with that. As it relates to Fiserv, Fiserv is one of our larger payment processors. They had a long-standing relationship with NIC prior to our acquisition. They primarily or exclusively right now serve our payment processing in the state market within NIC. What Fiserv does is they provide a lot of technology, and I think that's really what you're seeing from that relationship is it's an opportunity for us to really tap into some of the technology that they deliver. As of right now, it does not impact our other payment processing vendors. We use a handful of other ones. But it's sort of when I look at payment processing, I almost think back about how we were when we made our decision to go to the cloud and AWS and really to exit our data centers. When you think about things we used to talk about, you know, Tyler running its own data sets. We're not in the data center business. And we're not really in the payment processing business. And we're not going to invest in some of the technology around there the way that some of the core payment processors do. I mean, we have some of that, and we do invest, but I think going forward, being able to leverage broader technology and capabilities that can help our client base around things like enhanced fraud protection and cryptocurrency and things like that. So, you know, we're looking to deepen our relationships with payment processing providers so that we can leverage the things that they're really good at and we can leverage the things that we're good at. I mean, it's I think part of your question was which will ultimately drive higher margins for Tyler."
},
{
"speaker": "Alexei Gogolev",
"content": "Appreciate it, Lynn. And speaking about the increases in investments, based on what Brian suggested, and what you said, you're clearly investing in AI. So all that portion that is incremental this year. Looking forward to seeing those products at the main conference. How much of that is coming from AWS, which I'm assuming is probably your main partner that you're collaborating with? And are there any joint investments that you're doing or joint products that you're hoping to introduce?"
},
{
"speaker": "Lynn Moore",
"content": "Well, that's a good question. We obviously partner with AWS on a lot of things. Yes, they are helping us with roadmaps on not just AI, but just even other things with respect to our cloud initiative. We do have a number of investments in our 2025 plan around that AI. Those are both new headcount, but also repurposing of our existing headcount. Again, as I mentioned in my remarks, we're going to have all of our major applications will have some sort of AI component and feature, and we're gonna unveil some of those or a lot of those at Connect this spring."
},
{
"speaker": "Alexei Gogolev",
"content": "Appreciate it, Lynn. Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Joshua Reilly of Needham and Company. Please go ahead."
},
{
"speaker": "Joshua Reilly",
"content": "Great. Thanks for taking my question. If we look at the guidance of down 4% to 6% on maintenance revenue, clearly, you have some line of sight around migrations to kind of provide this revenue guidance sits down a little bit more this year. Can you help us understand the level of visibility you have right now on migrations for the year to provide that guidance? And are these migrations broad-based, or is there a particular product line that's accelerating the migration?"
},
{
"speaker": "Brian Miller",
"content": "Yeah. I think the migrations are generally pretty broad-based. Each product has a different sort of roadmap and timeline for its customer base, and as we get further down the road, we generally have more visibility over that. I'd say public safety is certainly an area where we've seen a pretty rapid increase in the desire to be in the cloud, both from new customers and existing on-premises customers. So I guess on a percentage basis, you're probably seeing more of an increase in the public safety. That flips the it's really across all customers and or all product lines, and we've said that right now, we still sort of envision a bell-shaped curve over the next several years as we move towards those long-term targets. We think 2027 and 2028 will probably be those peak years. But we'll continue to see a higher level of flips in 2025 than we did in 2024, and that will continue on through 2026, 2027, 2028. So we have decent visibility. Sometimes we're engaged with large numbers of our customers around the process of flipping. We've talked in the past about some of the things like cybersecurity attacks, ransomware attacks, their challenges in running their own internal networks and data centers, the replacement of hardware, all those things as factors that drive them to want to flip to the cloud. As well as our continued move to the cloud and focus there, the release of new features that are sometimes only available in the cloud. So all those things are contributing to that increased momentum towards flips. You know, we have a range, so sometimes the timing of when those flips actually sign and then that, like, from when they sign to when they're actually live is a factor in where we perform in that range, but I'd say we have pretty decent visibility over that."
},
{
"speaker": "Joshua Reilly",
"content": "Awesome. Thank you. I'll leave it to one question."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Ken Wong of Oppenheimer. Please go ahead."
},
{
"speaker": "Ken Wong",
"content": "Great. Thanks for taking my question. Brian, I wanted to ask about cash flows, you know, recognizing that this was a particularly strong cash flow year, which, you know, kind of creates the tougher comp into 2025. But as we kind of map out our models going forward, I mean, should we assume that some of the strength this year is gonna be a drag into future out years, or just trying to get a sense for kind of how we should kind of when we should start to kind of ramp up the cash flow growth?"
},
{
"speaker": "Brian Miller",
"content": "Yeah. We called out the two items that totaled around $55 million of incremental cash flow in the fourth quarter, that the Kentucky prepayment, which we talked about last quarter. That's a very unusual sort of an item where with the six-year prepayment. And then that so the timing of the float around some of the client money that flows through us for disbursements. That is a recurring item, but it was unusually high from some new customers at the end of right at the end of December, so that incremental, you know, $25 million or so kind of gave us a boost. But, you know, if it had happened two days later, it would have been in next year's cash flow. So sort of if you take those two items and sort of set them aside, our normalized what I'd sort of call it normalized cash flow margin would have been 24.3% for 2024, which is still above, you know, what we had targeted and what our guidance was at the beginning of the year. And so that would imply, you know, it's a midpoint of our guidance for 2025. That would imply another 100 basis points of margin expansion, free cash flow margin expansion in 2025. So some of the stuff has been pulled forward. We're seeing certainly some of the margin benefits sooner. But I think we'll continue to progress towards those 2030 targets that we talked about, you know, high 20s, 30% sort of range of free cash flow margin. So we're getting there a little faster, but I think we still have an upward trajectory and sort of normalized that still implies some expansion next year."
},
{
"speaker": "Ken Wong",
"content": "Got it. Thanks, Brian."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Kirk Materne. Evercore ISI. Please go ahead."
},
{
"speaker": "Dylan",
"content": "Hi. This is Dylan for Kirk, and thank you for taking my question. The prepared commentary mentioned strong cross-sell momentum."
},
{
"speaker": "Lynn Moore",
"content": "Yeah. No. I think I don't know that I would say anything specific. It's really across all of our product lines. You know, some of the things that we've done in the last couple of years around I mentioned in the prepared remarks around sales comp and incentives. Other things we one internal one Tyler initiative we've done have really been fueling this, but look, our sales teams have are just really knocking it out of the park. Last year was a really great sales year. Generally speaking, if you look across Tyler as a whole, we generally either add or exceeded, you know, our quotas for the year, which is really encouraging. What's exciting about me, I mentioned in my remarks about being excited for the future, not only is it how we're performing against the metrics that we set out in investor day. We're also now, you know, able to make some more investments into Tyler that are gonna keep fueling that growth without sacrificing margins. You know, we are making some additional investment of the change there. But we're making some investments in our sales teams. We're making investments across our inside sales teams. I mentioned the creation of a new state sales team. We've done things and looked at territories and quotas. So there's a lot of stuff going on right now that's exciting, but it's really across the board of Tyler."
},
{
"speaker": "Dylan",
"content": "Great. Thanks for taking my question."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Saket Kalia, Barclays. Please go ahead."
},
{
"speaker": "Saket Kalia",
"content": "Okay. Great. Hey, guys. Thanks for taking my question here. Lynn, maybe for you, I just wanted to flush out the question on those just a little bit more. You know, federal is clearly a small part of Tyler's business. I mean, I think you said it's probably 5% or less. Right? But I was wondering if you could speak to just roughly how much of an average state or local government budget comes from federal funding versus other sources like real estate taxes. And I know you spend a lot of time with customers. As you speak to customers, what are they saying about Doge, if anything, as they think about investing in tools like Tyler?"
},
{
"speaker": "Lynn Moore",
"content": "Yeah. It's a good question. I don't know that I have the Brian, you have that number?"
},
{
"speaker": "Brian Miller",
"content": "Yeah. I've got some sort of high-level averages on where government revenues come from, and at the local level, there's very, very little federal funding. There can be some grants around specific things. And generally, on a national average at the local level, about 14% of their revenues come from state funding, which can include some trickle-down from federal, but almost half of their revenues are from local taxes and another 17% from general charges like licenses and those sorts of things. So very, very little funding at the local level from federal revenues. And at the county level, there's roughly a quarter of their budgets tend to come from state funding, which again can include some trickle-down from federal. But again, at the county level, mostly, you know, 40% or more from local taxes. So not a whole lot that gets down to the local level, which is the vast majority of our revenues."
},
{
"speaker": "Lynn Moore",
"content": "Yeah. I'd say I'd just echo the comments I made in the opening remarks, which I view it and I think Tyler views it as really an opportunity, not a risk. There's a big splash going on out there right now. But the crux of that is how do we make government more efficient? How do we make sure we're not wasting dollars? You look at I mentioned this priority-based budgeting deal. Deals we did in Q4 with the city of LA. That's what that solution is all about. You know, we signed a $1.2 million ARR deal with the city of LA for that offering. So to me, you know, I'm not hearing from our clients that that's going to create a pause in spending. What I believe it's going to do is create more partnership opportunities and then looking for us to help to continue to help them find ways to be more efficient, which is really our been our business model for, you know, since I've been at Tyler 26 and a half years. So I don't see that as any as a headwind. I see it as an opportunity going forward."
},
{
"speaker": "Saket Kalia",
"content": "That makes a ton of sense. Thanks, guys."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Alex Zukin of Wolfe. Please go ahead."
},
{
"speaker": "Alex Zukin",
"content": "Hey, guys. Congrats on another great quarter. Maybe, Lynn, just first for you. Can you just maybe you touched on this in the prepared remarks, but maybe go a little bit deeper on just the quality of the demand environment, the pipeline going into this year, because it seems like, again, specifically on the SaaS line, it continues to outperform your expectation. I think you're even now guiding to an acceleration for next year. So what's been driving this faster than expected or faster than you anticipated conversion story? And how does AI play into this mix of maybe, you know, in addition to the cyber threats that have accelerated some of these migrations, actually also layering on top of that as a driver for the increased velocity of those conversions?"
},
{
"speaker": "Lynn Moore",
"content": "Yeah. There's a lot there. Our, you know, I just say generally, and we've been saying this for some time, which is really budgets are healthy and stable. Leading indicators are all steady. Our competitors remain strong. Just touched on it a couple of questions ago. Our sales team continues to execute at a really, really high level. And the more that we are getting better at our story of OneTyler and cross-selling and divisions helping other divisions sell and move product, it gains its own momentum. Then you're seeing things in the acceleration of SaaS we've talked about, public safety and the acceleration there. We often talk about how our clients, you know, they don't compete with each other. In fact, they share information with each other, and one of the things we've always been really, really good at is getting clients up and live in how we deal with our clients, whether it's a flip or a new client. And the more that our clients see us perform that and the efficiencies that start coming to the client, the more that they talk, then the more demand it creates for us and our services. So to me, it's a bit of a mini flywheel where we just continue we're building on our own momentum. But also, look, it starts with our people. It starts with really excellent sales execution. And it's excellent execution from our implementation people, from our services, from our support up and down the board. It's the stuff we don't spend enough time talking about it, but it's the stuff that really makes Tyler go. And I couldn't be more proud of our people for driving that kind of success."
},
{
"speaker": "Brian Miller",
"content": "And I'd just add that at this point, I don't think AI is really a big driver of either flips or new business. I think most things. Government doesn't want to be the first adopters, but a lot of our clients are very curious and want to know more about AI. They're looking for us in many cases to help show them the way that AI can increase productivity and make them more efficient. And as Lynn said, we'll be talking about that at our user conference coming up in May and making investments there. We have a story in each of our major products. But at this point, I don't think it's a significant factor in that cloud acceleration, but down the road, it'll certainly be another area that provides us competitive advantage."
},
{
"speaker": "Alex Zukin",
"content": "Excellent. And then, Brian, maybe on the R&D investment side. We've never necessarily covered the company. I think I've been waiting for that to come out of the cost of goods line and make its way onto the R&D line. Maybe just dive a little deeper on the trajectory that you see as the maintenance stream continues to kind of, you know, as those conversions pick up, how should we think about that R&D line even maybe beyond just this year taking on a different shape over the course of the next few years?"
},
{
"speaker": "Brian Miller",
"content": "Yeah. You know, there's talk about roughly, there's $100 million of development expense that's in cost of sales. This year, about $35 million we believe will be redeployed to the R&D line, and that's really tied to as individual products and development teams reach certain points where they're more cloud-focused and less focused on support and development around existing on-prem products. So that'll take place over the next several years, the balance of that or a big part of the balance of that $100 million moving and being redeployed to the R&D line. I'm not sure exactly how that trajectory will play out, but we just we'll see that over the next few years. But probably more front-end loaded over the next let's call it three to four years."
},
{
"speaker": "Lynn Moore",
"content": "And, Alex, to be clear as well, while the bulk of this is cost of sales, we are adding R&D people. I mentioned it earlier. We are making some investments in AI. We are making some other competitive investments across some of our core applications. So it's not just a shift that we are also increasing our investment in R&D."
},
{
"speaker": "Alex Zukin",
"content": "Perfect."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Michael Turrin of Wells Fargo. Please go ahead."
},
{
"speaker": "Michael Turrin",
"content": "Hey, thanks. Greg, good morning. I appreciate you taking the question. The commentary throughout the call, the Q4 results show an uptick in SaaS momentum, some of the growth metrics. The initial 2025 guide for overall growth, Brian, of 8.5% doesn't at least appear to fully capture some of that momentum. So maybe just speak a bit more to the mix of what you're seeing across segments, how that impacts total growth, and is there any change to the guidance approach you're embedding for 2025 here at all. Thank you."
},
{
"speaker": "Brian Miller",
"content": "There's not really a change to the approach. You know, one thing we point out is and then we did give a little bit more information around the ranges of growth expected for each of the major categories, and clearly, the growth is more on the high-value and higher-margin revenues. So, you know, SaaS revenues that range up 21% to 24%, which is kind of consistent with what we've seen in terms of bookings growth this year in kind of that low 20s. And so as that turns into revenues as the deals get implemented and those customers go live, the flips take place. That kind of mirrors the kind of growth we've seen in bookings. Transactions, up 10% to 12%, that does encompass the roughly $10 million decline from the wind-down of the Texas agreement. So excluding that, our transactions growth would be more up in the mid to upper teens. Maintenance is going down as we expected with the flips, and professional services is going down slightly, which is a good thing given that the margins around professional services and our ability to be more efficient around. So I'd say that the philosophy around our guidance is really not changed, and, you know, we give a range that encompasses what we believe are the various risks and opportunities embedded in there, and we would expect to fall within that range."
},
{
"speaker": "Lynn Moore",
"content": "And, Michael, I'd add and sorry, Alex. I think I called you Mike on the last question. I apologize for that. Just echo what Brian said. Look, our quality revenue lines are actually the ones that are gonna drive our growth. Those are the ones we focused on investor day. SaaS and transactions. There is a little bit of there is some noise in this year's financials from the Texas payments. That's actually gonna show up a little bit like last year. If you pull out those merchant fees, we're growing at our 10% target, which is good. But again, if you look at the metrics that we shared, the things to focus on at investor day, they're tracking either at or above where we said they'd be two years ago. And that's all extremely encouraging."
},
{
"speaker": "Michael Turrin",
"content": "That's all very helpful. Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Charles Strauzer of CJS Securities Incorporated. Please go ahead."
},
{
"speaker": "Charles Strauzer",
"content": "Hi. Good morning. Prime ABCU. Maybe initially shed some light on the abnormally high stock comp implied in the guidance."
},
{
"speaker": "Brian Miller",
"content": "Yeah. It looks like the stock comp, it goes up a bit next year, mostly related to expectation, you know, the higher level, higher stock price that we're going into the year with relative to where we were last year as the stock grows through the year. But generally, the dilution that we're going to see from the from new issues of stock compensation is pretty modest. There is an impact from the convert in the dilution, but stock comp should be really mostly related to just a higher stock price."
},
{
"speaker": "Lynn Moore",
"content": "Yeah. So Charlie, if you look at this year versus last year, I think our plan that we're gonna probably experience somewhere around 28 to 30 cents of dilution year over year. That's a combination of we obviously had a nice run on the stock last year. A number of option exercises. That will now have the full weight of the year plus the full value to convert. You step back and look at our compensation plans and how we do things with Tyler, you'll recall that in 2022, we stopped issuing options and went to purely share-based, mostly performance-based, and some are issued on an annual basis, the number of shares that will be approved that were approved by the board and that will be issued here. Less than on a net share issuance, less than four-tenths of one percent of our outstanding. So it's something I watch carefully every year. I think from a technology company perspective, our dilution is pretty modest. And I would expect that to continue going forward."
},
{
"speaker": "Charles Strauzer",
"content": "Great. Thanks for the clarification."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Clarke Jeffries of Piper Sandler. Please go ahead."
},
{
"speaker": "Clarke Jeffries",
"content": "Hello. Thank you for taking the question. You know, Brian, Lynn, I'm reflecting on the initial free cash flow guide you had for 2025 at the Analyst Day that was a midpoint of 18%. And I think, you know, since here less than two years later, we're over 700 basis points higher than that original estimate. And so I guess I wanted to ask the question, you know, reflecting on that. What has been the most significant outperformance? And with some of these items that still seem like margin tailwinds that are pretty controllable here over the next few years, you know, reduction of commodity payments, maybe scaling some of those R&D costs that might be accelerating in 2025, and then the data center closure. You know, why aren't long-term margins going higher in your mind as we get to, you know, the later part of those long-term targets for 2030?"
},
{
"speaker": "Lynn Moore",
"content": "Well, Clarke, I think that's a fair question. And I would say that we're I'll repeat what I said earlier. I'm really confident in Tyler's future. And, you know, we set four targets two years ago. We've kept our eye on the ball. We have outperformed those targets, as you mentioned, both from a SaaS growth perspective and even transactions, but also from a margin perspective, and we're starting to see those. I'm not sitting here today ready to adjust our 2030 targets. I'm just I'm really happy with where we sit here in 2025. As I told the management team, we have to hit our 2025 targets, and we're doing that, and again, the entire management team is focused on it. We will, you know, when we look up two years from now, three years from now, and maybe adjust those, we might. I don't want to get ahead of our skis. You know, we still have a lot of initiatives going on within Tyler. Again, I'm excited about all the signs that we're seeing out there, some of the things that you pointed to. But I'm not ready to declare that victory on our 2030 Investor Day. Now it's time to up the ante. We just want to keep executing and moving forward."
},
{
"speaker": "Brian Miller",
"content": "And I think cash flow, as you point out, we are well ahead of the targets that we originally set out for 2025. I think we've had some assumptions there around things like cash taxes, working capital. I mean, we've been very effective about managing those. We've had effective management of receivables that have given us an impact sooner. And then clearly, the fact we're also ahead on margins and that flows through the cash flow. So a lot of that is a pull ahead, but as Lynn said, that makes us, you know, highly confident of those longer-term targets as well. And, you know, as we move down the road, we'll look at adjusting those if that's appropriate."
},
{
"speaker": "Clarke Jeffries",
"content": "Thank you very much. And absolutely. I mean, the last two years is a very encouraging result. Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Rob Oliver from Baird. Please go ahead."
},
{
"speaker": "Rob Oliver",
"content": "Great. Thanks. Good morning, Lynn and Brian. My question is around the cloud-optimized products. Appreciate that you guys have been very methodical about laying out milestones for the street and hitting those milestones, and a lot is going on behind the scenes. I was wondering if you could update us on you mentioned you'd made progress in 2024. If you could update us on where we are with the cloud optimization of your products and what sort of milestones we should be looking for as the investment community over the next couple of years to get fully cloud optimized. Thank you."
},
{
"speaker": "Lynn Moore",
"content": "Yeah. I don't know that I'm ready to put out a specific metric. All I can tell you is sitting here today in 2025 in February 2025, I'm really pleased with where we are in our cloud transition, which includes the optimization of our products. There's still more room to go. I'm really pleased with where we are on version consolidation. If you would have told me three years ago that some of our core applications, for example, our enterprise ERP application, you know, over 95, 97 of our clients run a single version. Enterprise Justice, you know, I think we're north of 75 on a single version. These are things that were big moves, and I wasn't quite sure when we would get there. And to me, we're ahead of schedule. And all of that starts to feed into each other. We're gonna continue to make optimizations to the cloud, but we're also gonna continue our efficiencies in how we deliver the software as we continue to evolve into a more continuous improvement, continuous delivery. That's going to take time. But that is part of our goals. And I think as you look out to, you know, the later part of this decade, those are big milestones is when we really start moving down into synchronized cadence releases across our client base, across our major products. And we're making progress towards those goals."
},
{
"speaker": "Rob Oliver",
"content": "Great. Thanks, Lynn. Appreciate it."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Jonathan Ho of William Blair. Please go ahead."
},
{
"speaker": "Jonathan Ho",
"content": "Hi. Good morning, and congrats on the strong results. Is there a way for us to think about the impact that ARPA funding has had? And going forward, is there potentially any impact to agency spending confidence as this starts to wind down? Thank you."
},
{
"speaker": "Lynn Moore",
"content": "You know, we've talked about a lot over the last couple of years, Jonathan. ARPA funding has been around and in the background. It hasn't necessarily specifically driven a lot of deals. Although, I will say, that we got a few SaaS deals signed at the end of the quarter. Were on a shorter time fuse. We were going to win those deals anyway. Those were probably gonna be Q1 deals that got a little bit accelerated because there was some ARPA funding. You saw it we talked about it some last year in our hardware business school transportation business. One reason why our hardware line is going down this year, again, a low margin low margin line. I think generally, you know, I would more point to my comments of the general environment and the general health of the state and budget psych budget and local budgets, excuse me, and where we sit today and our competitiveness. I think it's been there. I don't if you're if you're I think part of your question is is it now is it a headwind going forward? I don't I don't believe it is. And there's still even even places where there are ARPA funds allocated, I believe there's still time for them to spend those. They had to earmark them. But again, I don't I've never viewed that as a as a material part of Tyler's performance over the last four to five years. It's there on the edges. And so therefore, I also don't view it as a headwind going forward. And doesn't change my confidence in our near-term or long-term sales projections."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Terry Tillman of Truist Security. Please go ahead."
},
{
"speaker": "Terry Tillman",
"content": "Yeah. Thanks for fitting me in here, Lynn, Brian, and Hala. It is a single question, but it's got a little bit of multiple tentacles to it. You know, all this narrative around Doge, what about some of that actually trickling down to some of these estates that we're hearing about? Maybe them thinking about efficiency incrementally and digitizing things. Are you hearing about anecdotally some increased conversations because of maybe this trickling down? And then the second part of this is you look at 2025 and just based on what you're seeing in terms of the pipeline, do you see any meaningful shift between just the composition of your business from local government versus state level? Thank you."
},
{
"speaker": "Lynn Moore",
"content": "I would say, next to the Doge question, no. We're not really hearing anything yet. And it's I don't really expect it to do anything other than to maybe spur more conversation around technology that can help them become more efficient. Those are still relatively new. Although, it was talked about before the new administration actually took over. But it's still relatively new. And our clients, at least that I know of, are not talking about it. I think if you look generally in 2025 and beyond, how we look at sales, I think it's still pretty consistent across the board, but I would go back to my comment in the prepared remarks. Look, we are in the midst of creating a new dedicated state sales team. It's something new to Tyler. It's going to be it's something I'm excited about. So, you know, I think we will start to see more product go in, but part of the mission of that sales team is really about representing the entire Tyler portfolio where it's our Cox solutions, our payments, our application platform, it's gonna be geared at not only where we have state enterprise contracts, but also looking at new states. Looking beyond our state enterprise contracts. Look, it's gonna take time for that to ramp up. I don't necessarily expect significant variance, but it's just another sales avenue that we're teeing up and investing in starting in 2025 that will take, you know, time to see meaningful results."
},
{
"speaker": "Terry Tillman",
"content": "Thanks, Lynn."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Mark Schappel with Capital Markets. Please go ahead."
},
{
"speaker": "Mark Schappel",
"content": "Hi. Thank you for taking my question. Lynn, I just want to ask about your priority-based budgeting solution. Appears to be off to a really strong start given the wins in the quarter. I was wondering if you could just provide an example or two of some public sector use cases that you're seeing your customers adopt around ResourceX?"
},
{
"speaker": "Lynn Moore",
"content": "Yeah. You know, what it does is it's a little bit different than, you know, sort of traditional line item budgeting, and it sort of looks it uses AI, it looks at the cost of all the programs that are out there, kind of lines budgets and programs and scores to those that, you know, really they look at an organization's priorities and sort of reshift dollars. It's relatively new. One of the things that we were excited about when we bought it is Chris Fabian, the founder, he's sort of known as the the leader, really, the leader in public sector around priority-based budgeting. And he is the expert in it's something that I think we can take and transport across our client base, you know, it's I think it's another example when our perfect tuck-in acquisitions and when we see large organizations like LA County or Kansas City taking this solution, it's pretty meaningful. We're able to do demos and fairly quickly show where organizations can achieve some real savings. There's been a lot of talk around those today. I can't think of a solution that we have that would be more in line with Doge than our priority-based budgeting solution."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Gabriela Borges of Goldman Sachs. Please go ahead."
},
{
"speaker": "Gabriela Borges",
"content": "Hi. Good morning. Thank you. I wanted to ask the Texas payments question in a slightly different way. Lynn and Brian, when you look at your revenue mix holistically, what percentage of business looks like the Texas payment business, meaning it's more commodity, it's lower margin, it's business type. Either you can focus on up leveling or perhaps at the time you might consider walking away from. Give us a sense of what sort of what the size of that quantum of business could look like today and where that could go longer term."
},
{
"speaker": "Lynn Moore",
"content": "Yeah. I think it's pretty small. Brian's looking for the numbers. Again, this is this was something we inherited with the NIC acquisition. It's not been a strategic focus for Tyler. When we talked earlier about our relationship with other payment providers, these are opportunities where we might be able to partner with them where they can provide those types of services and we can come on and do the types of things that around that that make our offering differentiated. You know, I think we talked a couple of years ago and it was something that was in the works when we acquired NIC. We talked about the IRS contract. That was another example of a pure payments and we quote had won that contract. They got it got protested and we subsequently lost it. You know, we built that into our with margins comparable to Texas. While we were disappointed that we lost it, it really it wasn't a strategic initiative for us. It's not a place we want to grow. And I wouldn't expect that going forward, Brian. Do you have?"
},
{
"speaker": "Brian Miller",
"content": "Yeah. We really we have two other enterprise states where we have separate payment contracts from the enterprise agreement, but they are states where we provide a lot of other portal services, other digital government services. It's just the payments contracts are separate. We have one other state, Florida, which is a payments-only contract. But it has a lot of differences from Texas. We have a lot of other value-added services that we provide there. And it's a very different kind of an arrangement in Texas. Other than that, we really don't have a lot of pure what we kind of call commoditized payments business. Generally, it's either at the state level when it's part of an enterprise agreement where we're providing a lot of services, many of which payments are associated with them, or now with our focus on the local level integrating it with our back-office software solutions and proprietary solutions that add that value."
},
{
"speaker": "Lynn Moore",
"content": "Yeah. I think just to answer that, Gabriela, as you know, a year ago, I changed all of our senior executive comp. When we look at our long-term performance drivers around margin and ARR to exclude the impact of merchant fees because it is we do not want to pursue these contracts which could, quote, theoretically, increase our ARR, but decrease our margins. So, you know, when I look internally at how I look at the business, I have all my presentations show me with and without merchant fees because that's really just to me showing the health of the business. Texas and its impact this year, I just want to remind you that this is something that's winding down this year, but we will continue to see the same headwind next year on a top-line basis. But excluding those merchant fees, like, as we said earlier, you know, Tyler's growing at right at 10%. Our transactions are growing between 15% and 17%. That shows the health of the business and where we're strategically going in the future."
},
{
"speaker": "Gabriela Borges",
"content": "Thanks, Lynn. Thank you."
},
{
"speaker": "Operator",
"content": "There are no further questions at this time. With that, I will now turn the call back over to Lynn Moore, Chief Executive Officer, for final closing remarks. Please go ahead."
},
{
"speaker": "Lynn Moore",
"content": "Thanks, Calvin, and thanks, everybody, for joining us today. If you have any other questions, please feel free to contact Brian Miller or myself. Thanks again, and have a great day."
},
{
"speaker": "Operator",
"content": "Ladies and gentlemen, that concludes your conference call. We thank you for participating and ask that you please disconnect your lines."
}
] |
tyl | 2,024 | 3 | [
{
"speaker": "Operator",
"content": "Hello, and welcome to today's Tyler Technologies Third Quarter 2024 Conference Call. Your host for today's call is Lynn Moore, President and CEO of Tyler Technologies. At this time, all participants are in a listen-only mode. Later, we will conduct a question and answer session and instruction will follow at that time. [Operator Instructions] And as a reminder, this conference is being recorded today, October 24, 2024. I would like to turn the call over to Hala Elsherbini, Tyler's Senior Director of Investor Relations. Please go ahead."
},
{
"speaker": "Hala Elsherbini",
"content": "Thank you, Rob, and welcome to our call. With me today is Lynn Moore, our President and Chief Executive Officer; and Brian Miller, our Chief Financial Officer. After I give the safe harbor statement, Lynn will have some initial comments on our quarter, and then Brian will review the details of our results and update our annual guidance for 2024. Lynn will end with some additional comments, and then we'll take your questions. During this conference call, management may make statements that provide information other than historical information and may include projections concerning the company's future prospects, revenues, expenses and profits. Such statements are considered forward-looking statements under the safe harbor provision of the Private Securities Litigation Reform Act of 1995 and are subject to certain risks and uncertainties, which could cause actual results to differ materially from those projections. We would refer you to our Form 10-K and other SEC filings for more information on those risks. Also, in our earnings release, we have included non-GAAP measures that we believe facilitate understanding of our results and comparisons with peers in the software industry. A reconciliation of GAAP to non-GAAP measures is provided in our earnings release. We have also posted on the Investor Relations section of our website, under the Financials tab, schedules with supplemental information, including information about quarterly recurring revenues and bookings. On the Events and Presentations tab, we posted an earnings summary slide deck to supplement our prepared remarks. Please note that all growth comparisons we make on the call today will relate to corresponding period of last year unless we specify otherwise. Lynn?"
},
{
"speaker": "Lynn Moore",
"content": "Thanks, Hala. We carried our momentum from the first half of the year into the third quarter and delivered remarkably strong results. The quarter was highlighted by strong top and bottom line performance, even as we saw a more pronounced shift towards SaaS and our new software contract mix, particularly in public safety, where expected on-premise license deals shifted to SaaS contracts in the quarter resulting in license revenues that were below plan. SaaS and transaction revenues fueled our growth and both exceeded our expectations. Our non-GAAP operating margin expanded to 25.4%, benefiting from our cloud efficiency initiatives and improved professional services margins and free cash flow reached a new quarterly high. As we've discussed in the past, our progress towards our 2025 and 2030 targets will not be linear. But our results through the first 9 months of this year bolster our confidence in achieving those top targets. We are beginning to see benefits from our cloud operations initiatives with efficiencies reflected in our results somewhat ahead of plan. Recurring revenues grew 12.1% and comprised 85% of our total revenues. Our SaaS revenues growth of 20.3% represents our 15th consecutive quarter of SaaS revenue growth of 20% or more, consistent with our target of a 20% CAGR in SaaS revenues through 2025. The public sector market remains robust, supported by healthy budgets and an increased focus on modernizing aging mission-critical systems through cloud adoption. The strong market activity we've discussed for the past few quarters along with excellent execution by our sales teams, is reflected in our new software bookings this quarter with our new SaaS contract value of approximately $105.6 million, up 78% over last year. Our leading market position, anchored by our deep domain expertise and large installed base forms the foundation of our long-term strategic focus on 4 key growth drivers: executing our cloud-first strategy, leveraging our unmatched installed base, expanding into new markets and growing our payments business. Our cloud-first strategy is a pivotal driver of our success and continues to shape our future in our cloud living culture. We are leading with cloud across our product portfolio as the public sector market continues to embrace digital modernization and choose Tyler's next-generation cloud solutions. Additionally, we've made substantial progress with our cloud optimization efforts, driving efficiencies and scalability, while also making solid progress on version consolidation to further accelerate on-premise client migrations and enable clients to easily expand their mission-critical applications in the cloud. The pendulum is continuing to shift to the cloud with both new and existing clients, and we are seeing a growing trend of client-driven SaaS adoption. This is especially apparent in areas that have previously lagged the rest of our market in terms of cloud adoption, most notably, the public safety market, along with the state and federal market with our application platform. Overall, SaaS arrangements comprised 97% of our new software contract value in the third quarter. For the second consecutive quarter, 100% of our public safety new contract value was SaaS compared to only 28% a year ago. It was also a great quarter for flip signings as we signed a total of 108 flips of on-premises clients. The total contract value from flips was more than triple that of last year's third quarter, and the average ARR of flips rose 37.2%. Our Courts & Justice business was very active in the third quarter. Our largest deal in the quarter was a contract with Kentucky Court of Justice for Enterprise Justice suite, including case manager, e-filing and court analytics in addition to payments. The initial 6-year term represents $35 million in total contract value, although only $10.6 million was recorded in bookings in backlog this quarter due to contract provisions. ARR starts at approximately $2.5 million and grows to $6.5 million in year 6, in addition to payments processing under a gross revenue model. Of note, the first 6 years of SaaS fees totaling $29 million was prepaid in October using ARPA funds. Other successful Tyler court clients and in particular, the North Carolina Administrative Office of the Courts served as strong references in this competitive sales process that span more than 12 years. Kentucky is our 17th statewide courts client and our third statewide enterprise justice solution deployed in the cloud. We also signed a 3-year $9.6 million SaaS contract for our Enterprise Justice suite with the Phoenix, Arizona Municipal Court. That agreement includes a cooperative master purchase agreement provision that enabled the Arizona Supreme Court to designate Tyler as a preferred software provider for all 170 courts in the state, including superior, justice and municipal courts, with the alternative option being the state's aging legacy system. We're excited about the opportunity to expand our partnership across Arizona courts with significant potential ARR. Other notable third quarter SaaS deals included a $12 million 5-year contract with the city of St. Petersburg, Florida, the fifth largest in the state for enterprise permitting and licensing and enterprise ERP utility billing solutions along with payments. We signed 6 SaaS contracts for our enterprise public safety solution, including 2 of the fastest-growing cities in the U.S., the City of Frisco, Texas Police Department for $750,000 in ARR and the City of Round Rock, Texas police for $730,000 in ARR. Central to our growth is leveraging our unmatched installed base and expanding our addressable market through strategic cross-sell and upsell activity that unlocks significant expansion opportunities with both new and existing clients. A key cross-sell win this quarter was a multiyear strategic contract with the Texas Office of Court Administration for our Texas Connected Justice Data Cloud. This includes alliance exchange, enterprise data platform, open data platform and our Digital Solutions division's engagement builder platform. This integrated solution captures real-time online data across every jurisdiction in the state. This multiyear engagement exemplifies our connected communities vision by creating a digital infrastructure for data sharing and decision-useful business intelligence and reporting. The contract adds $1.5 million in ARR and is the first of its kind in a large population state, paving the way for additional add-on opportunities. Another significant cross-sell win was a contract for the modernization of 18 different boards with the Illinois Department of Financial and Professional Regulation for our state regulatory application platform suite which also brings in augmented field operations, formerly ARInspect. The 3-year contract leveraged our Illinois state enterprise agreement and represents $9.2 million in total contract value, with a 7-year option that adds $12.5 million in total contract value. We're pleased to see an increasing number of our clients modernizing their enterprise solutions using our application platform. Driving payments adoption of our differentiated payments business is another key element in our growth strategy. In the third quarter, we signed 268 new payment deals across Tyler software clients, representing approximately $8.6 million in projected ARR. Riverside County, an existing property and recording software client is our first enterprise payments win in California. This collaborative effort expanded from initial property and recording payments contracts to processing payments for more than 10 agencies across the county, which is the fourth most populated county in California. In our enterprise portal business, we secured extensions for our digital government and payment processing services in 5 states, which includes winning competitive rebids for state enterprise portals in New Jersey and Indiana. We also expanded our scope with the state of Indiana to include resident engagement identity proofing for approximately $1 million in additional ARR. This builds on Tyler's chatbot front-end technology recently deployed representing the first AI project for Indiana and its residents. This solution was provided through a joint effort with our AI task force and our Indian state enterprise team in collaboration with the Indiana Office of Technology. Now I'd like Brian to provide more detail on the results for the quarter and our updated annual guidance for 2024."
},
{
"speaker": "Brian Miller",
"content": "Thanks, Lynn. Total revenues for the quarter were $543.3 million, up 9.8% and organically grew 9.4%. Subscriptions revenue increased 17.6% and organically rose 17.3%. Within subscription, SaaS revenues grew 20.3% to $166.6 million and grew organically 19.7% against a tough comparison with last year's third quarter. Keep in mind that there's often a lag from the signing of a new SaaS dealer flip to the start of revenue recognition, they can vary from one to several quarters. Because of this, as well as the timing of SaaS renewals and related price increases, SaaS revenue growth both year-over-year and sequentially may fluctuate from quarter-to-quarter. Transaction revenues grew 15.2% to $180.5 million, driven by higher transaction volumes from both new and existing clients, including the August go-live of the California Department of Parks and Recreation. SaaS deals comprised approximately 97% of our Q3 new software contract value compared to 80% last year. During the quarter, we added 181 new SaaS arrangements and converted 108 existing on-premises clients to SaaS, with a total contract value of approximately $141 million. In Q3 of last year, we added 161 new SaaS arrangements and had 79 flips with a total contract value of approximately $71 million. The average ARR from new SaaS contracts increased 38% over last year. The average ARR associated with our Q3 flips increased 37% over last year as larger clients such as Cobb County, Georgia and Providence, Rhode Island flips to the cloud. Our total annualized recurring revenue was approximately $1.85 billion, up 12.1% and organically grew 11.8%. We entered 2024 expecting operating margin expansion after experiencing the margin trough from our cloud transition in 2023. Our non-GAAP operating margin in the third quarter was 25.4% up 60 basis points from last year. The margin expansion reflects the impact of our cloud efficiency initiatives, along with effective operating expense management and improved professional services margins. As we discussed on previous calls, merchant and interchange fees from our payment business under the gross revenue model have a meaningful impact on our overall margins as they are passed through to clients and are included in both revenues and cost of revenues. We incurred merchant fees of approximately $42 million in Q3 compared to $36 million last year. Because of strong earnings and effective working capital management, both cash flows, operations and free cash flow reached new quarterly highs at $263.7 million and $252.9 million, respectively, with free cash flow up 55.5%. Cash flow in the quarter was positively impacted by the deferral to the fourth quarter of approximately $14 million of federal tax payments. We ended the quarter with $600 million of convertible debt outstanding and cash and investments of approximately $548 million. Our net leverage at quarter end was approximately 0.1 times trailing 12-month pro forma EBITDA. In September, we replaced our existing $500 million unsecured revolving credit facility with a new facility that matures in 2029, increasing the size to $700 million in improving terms. This new revolver further improves our available liquidity and provide us with maximum flexibility to address potential financing needs. Our updated 2024 annual guidance is as follows: we expect total revenues will be between $2.125 billion and $2.145 billion. The midpoint of our guidance implies organic growth of approximately 9%. We expect that merchant fees will be up approximately 7% over last year and that implied organic growth, excluding merchant fees would be approximately 20 basis points higher. We expect GAAP diluted EPS will be between $6.13 and $6.28 and may vary significantly due to the impact of discrete tax items on the GAAP effective tax rate. We expect non-GAAP diluted EPS will be between $9.47 and $9.62. We expect our free cash flow margin will be between 21% and 23%, including an estimated impact of approximately $54 million of incremental cash taxes related to Section 174. Other details of our guidance are included in our earnings release and in the Q3 earnings deck posted on our website. Now I'd like to turn the call back over to Lynn."
},
{
"speaker": "Lynn Moore",
"content": "Thanks, Brian. As we close out another strong quarter, I want to highlight the consistently high level of execution and collaboration across our teams, which is even more critical to our ongoing success as we leverage a fully enabled cloud infrastructure to deliver continuous innovation and enhanced client experience. The strength of our One Tyler team is rooted in a shared commitment to excellence and to our mission, vision and values, which drives our ability to execute at high levels. During the quarter, we were recognized by Newsweek as one of America's greenest companies, placing us among the top 500 greenest companies in the United States based on environmental sustainability. We were also named the Newsweek's America's greatest workplaces for parents and families 2024 list. We're gratified by this recognition of our commitment to fostering a strong inclusive culture with a healthy work-life balance and high-quality benefits. Now we'd like to open up the line for Q&A."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Your first question comes from the line of Ken Wong from Oppenheimer. Your line is open."
},
{
"speaker": "Ken Wong",
"content": "Lots of momentum this quarter on the cloud side. I wanted to maybe dive into that 3 times on the TCV of flips up to $36 million. Lynn or Brian, do you think this is a new run rate? Or is this just more of a one-off quarterly dynamic here?"
},
{
"speaker": "Brian Miller",
"content": "As we said, these can be a little bit lumpy. This was a strong quarter with some larger flips, but that's a trend that we're seeing, more of our larger customers that have been slower to flip to the cloud, more complicated projects are now starting to move at a faster pace and the progress we've made with version consolidation over the last couple of years has also helped get us in a position to facilitate that as more of those customers are now on current versions of software and have gone through that upgrade process to put them in a position to move to the cloud. So I think as we've said in the past, we should expect to continue to see growth in the flip volume and the size of flips and we sort of envision a bell curve-shaped trend of those over the next 3 or 4 years, and we're still kind of moving up the left-hand side of that bell curve. But it could be lumpy from quarter-to-quarter. But generally, we expect to continue to see the flips growth to achieve the targets we set out for 2030 of 80% to 85% of our on-prem base having moved to the cloud by then."
},
{
"speaker": "Lynn Moore",
"content": "Yes. Just to amplify, Ken, Brian is right. It will tend to be lumpy. I don't think I would model this as our new run rate, which was your question. But we do expect to see this continued momentum."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Matt VanVliet from BTIG. Your line is open."
},
{
"speaker": "Matt VanVliet",
"content": "I'd be curious in terms of what you saw of sales linearity throughout the third quarter and maybe into October? And are you seeing at least lately any pressure of maybe decisions not being made until after the election? Or any impact there? But maybe just overall, what you're seeing in terms of demand linearity?"
},
{
"speaker": "Lynn Moore",
"content": "Yes. That's a good question. We're actually not seeing any slowdowns or hesitations due to the election. Generally speaking, when you look across all the business units at Tyler and particularly at our flagship products, most of our divisions are either at or exceeding their sales plans for the year. And so that's been good. The things that we've been talking in the past couple of quarters have continued. And so we're not seeing any slowdown at this point or any pauses due to any macro factors or the election."
},
{
"speaker": "Brian Miller",
"content": "And really not any changes in linearity, we tend not to be super back-end loaded within quarters, and I don't think we've seen any change in that."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line from Alexei Gogolev from JPMorgan. Your line is open."
},
{
"speaker": "Alexei Gogolev",
"content": "Lynn, I had a question about the incremental competition during the quarter. Are you seeing more pressure from players like ServiceNow and intelligence and analytics, in Workday in ERP? Or have those competitors subsided as demand in their core markets begins to recover?"
},
{
"speaker": "Lynn Moore",
"content": "I think generally stepping back, the competitive landscape is has been pretty neutral throughout the year. I wouldn't say there's been any significant increased competition or any decreased competition. As you know, all of our -- I think when you look at our -- the subverticals like ERP, we certainly see more competition from players that are more horizontal players like Workday, we see them -- I don't know that we see them a significant amount more than we have in the past. When you talk about ServiceNow and our -- against our platform solution, we see them in that space, but we're kind of a different offering. And a lot of the things that were -- the application platform plays best is are areas where ServiceNow is really probably a little bit bigger and heavier. So overall, I think the competitive landscape is generally the same. I think our -- when I look at win rates, they've generally been consistent and were consistent in Q3 with what we've been experiencing over the past several quarters and probably a couple of years."
},
{
"speaker": "Alexei Gogolev",
"content": "And Brian, a quick question on 2025 guidance that you've provided last year. Directionally, would you be able to suggest that you think you could see top line growth acceleration next year versus this year. And how are you thinking about free cash flow margin that you provided considering the net working capital improvements that you've just reported?"
},
{
"speaker": "Brian Miller",
"content": "Sure. Well, we're obviously not ready to give our '25 guidance yet and we're in our planning process and kind of in the early stages of that. I think what we've talked about is that we're probably a little bit ahead of where we targeted 2025 along the path to our 2030 targets. But we said it's not linear. And being a little bit ahead doesn't necessarily mean where we finish up '25 or 2030 will be significantly ahead of those initial targets. So we're confident around those. I think specifically on the cash flow side, we're certainly well ahead of that. We're above where we targeted 2025 already. There are some things that have been affected this year that are a little bit more onetime. But I think generally, this would be a level we'd look to build off of for 2025. So I do expect that '25, our cash flow will be at least kind of consistent with where we are this year."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Michael Turrin from Wells Fargo Securities. Your line is open."
},
{
"speaker": "Michael Turrin",
"content": "On the transaction business, ARR there are meaningful, we're used to seeing that may be down sequentially in 3Q, and it was up this year. I know you had a comment on a go live, but anything else you'd point us towards and drivers of the transaction revenue base? And is the seasonality there at all changing?"
},
{
"speaker": "Brian Miller",
"content": "I don't think there's really a change in the seasonality. And typically, the last half of the year is slower in terms of volumes. But that's been offset really by a couple of things. One is the revenues from new payments clients that we've added over the course of the last year, we've been disclosing those numbers. And consistently close to a couple of hundred this quarter, significantly above that in terms of the number of new payments customers that we're adding within our software client base. And we're also having better experience in getting those clients live faster and getting those revenues flowing faster from the time we sign them to the time that they're onboarded, and that's having a positive impact. And then within the transactions business in general, what we alluded to in terms of some new customers to the California State Parks contract that we signed late last year went live this quarter. That added about $3 million of revenue, although it wasn't a full quarter impact. Various things like in Florida with our payments contract the Florida turnpikes with SunPass went live during the quarter, and that added a couple of million dollars of new revenues. So it's really a combination of new business as well as increased volume. So we're seeing greater adoption through our client base, and we're working with our clients to help them get more of their citizens doing things online and running through our systems."
},
{
"speaker": "Lynn Moore",
"content": "Yes. And to amplify that a little, Michael, I mean Brian is right. We are starting to experience -- we're learning better. The onboarding efficiencies is bringing revenue recognition faster, which is great. The California State go live, I want to emphasize that for a minute because that's a big deal. I mean, we signed this contract late last year in less than 3 quarters, we were up and live. And remember, this is the largest contract in Tyler's history. And we've talked about this sometimes on the call, and it gets lost sometimes in the numbers. But really, the secret sauce of Tyler is execution. And it's our sales execution. It's our implementation execution, it's our support, it's management. And it just -- it takes a lot to do what we do. And we signed over 200 new deals, 100 flips a quarter. That's a lot of business that's going on, and it's the work of our teams and the execution is what provides that referenceability that keeps the engine running. And to get a big go-live in California to go basically on time and on budget is really a great accomplishment for our teams and sets us up not only well to execute on that contract. But then to -- for others to look at that success and duplicate that in other jurisdictions."
},
{
"speaker": "Michael Turrin",
"content": "Just a small follow-on clarification, if I may, on the prior question. I think the primary question we're getting is just on the free cash flow performance. So Brian, just in summarizing some of what you said previously, it sounds like, is there anything you could do to help quantify anything that would fall into the more onetime basket. And it sounds like while you're not updating 2025 targets here, there's no reason to expect margin to go down next year relative to what you're delivering. You're just kind of working through plans. Is that the right takeaway for us at this point?"
},
{
"speaker": "Brian Miller",
"content": "Yes, I think so. We're kind of at a little bit higher level than we had initially planned. I don't know that we would grow in terms of a margin significantly from where we are right now. But again, that's ahead of where we plan to be. The biggest onetime thing, which really will be reflected in the fourth quarter that's reflected in our full year guidance is what Lynn mentioned around the Kentucky courts contract where they are prepaying or prepaid in October, 6 years of SaaS payments. So there's a $29 million bump. That's not a typical situation that we see we're happy to accept that payment, but it's not typical. So that's the biggest onetime thing we're seeing that pull forward."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Terry Tillman from Truist. Your line is open."
},
{
"speaker": "Terry Tillman",
"content": "It's great to hear the call out from my home state, Kentucky, multiple times. I have one question. It's a multiparter though. I think, Lynn, you've talked in your prepared remarks and it's in the press release around cross-selling success. What I'm curious is have you done things go-to-market kind of organized to kind of drive more of that pattern recognition? And what are some common plays you see for kind of the cross-selling? Like what product in particular seems to stand out? And then the second part of this question is the reality there's another milestone here for cross-selling success once you get these flips kind of stood up. And so maybe we could see a step-up even in more cross-selling once they're kind of stable on new kind of cloud technology."
},
{
"speaker": "Lynn Moore",
"content": "Yes. Good questions, Terry. I'll start with the second one. The answer to that is yes. I think part of the part of the equation of doing flips is it brings actually the uptake, we call it more upselling. But yes, that is part of that equation. And I do think it's something. It's another opportunity for us to be in front of the client. Another opportunity to add additional products as they're making another decision. On cross-selling, there's a lot of things that go into that. And I would say things that we have done internally over the last year, 12, 18 months have played a significant role in that. I've talked -- I think I've talked about that on some prior calls, things that we've done around how we comp our sales people, how we comp the different divisions what that basis is. And we've moved to a more of a One Tyler compensation level so that basically, if there are multiple divisions that are contributing to a sales process, we don't have to fight over who's getting the credit because the credit, it shouldn't really matter, if's Tyler wins. And so we've done things internally that I think have broken down internal barriers that have just sort of, I think, grease the wheels a little bit more. In terms of product suites, it's funny, yes, some tend to go a little bit more than others. Sometimes you may get some Courts & Justice products that tie well to our Public Safety products. Sometimes, for example, we did a significant deal this quarter in Kenosha, Wisconsin. That was our ERP full suite. It would also include enterprise, appraisal and tax including our municipal justice. Big integrated story, Gartner-led procurement about $1.6 million in ARR. So while there are products that sort of sometimes naturally seem to go together, our integrated story and the Tyler story tends to also sometimes bring products together in deals that you might not necessarily think on the face of it that, that would have been an inclusive sale, but we're seeing that. We also saw that in St. Petersburg, Florida. I think I mentioned that in my prepared remarks. That was enterprise permanent license, but it also brought in our utility billing and payments. That was almost a $2 million ARR deal. So we're seeing progress and a lot of it is the result of some internal initiatives, and it's just the more success we're having in the market and selling that sort of integrated story of Tyler is resonating."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Joshua Reilly from Needham & Company. Your line is open."
},
{
"speaker": "Joshua Reilly",
"content": "So after being at the IACP event here, one of the topics that came up was where customers are at in terms of version consolidation. Just wanted to get an update on some of the key product areas where we are at with that. I believe Public Safety is at around 30%, which might get a bit behind some of the other larger products? And how do you think about the benefit to margins over the next several quarters as you get more up-to-date there?"
},
{
"speaker": "Lynn Moore",
"content": "No, good question, Josh. I think I talked about on the last call, version consolidation is a big piece of what we call Phase 1 of our cloud transition. And each of our flagship products have been going at different paces because they have different starting points. I would say, generally speaking, sitting here in the fall of 2024, I'm pleased with where we are at version consolidation. I think we're ahead of where I thought we would have been looking back 2 or 3 years ago. And some of our products, this is a heavier lift. But if you look, for example, at our Courts & Justice, our Enterprise Justice solution, you look at our enterprise ERP solution, we have an overwhelming number of clients now that are down to 1 or 2 versions, far removed from the days of having 5, 6, 7 versions out in the field. I think that's part of what you're seeing with our outperformance this year. We talked about our margin outperformance being driven in part by some of our cloud efficiencies. Those cloud efficiencies are -- our products are getting more optimized to be run in AWS. But we're also seeing the benefits of that version consolidation. It takes a lot less people to maintain and support fixed bugs on a single version or even 2 versions than 6 or 7 versions. And that's part of what we're looking at when we start talking about Phase 2 of our cloud strategy, which is what we call cloud living. It's getting all of our clients onto that single version, getting them on really short release cycles, less disruptive, large versions out in the field, higher client set. So I think we're making really good progress there. I do expect that to continue to help gross margins as we look towards our Tyler 2030 goals, that's where some of that gross margin improvement is going to come. And again, I'm pleased with where we're at right now on version consolidation."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Gabriela Borges from Goldman Sachs. Your line is open."
},
{
"speaker": "Gabriela Borges",
"content": "Lynn and Brian, I wanted to ask, given your experience in the space, we're clearly in a really healthy part of the budgeting cycle and the willingness to spend cycle across state and local governments. How should we be thinking about the sustainability of some of the healthy demand that you're seeing. And maybe just level set us on the ARPA funds, how much of a benefit do you think that you're seeing today versus how much could you see in 2025 and 2026 as the funds that are committed to actually get spent?"
},
{
"speaker": "Lynn Moore",
"content": "Yes, Gabriela, I think overall, I mean, budgets have been at a pretty good level for, I'd say, a couple of years now. And I can't predict what's going to happen 3 or 5 years from now. I can't even predict what's going to happen in 2 weeks with the election. But I think our outlook right now and what we're seeing in leading sales indicators is we see that continue -- that level staying for the foreseeable future, our RFP counts, our demo counts, all those leading sales indicators are strong and are consistent with prior quarters and really the last couple of years. And so those are really the data points that I look at most. I'm sorry, I forgot the second question."
},
{
"speaker": "Brian Miller",
"content": "ARPA funds."
},
{
"speaker": "Lynn Moore",
"content": "ARPA funds have been an interesting topic over the last several years. There are certain deals that were clearly driven by ARPA funds. We talked about the Kentucky Enterprise Justice deal where they prepaid that all up front. We also had a significant deal, the Arizona Supreme Court deal that I mentioned in my prepared remarks, was also funded by ARPA funds. We don't always know and we haven't always known when ARPA is the trigger and what we've said over the past, sometimes, it's not the direct trigger, but it may have freed up other opportunities. There's been a hesitancy sometimes in our business to use ARPA funds given the recurring nature, they sometimes tend to have been used more on onetime things. We saw that sort of in our student transportation business, maybe for a large purchase of hardware, something like that. I think they've been helpful over the last few years. I don't think that's been a major tailwind to growth in sales. That's not what we're hearing from our sales folks."
},
{
"speaker": "Brian Miller",
"content": "But those do -- until the end of '26 to send those dollars. So some of those things that ARPA funds will be used for may not even have started. They may have been committed but internally, but haven't even started the buying process. And just, for example, like with the Kentucky deal, even though they're using ARPA funds to pay 6 years of SaaS, that was a 12-year sales process from the time we started talking to them. So the deal didn't materialize because of ARPA funds, but it affected -- so we wouldn't say that, that deal just happened because of ARPA and wouldn't have happened without it, but it certainly benefited the timing of it."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Saket Kalia from Barclays. Your line is open."
},
{
"speaker": "Saket Kalia",
"content": "Lynn, maybe for you, just to hit on a little bit of a different topic. Tyler's services has always been really important for your government customers. But it's been interesting to see that business over time grow just a little bit slower than the rest of the software business. So maybe the question is, could you maybe speak to how the services intensity in the business is changing as Tyler becomes more of a SaaS company, and maybe relatedly, Brian, for you, maybe touch on how that impacts margins over time."
},
{
"speaker": "Lynn Moore",
"content": "Yes, that's a good question. And actually, I'll start a little bit, too, with what you asked Brian, is part of our outperformance this year has been our services gross margins. And that has been something that we have focused on at a management level over the last couple of years, and you're starting to see some of that. So a good management focus and attention. It's also been a function of the labor market. So the labor markets have really stabilized. We're seeing a lot less turnover and high turnover in our services areas creates a lot of inefficiencies. It takes a long time for people to get onboarded, up to speed and out and billable. But we've had some other internal initiatives that really help drive those professional services. As we look out over the next several years, I would expect our services to remain relatively flat. In fact, next year, they may actually decrease a little bit. That's a function of a couple of things. I think it is a function of efficiencies and how we can onboard clients. We've done some internal initiatives around that which also a function of in our -- some of our really large implementations, like in Courts & Justice and a lot of customization work. We're moving away from that. We don't have as many of those on the horizon and the whole concept of clients having one-off custom applications is something that we are moving. It's part of our cloud living goals as move forward. So it's a number of factors there. It is something that's been a focus of it. But you're right, it has been declining as a percentage of revenues. And as I look out, I would expect it to stay flat to decline as compared to other growth in our revenue lines."
},
{
"speaker": "Brian Miller",
"content": "Yes. So just as Lynn said, less services in the mix. Services are lowest margin, and in fact, historically, have had a negative margin. So the combination of less services in the mix from all those factors that Lynn mentioned, combined with improving margins on the services we are doing should continue to have a positive impact on our margins. And we pointed that out as one of the not the biggest, but one of the factors in driving towards our 2030 margin targets."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Charlie Strauzer from CJS Securities. Your line is open."
},
{
"speaker": "Charlie Strauzer",
"content": "Lynn and Brian, when you talk to clients who are somewhat hesitant to flip, what are some of the reasons why they're so cautious? And ultimately, how do you convince them otherwise?"
},
{
"speaker": "Lynn Moore",
"content": "I think some of the reasons are just some of the historic reasons, control. You've got people maybe who are not -- have been there a long time. They're used to having control of their systems, control of everything. I think what happens is, we've talked about aging technology, but also aging infrastructure starts to lead to more and more openness to flips. I think you also see the increase in cyber attacks, creating a different sort of demand and new demand for flips. But I think also we talk a lot about how everything we do is public. Every implementation we do all -- every county, every city looks at their neighbors, looks across jurisdictions to see what's going on. And whatever hesitancy that people may have felt 5 years ago, 7 years ago, as they see their neighboring jurisdictions make those decisions and the success that they're having, and I'll go back to my comment earlier about our success in executing and they see us being able to get them up and live and running in a better environment. I think that starts to break down those barriers as we move forward."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Rob Oliver from Baird. Your line is open."
},
{
"speaker": "Rob Oliver",
"content": "Lynn, I just wanted to go back quickly to the question earlier regarding the ARPA funds. Given the fact that we have a deadline now to obligate these funds, I know you guys have been hesitant to draw a direct line between them and the actual deals. And you alluded to the Kentucky win, which is obviously exciting in Courts & Justice, but you noted that it was over a decade in the hopper. What, if anything, is your sales force doing now at state and local to be in front of your customers to talk about that commit process, how Tyler products could be useful. I know the vendor decision doesn't need to be made necessarily by the end of December. But I just -- I guess, another way of asking the previous question from Gabriela in terms of confidence that we might see more deals that could be supportive of that '25 and '26 progress, the deadline by which they need to spend it."
},
{
"speaker": "Lynn Moore",
"content": "Yes, Rob, I don't know that we're doing anything different than we've done in the last couple of years. All of our sales teams have been armed with information on ARPA funds. They're armed with the right marketing materials. They generally know what's around. They've got their talking points. But I'll reiterate, I don't think -- I can't draw a direct correlation over the last few years of ARPA funds to Tyler's performance in a material way. It has definitely been part of the overall environment. But again, as I said, as I look at indicators going out into the future, the things that we track that sort of help us track demand and budgets. Those are remaining pretty consistent right now. So I'm not suggesting that ARPA hasn't been helpful. I just -- I have not been able to really draw a material one-on-one direct correlation to that other than, obviously, some deals, but the Kentucky deal. I think the interesting thing about that is it sometimes -- it highlights really sometimes the long nature of these sales processes and the tenacity of us and the long-term nature of everything we do in our long-term vision and staying power there was 12 years later, and we benefited from cash flow with ARPA funds, but we were going to get that deal whether ARPA funds were available or not."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Jonathan Ho from William Blair. Your line is open."
},
{
"speaker": "Jonathan Ho",
"content": "Can you give us a little bit of sense around the AI opportunity? I think you referenced one large deal and how your customers are maybe thinking about leveraging AI over time and what that means from an upsell perspective?"
},
{
"speaker": "Lynn Moore",
"content": "Yes. Jonathan, it's -- we're starting to see a little bit of questions in RFPs around AI and what AI technology we're using, how we're leveraging it. I don't think anything right now has changed from what we've said over the last couple of quarters. We're focusing our efforts on sort of right now, trying to decide where exactly we want to put most of our resources behind AI internal versus external facing solutions. I still continue to believe that there's a lot of applicability pointing inward in things that we can do on repetitive type activity that some of our employees do. But we have seen an uptick. I mean we made the acquisition of CSI last year. AI is a deeply embedded part of that solution is having a lot of success in the market. ARInspect has some AI tools, and I mentioned the ARInspect deal on the portion of the Illinois deal that I talked about earlier. So we're doing things around AI. Customers are starting to be more open about talking about it. I think a year ago, clients were probably really hesitant. It's not a driver right now in deals, but they're curiosity and their interest is starting to surface. And my guess is we'll hear more about it when we get together connect next year and probably even more about it the following year."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Keith Housum from Northcoast Research. Your line is open."
},
{
"speaker": "Keith Housum",
"content": "In terms of like the acquisition front, you've got favorable debt terms, you're generating a good amount of cash. How are you guys thinking about acquisitions now? And then in terms of more specifically, is there specific end markets within your business that you're thinking that could benefit from acquisitions more than others? And perhaps what would they be?"
},
{
"speaker": "Lynn Moore",
"content": "Yes, Keith, we're viewing it similarly. I mean, I've talked about the last couple of years, our priority is debt pay down. Our cash balances are approaching what our convertibles do in about 16, 17 months. And so we're looking. We always look. We've been looking, I look at deals every quarter. we're probably a little pickier right now than we might otherwise be. But I do think as we go into 2025 and then into 2026, we're not going to change our standards. We're not going to change our valuation approach. But I do think you'll see us -- I'll probably evaluate more and maybe a deal that we might have said, “Hey, maybe we don't do it right now, that might tip in that direction”. We don't have anything specific right now in the hopper. We do talk internally about really what's the best area for us to go get our bang for a buck. And should we sort of start being a little more proactive as opposed to reactive. Those are discussions we're having internally. But generally, as it relates to capital, our stance is kind of the same right now, but I can see that evolving over the next 12, 18 months."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Mark Schappel from Loop Capital. Your line is open."
},
{
"speaker": "Mark Schappel",
"content": "John, a question for you. Building on the earlier question on version consolidation which has been somewhat of a gating item to get customers to migrate to the cloud. Could you just discuss some of the characteristics that you're using to encourage customers to move to the latest product release?"
},
{
"speaker": "John Marr",
"content": "Well, there's a combination of things. And each of our products are in different stages of using those combination of things. Some of them have been maybe some minor financial considerations. Some of them have been only new feature will be available in the cloud, some of it will be -- we're no longer going to support a version of the cloud. We haven't drawn a lot of those hard sticks yet, particularly with our flagships. But it's a variety of things that's going on. I think clients also are starting to realize the benefit and the need to get upgraded. Part of the -- what happened is when particularly when clients have multiple products of ours and those products are on multiple different years of versions. It's really hard for the products to talk. And I think you also see it with support calls. You've got clients who might have been on a version that's 4 or 5 years old and they're having issues, but what they didn't realize is that those issues were corrected in a version 3 years ago, they just didn't take the upgrade. So it's sales pitch. it's things we're doing internally. It's a variety of things. It's not one thing. And each one is in a different stage. As I talked before, we're doing multiple cloud transitions, which means we're doing multiple version consolidations at the same time."
},
{
"speaker": "Brian Miller",
"content": "But with respect to version consolidation specifically, I guess, you call it a stick is that we actually are sunsetting older versions and giving clients certainly ample notice. But letting clients know the version they're on, the oldest versions will no longer be supported after a certain date and working with them to move them to the current version for that date. And we've done that with multiple products. We've sunset multiple old versions of our enterprise ERP solution, our Enterprise Justice solution and have made significant progress in moving those customers to current versions as we discontinue support of the older versions."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Clarke Jeffries from Piper Sandler. Your line is open."
},
{
"speaker": "Clarke Jeffries",
"content": "A question for Brian on the sort of the pace of the SaaS revenue I know you had quoted that the volatility of SaaS revenue, the timing of the go-lives from booked to a live system can be variable. But I just wanted to ask, we have 2 years now where the sequential growth in Q3 is the highest. I wanted to understand if that's purely circumstantial if there's any emerging seasonality to those go live. Any prerogative of these governments to get live on a Q3 or is that just really reflective of typically high Q4 bookings activity?"
},
{
"speaker": "Brian Miller",
"content": "Yes. It's probably more the latter. I don't think there's a certain characteristic or something that's causing that. It's probably around the timing, especially bigger customers, and it varies by market. For example, in the schools market, which is smaller for us, but they typically have a big push more in Q2 because they want to have new systems live before a new school year starts. Fiscal years don't really have as much to do with it. So I think it's more circumstantial."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Alex Zukin from Wolfe Research. Your line is open."
},
{
"speaker": "Alex Zukin",
"content": "Congrats on another solid quarter. I'll ask maybe a longer-term question. I think it's been alluded to a little bit. But again, as we think about AI, both agentic, copilot or system and you think about the customers that are starting to ask those questions. You think about the breadth of solutions that you're offering, both to your customers and across the portfolio of products. As we think about that monetization pathway, is that something we should think about maybe on top of the long-term guidance that you provided at the last Analyst Day through 2030, or is that embedded in there? I ask because it seems like the pace of the innovation wave has moved so fast since you guys fully were even able to contemplate that. So how do we think about those, the top line growth characteristics that could be associated there? And any incremental potential margin degradation or headwinds or thoughts about that? And then I have a quick follow-up."
},
{
"speaker": "Lynn Moore",
"content": "Yes, sure, Alex. The short answer is, yes, when we gave our 2030 targets, we did not bake in efficiencies, internal efficiencies on any gross margin lines that were going to be driven by AI nor did we really bake in any sales that were really a result of either new products, products, newly developed products or newly acquired products. To the extent, AI was already in some of our products, we already had sort of some long-term sales road maps. So perhaps a little bit, but not in terms of additional R&D, additional M&A. And so that's the way I would think about it. I'd just remember that we're taking a very deliberative approach to AI. And while I say that we're hearing more and more customers start to have things in their RFPs around AI. It's not a majority yet. And I think our clients will still be a little bit conservative. But when you start looking out 5, 7 years, those opportunities are there, and we're not going to wait 5 to 7 years to then spin up initiatives. We will be doing those along the way. And to the extent there was some major R&D initiative, which hypothetically because that's not right now on our road map and it adjusted our -- an R&D expense line or something we would obviously signal that and tell you that. But in terms of our long-term targets, no, no significant AI benefits, either margin or revenue were baked in."
},
{
"speaker": "Alex Zukin",
"content": "And to what extent, maybe this is just a clarification. To what extent are you hearing or seeing in sales cycles that those types of questions are actually facilitating or we're amplifying flips or converts either the timeline around them or the momentum or enthusiasm. And then on free cash flow, Brian, again, I think the outperformance obviously both in the quarter and the guide for the full year, very notable. You noted that one Kentucky prepayment contract. How do we think about like when, where and like why those prepayments happen. And more so, as we look to '25 and beyond, is there any reason to assume that those would happen more frequently or less frequently and kind of changing the complexion of the free cash flow margins."
},
{
"speaker": "Brian Miller",
"content": "Yes. The prepayment was really kind of a one-off thing where at least relative to that size of that were -- and that actually will show up in the fourth quarter cash flow. But that was, again, ARPA funds being used to prepay 6 years of SaaS payments. I don't think that would be the norm. The thing that I think more consistent with an impact on free cash flow is the characteristics around the transaction business. That transaction revenues, whether they're payments or e-filing and those sorts of things. We generally get paid at the time of the transaction or very quickly after it. So we're not carrying large receivables there. So the cash flow characteristics of that transaction business are very attractive. And so as it continues to grow even at a tick higher than the rest of our business, that has a positive impact on cash flow. We've also had really effective management around our receivables and have brought down our DSOs and continue to manage that. And that helps as well that those revenues are typically paid in advance, annually in advance as opposed to carrying long -- bigger receivables. So really, the transaction business is probably the biggest grower of improved margins and cash flow."
},
{
"speaker": "Lynn Moore",
"content": "Yes. And the follow-up question on AI and sales. I mean, it's -- clients aren't looking for AI for AI's sake but there are -- when you look at our CSI acquisition, the document redaction solution, there's an ROI involved. There's an ROI for the clients. And that's a big sales point. They can do things with that system that used to take a lot of people to do, and they've removed that manual labor, that manual toil. And so yes, things like that are driving sales."
},
{
"speaker": "Operator",
"content": "That concludes our question-and-answer session. I will now turn the call back over to President and CEO, Lynn Moore, for closing remarks."
},
{
"speaker": "Lynn Moore",
"content": "All right. Thanks, Rob, and thanks, everybody, for joining us today. If you have any further questions, please feel free to contact Brian Miller or myself. Thanks, everybody. Have a great day."
},
{
"speaker": "Operator",
"content": "This concludes today's conference call. Thank you for your participation. You may now disconnect."
}
] |
tyl | 2,024 | 2 | [
{
"speaker": "Operator",
"content": "Hello, and welcome to today's Tyler Technologies Second Quarter 2024 Conference Call. Your host for today's call is Lynn Moore, President and CEO of Tyler Technologies. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session, and instructions will follow at that time. [Operator Instructions] As a reminder, this conference is being recorded today, July 25, 2024. I would like to turn the call over to Hala Elsherbini, Tyler's Senior Director, Investor Relations. Please go ahead."
},
{
"speaker": "Hala Elsherbini",
"content": "Thank you, Matt, and welcome to our call. With me today is Lynn Moore, our President and Chief Executive Officer; and Brian Miller, our Chief Financial Officer. After I give the safe harbor statement, Lynn will have some initial comments on our quarter, and then Brian will review the details of our results and update our annual guidance for 2024. Lynn will end with some additional comments, and then we'll take your questions. During this conference call, management may make statements that provide information other than historical information and may include projections concerning the Company's future prospects, revenues, expenses and profits. Such statements are considered forward-looking statements under the safe harbor provision of the Private Securities Litigation Reform Act of 1995 and are subject to certain risks and uncertainties, which could cause actual results to differ materially from these projections. We would refer you to our Form 10-K and other SEC filings for more information on those risks. Also, in our earnings release, we have included non-GAAP measures that we believe facilitate understanding of our results and comparisons with peers in the software industry. A reconciliation of GAAP to non-GAAP measures is provided in our earnings release. We have also posted on the Investor Relations section of our website under the Financials tab, schedules with supplemental information, including information about quarterly recurring revenues and bookings. On the Events and Presentations tab, we posted an earnings summary slide deck to supplement our prepared remarks. Please note that all growth comparisons we make on the call today will relate to the corresponding period of last year unless we specify otherwise. Lynn?"
},
{
"speaker": "Lynn Moore",
"content": "Thanks, Hala. We built on the momentum from our strong first quarter performance to, again, deliver exceptional second quarter results marked by consistently high execution and a continuation of solid operating and financial performance. Each of our key metrics across revenues, earnings, operating margin and cash flow exceeded our expectations. These results are especially meaningful given the significant shift towards SaaS in our new software contract mix, which pressured revenues and margins. Recurring revenues grew 8.4% and comprised 83% of our total revenues. SaaS revenues grew 23.2%, our 14th consecutive quarter of SaaS revenue growth of 20% or more above our target of a 20% CAGR in SaaS revenues through 2025. In addition, transaction revenues were ahead of plan driven by higher transaction volumes, including an increase in e-filing volumes and expanded payment services. Since committing to our cloud-first strategy in 2019, we've been intently focused on supporting our public sector's clients' digital transformation and guiding their migration to Tyler's next-generation cloud applications. Last year, we reached an inflection point where valuable, long-term recurring SaaS revenues surpassed on-premises' license and maintenance revenues. We're pleased to reach another milestone as we have now essentially completed the exit of our Dallas data center. This move is a significant achievement in our cloud migration road map as we continue to scale our deployments at AWS and drive more durable growth and margin benefits from our SaaS-based operating model. The public sector market remains healthy, characterized by high levels of RFP and sales demo activity. Our new business pipeline remains at elevated levels, reflecting the robust market environment, growing cross-sell opportunities and continued strong execution by our sales organization. Our leading market position and competitive strengths, including our deep domain expertise continue to differentiate us in the marketplace. These strengths underpin our long-term strategic focus on four key growth drivers, leveraging our unmatched installed base, expanding into new markets, completing our cloud transition and growing our payments business. Our large client base represents one of our most significant assets, and we're pleased to see strong go-to-market execution with significant cross-sell and upsell wins during the quarter, which included a joint effort with our Justice Group, leveraging our Digital Solution division's strong relationships in Florida, for an agreement with the Florida Department of Corrections to manage all aspects of money transfer services for correctional facilities across the state. The contract brings together disbursement solutions from our Rapid Financial Solutions acquisition, inmate trust and accounting and e-communications from the VendEngine acquisitions and payments through our Digital Solutions division. A single sourced enterprise supervision and enterprise public safety contract with Cherokee Nation, Oklahoma, adding to its existing enterprise ERP solutions. The SaaS agreement was a joint collaborative sales effort resulting in a total Tyler client win. Additionally, we continue to innovate and elevate our clients' resident engagement experience by empowering citizens with direct connections to government through Tyler's MyCivic platform. In Mississippi, we expanded citizen access to mental health resources with the Mississippi State Department of Health, leveraging our state enterprise agreement. We continue to advance our cloud transition and make substantial progress with our product version consolidation efforts, which will accelerate our continued migration of on-premises clients to the cloud. We're also pleased with the numerous second quarter SaaS contract wins, which underscore the public sector market's recognition of cloud benefits, including enhanced security. One of the key themes that emerged during client interactions at our recent Connect 2024 user conference was a notable shift in client openness to embrace cloud technology and a growing expectation among on-premises clients that they will migrate to the cloud. This shift is especially apparent in the state and federal market with our application platform and in the public safety market, where 90% of second quarter public safety contract value was SaaS compared to 13% a year ago. Primarily as a result of this accelerated shift in public safety cloud adoption, SaaS arrangements comprised 97% of our new software contract value in the second quarter. Additionally, we signed 111 flips of on-premises clients, including a number of larger clients, with the average ARR flips growing 21.8%. We also had a very successful go-live in May with the SaaS migration of the Idaho State Court system. This is our first flip to the cloud of a statewide court system, and Idaho went live just four months after the project kicked off. This high-profile migration has been watched closely by other statewide and large county courts and its successful execution is certainly a positive reference point as we engage with other large core clients about moving to the cloud. Key second quarter new SaaS deals and flips included a competitive win with the City of Topeka, Kansas for multiple integrated solutions, including enterprise ERP, enterprise permitting & licensing, enterprise asset management for nearly $700,000 in ARR. And ERP Pro and Payments contract with Richland County, Wisconsin, funded via ARPA funds. That was executed on an accelerated 90-day sales cycle, leveraging our enhanced sales enablement and competitive intel teams. The Idaho State Police signed a SaaS contract for our integrated enterprise public safety suite including CAD, records management and e-citations. This Tier 1 competitive win demonstrates our growing momentum with state public safety agencies and represents the sixth state police agency to adopt our enterprise public safety solutions. The United County, New York Department of Emergency Services also chose our integrated Public Safety Suite for 64 agency client-driven, SaaS deployment. Hunt County, Texas, upgraded to Enterprise Public Safety from our Public Safety Pro solution and Spotsylvania County, Virginia, signed a contract for our enforcement Mobile Solutions, joining eight of the 14 largest Virginia agencies using Tyler Public Safety applications. We signed an enterprise justice SaaS flip with Fulton County, Georgia, which includes Atlanta. The contract with ARR of $1.9 million follows Fulton County's Enterprise appraisal and tax SaaS flip signed in the first quarter, and includes integrated justice solutions such as prosecutor and jail as well as additional client management services under our unified One Tyler approach. We also signed an enterprise supervision expansion with the Arizona Supreme Court that builds on the success of adult probation to add juvenile probation for all 15 counties across the state. We leveraged the state relationship, which led to a five-year enterprise justice agreement with the Phoenix Municipal Court, representing in excess of $2.25 million in ARR. This strategic and highly competitive win includes five one-year extension options and paves the way for expansion and new court software opportunities in a large population state. Another theme coming out of Connect '24 was pronounced interest in AI and our expanded AI capabilities that were added through our 2023 acquisitions. High interest is turning into multiple new deals and cross-sell wins for our application platform, leveraging our augmented field operation solutions, formerly ARInspect with four inspection SaaS arrangements in the quarter across state, environmental, health and regulatory agencies. These included the California State Board of Pharmacy to configure and automate five regulatory inspection types, the Kentucky Department Environmental Protection, the New York Department of Health and the Arkansas Department of Labor and Licensing, which was a cross-sell win leveraging our Digital Solutions division state enterprise relationship. Another key to our growth strategy is expanding our differentiated payments business. And similar to our first quarter results, higher transaction volumes contributed to better-than-expected transaction revenues. In the second quarter, we signed 195 new payments deals across Tyler Software clients, representing approximately $8 million in projected ARR. In our state enterprise portal business, we secured extensions for our digital government and payment processing services under four state enterprise contracts, including Hawaii, New Jersey, Kansas and Kentucky and also won a sole source award with the state of Rhode Island as no extensions remained under the previous contract. We also signed a two-year renewal with the state of Illinois for our Outdoor and Enterprise Licensing Solutions. Now I'd like Brian to provide more detail on the results for the quarter and our updated annual guidance for 2024."
},
{
"speaker": "Brian Miller",
"content": "Thanks, Lynn. Total revenues for the quarter were $541 million, up 7.3% and organically grew 6.5%. Subscriptions revenue increased 12.1% and organically rose 11.8%. Within subscriptions, our SaaS revenues grew 23.2% to $156 million and grew organically 22.5%. Keep in mind that there's often a lag from the signing of a new SaaS flip or SaaS deal or flip to the start of revenue recognition that can vary from one to several quarters. Because of this, as well as the timing of SaaS renewals and related price increases, SaaS revenue growth both year-over-year and sequentially may fluctuate from quarter to quarter. Transaction revenues grew 3.8% to $177.7 million. Transaction revenues exceeded our plan, primarily due to higher transaction volumes from new and existing clients, including recreational licenses such as hunting and fishing, which begin their peak season during Q2. In addition, e-filing revenues grew 11.2%. The year-over-year comparison for transaction revenues continued to be impacted by the change in mid-2023 from the gross model to the net model for payments under one of our state enterprise agreements. This will no longer be a factor in year-over-year growth comparisons in the second half of the year, and our expectation is for mid- to high teens growth in transaction revenues in the second half of 2024. SaaS deals comprised approximately 97% of our Q2 new software contract value compared to 82% last year. During the quarter, we added 203 new SaaS arrangements and converted 111 existing on-premises clients to SaaS with a total contract value of approximately $127 million. In Q2 of last year, we added 170 new SaaS arrangements and had 94 on-premises conversions with total contract value of approximately $93 million. More importantly, the average ARR associated with our Q2 flips increased 21.8% over last year as larger clients such as Fulton and Clayton Counties in in Metropolitan Atlanta, Georgia; the cities of Tucson, Arizona and Birmingham, Alabama; and the Columbus, Ohio City schools flipped to the cloud, including transaction revenues, expansions with existing clients and professional services, total bookings increased 7.3% on an organic basis. Our total annualized recurring revenue was approximately $1.8 billion, up 8.4% and organically grew 7.8%. In previous quarters, we discussed our expectation that 2023 would be the operating margin trough from our cloud transition and that 2024 would mark a return to operating margin expansion. Our non-GAAP operating margin in the second quarter was 24.5%, up 150 basis points from last year. The margin expansion reflects improved margins from our cloud operations, along with expensive effective operating expense management and improving professional services margins. As we discussed on previous calls, merchant and interchange fees from our payments business under the gross revenue model have a meaningful impact on our overall margins as they are passed through to clients and are included in both revenues and cost of revenues. We incurred merchant fees of approximately $45 million in Q2. Because of strong earnings and effective working capital management, both cash flows from operations and free cash flow were above expectations for the quarter at $64.3 million and $48.6 million, respectively. Cash flow in the quarter was impacted by approximately $29 million of incremental cash taxes due to Section 174. We ended the quarter with $600 million of convertible debt outstanding and cash and investments of approximately $262 million. Our net leverage at quarter end was approximately 0.65x trailing 12-month pro forma EBITDA. Our updated 2024 annual guidance is as follows: We expect total revenues will be between $2.120 billion and $2.150 billion. The midpoint of our guidance implies organic growth of approximately 9%. We expect that merchant fees will be up approximately 6% over last year, and then implied organic growth, excluding merchant fees, would be approximately 20 basis points higher. We expect GAAP diluted EPS will be between $5.76 and $5.96 and may vary significantly due to the impact of discrete tax items on the GAAP effective tax rate. We expect non-GAAP diluted EPS will be between $9.25 and $9.45. We expect our free cash flow margin will be between 18% and 20%, including an estimated impact of approximately $60 million of incremental cash taxes related to Section 174. Other details of our guidance are included in our earnings release and in the Q2 earnings deck posted on our website. Now I'd like to turn the call back over to Lynn."
},
{
"speaker": "Lynn Moore",
"content": "Thanks, Brian. Our exceptional performance in the first half of 2024 positions us well for a strong second half. We're pleased with our progress across all fronts as we remain on track with key initiatives around our four-pronged growth strategy while demonstrating our competitive strength and model durability. Our cloud transition is beginning to generate the expected benefits of margin improvement and enhanced client experience. As you know, in 2019, we launched a multiyear cloud strategy to shift our solutions and operations to a cloud-first business model, leading our clients to a future in the cloud. As we enter the next phase of our cloud journey, and as more new and existing clients embrace our cloud strategy, we see increasing opportunities to prove areas critical to our clients that ultimately affect client satisfaction, including product release cycles, product consistency, performance reliability and cost effectiveness. To effectively address these areas and lead this change, I'm pleased to share that Russell Gainford has been promoted to Chief Cloud Officer, effective immediately. Over the past three years, Russell has proven his ability to own the overall vision for Tyler's cloud-first strategy. And in his new capacity, he will continue to drive our cloud initiatives across our organization, including developing our cloud technology and operation standards, controls and business processes, overseeing our strategic business partner and vendor relationships as well as architecting the organizational design and staffing plans in collaboration with operational leaders. Shifting to capital allocation. Our disciplined approach bolsters our strong balance sheet as we've repaid our term debt during this period of higher interest rates. This coupled with our ability to consistently generate strong free cash flow provides tremendous flexibility to take advantage of opportunities to make investments that drive shareholder value, including product development, M&A and potentially stock buybacks. And while the bar is currently high for acquisitions, we continue to evaluate strategic tuck-in acquisitions, while building liquidity to be in a position to address our convertible debt maturity in March of '26. I'm also pleased to highlight that Tyler recently was recognized by two leading publications as we were included on Times list of America's best midsized companies and Forbes' Best Employers for Women's list. Before I close, I'd like to welcome our two new board members, Margot Carter and Andy Teed, who were elected at our May 9th Annual Meeting. Margot brings a wealth of experience in cloud software and SaaS transformations, AI and payments. She currently serves as President of Living Mountain Capital, where she invests in and advises companies and private equity firms on digital transformation and innovative strategies. She has an extensive background in finance M&A and corporate governance and has served on several public company boards. Andy is a seasoned technology executive with significant public sector experience. He currently serves as the CEO of Eco Parking Technologies, an integrated lighting and parking guidance company. Prior to that, Andy spent nearly 20 years at Tyler in various senior leadership roles. His extensive public sector experience and familiarity with our products and clients along with his knowledge of cloud technologies, make Andy a valuable addition to our Board. I also want to thank our two outgoing Board Directors, Dusty Womble and [Mary Landro] for their years of service and contributions to Tyler's success. Finally, I'd like to express my appreciation to our entire Tyler team for their hard work and continued commitment to driving growth while leading our clients on their digital modernization journeys. Our leadership is aligned with a unified focus on cloud living, and I've never been more confident in our prospects and Tyler's future. Now, we'd like to open the line for Q&A."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] The first question is from the line of Alexei Gogolev with JPMorgan. Your line is now open."
},
{
"speaker": "Alexei Gogolev",
"content": "Thank you, Brian. Congratulations with great results. Brian, I was wondering the components of higher CapEx, what were they? If you could elaborate on that? And why are we seeing some decline in R&D? And does this have anything to do with your plans to reallocate certain R&D components? Remember, you were saying you were planning to do that for COGS going into OpEx?"
},
{
"speaker": "Brian Miller",
"content": "Those two are related, but they're not related to any reclassification of R&D. They're just interrelated in terms of as we perform different R&D projects. Some of them fall in the category of requiring capitalization and others are expensed. And sometimes, there's a -- and this just reflects a little bit of a shift between those two. So more of our development costs are being expensed and less being -- I'm sorry, more being capitalized and less are being expensed to R&D. So, it's just a shift between capitalization and expense based on the nature of the projects."
},
{
"speaker": "Alexei Gogolev",
"content": "Understood. And then the second one about your AWS contract renewal. Could you elaborate on the potential benefits to gross margin and whether you think there will be a one-off benefit or you expect to unlock more discounts as you progress through the contract?"
},
{
"speaker": "Lynn Moore",
"content": "Yes, Alex, I think it's a couple of things. We did sign that long-term extension as we continue to commit more and more of our clients going into AWS and more and more spend each year, we do receive some additional discounts. So, I would expect those to continue. I think the other side is just -- is really just some of the operational efficiencies that we're starting to see the product optimization as we continue to optimize and move them into AWS version consolidation, the things that we've talked about. So, it's a number of factors, but I do expect looking forward that some of our gross margins would improve. I don't know that I would look -- I think as you look out over the next six, seven years, our Tyler 2030 vision, I would expect several of our gross margin lines to improve. I don't know that necessarily it's going to happen in the next 12 months, but we are making progress on all of those items."
},
{
"speaker": "Operator",
"content": "Next question is from the line of Matt VanVliet with BTIG. Your line is now open."
},
{
"speaker": "Matt VanVliet",
"content": "Continuing to have more success at the state level, curious how much of that's being driven by the integration sort of more holistically on the sales team with the NIC team and sort of some of those hunting licenses versus the product maturation and the acceptance of cloud at that level. And as you look on a go-forward basis, how much of these deals are having sort of multiproduct together to where the more, I guess, combined sales effort is paying off here?"
},
{
"speaker": "Lynn Moore",
"content": "Yes, Matt, it's a good point. We are seeing more momentum, certainly more cross-sell momentum in that state space. I think it's a testament to our DSD division's long-standing relationships and really our enhanced focus on leveraging those these last couple of years. There's things that we've done. We've talked about in the last couple of earnings calls around compensation and sales commissions and also executive leadership compensation that sort of try to break down some of those barriers and enhance those cross-sell opportunities. We are seeing more and more multiproduct deals. I think I referenced a few in my notes earlier. And that again, that's just -- it's a testament to what we've been -- what I've been sort of calling for the last couple of years, this vision of one Tyler operating more as a singular unified company, breaking down any sort of internal barriers that might have been just a slight hindrance in the past around cross sells and upsells. And I think we're starting to see that pay off as relationships are continuing to forge and as they start to become more and more productive."
},
{
"speaker": "Operator",
"content": "Next question is from the line of Rob Oliver with Baird. Your line is now open."
},
{
"speaker": "Rob Oliver",
"content": "Great. Lynn, my question is for you. Just a pretty rapid and somewhat stunning, I guess, I would say, having followed you guys a long time increase in public safety's willingness -- public safety’s customers willingness to adopt the cloud. And you guys clearly are right there to address that opportunity. I was just wondering this is one of the areas within core Tyler that has been historically the most competitive. And I think somewhat of a modest concern for investors. I was hoping you could address the extent to which this cloud move is really underscoring competitive advantages for you guys, perhaps the relationship with AWS as you take a sector of your market that historically was somewhat more reticent to move to the cloud, how that is helping you? And then as you look at that public safety pipeline where you see sort of current Tyler customers and where that cross-sell advantage might be?"
},
{
"speaker": "Lynn Moore",
"content": "Yes, you're right, Rob. Public safety has -- it's actually been a little bit surprising their results this year. At the end of last year and really coming into this year, we had made the decision that we were going to really lead our clients to the cloud sort of like the position we took across all of Tyler. And you're right, the momentum is there. Momentum is an interesting thing. And as you know, our clients talk and so I think right now, it is a competitive advantage for us. We are able to offer all of our core public safety products in a SaaS environment. That's not necessarily the case with all of our competitors. It's still a very competitive market. I like where we sit right now. I like some of our key wins or against some really key Tier 1 competitors, some that I mentioned in my remarks earlier, like Idaho State police deal. So, it's an interesting dynamic and one that I think is -- I talked earlier about momentum it is building momentum, and it's exciting to see. And I think we're also starting to see the impact of some of the cybersecurity concerns, which are -- they're heightened across all of our clients, but we've seen a number of flips. I think we had six flips in public safety in Q2. A couple of those were actually the result of some ransomware. And so being able to be nimble and stand up those clients very quickly, perhaps not with full functionality, but get them up and running where they can do their job has actually shown a lot of benefits and starting to give confidence to our clients and to their surrounding communities that the cloud is something that they should be looking at."
},
{
"speaker": "Operator",
"content": "Next question is from the line of Michael Turrin with Wells Fargo. Your line is now open."
},
{
"speaker": "Michael Turrin",
"content": "Great, looks like a strong Q2 for SaaS, fairly even split between new deals and conversions and the metrics. So, I was just hoping you could maybe speak to the drivers there. How you'd expect that mix between new deals and conversions likely trends. And if anything, seasonal in terms of Q2 and what we're looking at, we should be mindful of there?"
},
{
"speaker": "Brian Miller",
"content": "Yes. I don't think there's anything particularly seasonal around the pace of those, both the timing of new deals and especially the timing of flips can be a little bit lumpy. So, we certainly expect the trend to continue to be over the mid- and long term for the number of flips and the size of flips to continue to increase. That was one of the big factors this quarter was that the average ARR from flips this quarter was up almost 20%, and we highlighted some of those larger flips that are taking place. But I think in general, obviously, we're at a very high percentage of SaaS at 97% of the new business. I think public safety still will have some license deals in the second half of the year. And so that may even fall back a little bit. But the trend that Lynn just described is certainly continuing of greater acceptance of SaaS and public safety. So, I think you'll continue to see the flips trend upward, although they may bounce around a little bit from quarter to quarter and that the continuing -- the vast majority of our new deals coming in and SaaS will also continue."
},
{
"speaker": "Lynn Moore",
"content": "Yes. I think, Michael, too, I think when you look at the numbers and compare quarter-over-quarter from last year, we've talked about the public sector market and how budgets are healthy and sales pipeline is strong. I think you're seeing that. We had I think if you look at our total new software deals, it's up about 11% year-over-year. Our flips are actually up about 18% and our new SaaS deals were up about 20%. Licenses, as Brian mentioned, are continuing to decline. I think licenses in Q2 were a little less than 1% of total revenues. And for the year, maybe a little less than 1.5% is what we're looking for the rest of the year. You're seeing the results of a good healthy market, and you're seeing the results of that market continuing to embrace SaaS and the cloud."
},
{
"speaker": "Operator",
"content": "Next question is from the line of Charles Strauzer with CJS Securities. Your line is now open."
},
{
"speaker": "Charles Strauzer",
"content": "Just looking at guidance for the back half of the year, is there anything abnormal that we should think about when modeling the cadence of the back half? Just anything [indiscernible] into our thinking here."
},
{
"speaker": "Brian Miller",
"content": "I don't think there's a whole lot at a very high level, I think you'll continue to see revenue step up a bit from where they were in the second quarter, particularly around professional services, we'll continue to see grow a bit. SaaS will continue to see growth sequentially. I think the biggest growth in the second half will be, as you'd expect, SaaS revenues continue to step up quarter-to-quarter as more new customers come online and as we execute more flips and we get the impact of those revenues. The other revenue lines, I think generally, you'll see be fairly consistent with where they were in the second quarter across the third and fourth quarters. And dropping down to the bottom line, I think you'll see earnings generally in the same range that we see in the second quarter in the third and fourth quarters. And cash flow, certainly, the third quarter historically is by far our strongest cash flow quarter because of timing of maintenance collections and that will be the case as well."
},
{
"speaker": "Operator",
"content": "Next question is from the line of Alex Zukin with Wolfe Research. Your line is now open."
},
{
"speaker": "Alex Zukin",
"content": "I'm going to try to link a few threads and just throw something out there, which is it seems like your -- the flips are happening faster, they're larger. You're promoting somebody to run cloud full-time immediately. And so, I guess my question is, does it feel as though the value of that maintenance portfolio, the value of these flips given even the attach rate and the expanded portfolio of other services that you're cross-selling and the transactional revenues, is it just growing -- like if you look at the value of that pipeline, is it a lot larger than maybe what you were previously anticipating? And kind of how do you see that -- how should we think about that playing out in the P&L over the course of the next year or two?"
},
{
"speaker": "Lynn Moore",
"content": "Yes, Alex, I would say, I think in the last several quarters, we're actually starting to see a little bit more uplift than what we had expected. But I think what it does is when you step back and you look at our long-term Tyler 2030 goals, I'd say what's been happening over the last several quarters now as it's really validating what we've set out to do and what we said we're going to do. I would like to -- when you think about timing, one of the things we've constantly said is that as we look out to 2030, it won't be linear. But again, each quarter where I start to see some of these what I'm now calling momentums makes me feel even more confident about what we're doing and what we've set out to do."
},
{
"speaker": "Operator",
"content": "Next question is from the line of Saket Kalia with Barclays. Your line is now open."
},
{
"speaker": "Saket Kalia",
"content": "Okay. Great and echo the nice results in the quarter. Brian, maybe my question is for you. I want to just talk about the payments business a little bit. I think you said mid- to high teens growth -- revenue growth in the second half, and you correct me there if I'm wrong. But is there a way that you think about kind of the payments business as sort of an equation, right, between kind of same-store sales growth plus sort of share gains? Or maybe said another way, kind of a net revenue retention in that business plus new logo. How do you think about sort of that equation, even anecdotally as part of that kind of mid- to high teens growth rate in the second half?"
},
{
"speaker": "Brian Miller",
"content": "Yes. I think, and obviously, the change from the sort of low single-digit growth in the first half to the mid- to high teens in the second half, mostly revolves around that, the impact of us lapping the gross to net change from one of our state contracts midyear last year. But if you break down that kind of high teens growth, I think, generally, sort of the -- and it's a high level, but the sort of the same same-store growth or the same customer growth is typically kind of high-single digits, maybe approaching 10%, but kind of in that range is how we think about it. Some of that around our Digital Solutions division state contracts where they either have higher transaction volumes or we add additional services in a state that drive more revenues with that same customer. And then the difference going up into the mid- to high teens is sort of our new customer growth, and that's really reflecting the impact of driving the payments platform into our local government customer base and attaching it to both new and existing software customers. And we've talked about those being higher margin, higher premium pricing kinds of engagements. And those are the ones we're talking about. For example, this quarter that added $8 million of new ARR from new payment customers in our -- associated with our software customers. So, that's kind of generally how we think about that split."
},
{
"speaker": "Lynn Moore",
"content": "Yes. And I think when we think -- I think we outlined when we're looking out to Tyler 2030, we looked at transaction growth. It was really -- we're projecting long-term CAGR of sort of low double-digit growth. One of the things we're also seeing, Saket, is we've gotten a lot better at onboarding our clients. We're getting a lot more efficiencies there. And so, we're actually starting to get revenues recognized sooner. And then over time, to your point about sort of same-store sales is trying to drive further and further adoption across that client base is a significant driver."
},
{
"speaker": "Operator",
"content": "Next question is from the line of Terrell Tillman with Truist. Your line is now open."
},
{
"speaker": "Terrell Tillman",
"content": "I have one question and it'd almost be in two parts. So just bear with me. First, in terms of Idaho, congrats, Lynn, on the successful go-live. It sounded like four months, that's pretty strong. I'm curious though, you said this is an important milestone, I know you have some really large, on-prem or kind of private cloud customers in courts, but also maybe some that are more ready to move. How are you thinking about some of these other potential large, court flip opportunities, whether they're actionable this year or into next year? And then, Brian, just the second part of this question is, with CSI, ResourceX, ARInspect. I was intrigued last quarter because there were some big deals there. I think you said it was about a $4 million kind of quarterly run rate on those AI-based kind of solutions. Does that still hold? Or is it picking up from there?"
},
{
"speaker": "Lynn Moore",
"content": "Yes. Good question, Terry. On the Idaho SaaS flip, our courts -- there's only so many state court implementations out there. And so, getting the first one out there on time, live and referenceable was a pretty impressive feat by our people. And I'm going to make a little sidebar comment because we've talked about it before over the years. But I think one of the things that's really impressive about our teams is all the work that we do behind the scenes. We talk a lot about the numbers, but there's a lot of work that goes into getting these clients up and actionable, whether it's a SaaS flip or even just a new implementation, and our teams just did an incredible job. And as you know, this entire business is a reference business. And there were a lot of state courts who had inquired, have been asking about the SaaS flip, but they all were sort of keeping an eye on Idaho. So do I expect that to translate into other large, statewide SaaS flips or just other large court SaaS flips, I do. I'm not going to say that they're going to start happening in the month of September. But I think as you look out over the coming quarters, you'll start to see that momentum grow and build in that market?"
},
{
"speaker": "Brian Miller",
"content": "Yes. With respect to the three acquisitions from last year that have strong AI capabilities, they continue to perform really well in terms of the new business market, and they are continuing to grow. We highlighted last quarter a couple of large deals, and I think we mentioned a few of those this time as well. I think we've been really pleased with the speed at which those have started to contribute and we're able to leverage cross-sells. Of course, that's part of the thesis behind all of those acquisitions that we can leverage our existing sales organizations in our existing customer base and new deal opportunities to sell more of those newly acquired products. And I think we've been really pleased with the speed at which we've been able to execute on those and particularly CSI adding that to some of our large court deals. ResourceX already had some large client engagements, and we're continuing to see those come on board as well in ARInspect. We called out several state deals there this quarter. So those are all performing really well and contributing nicely kind of out of the box."
},
{
"speaker": "Lynn Moore",
"content": "Yes, there's a lot of buzz for these out in the marketplace, Terry. And as Brian said, it's kind of twofold. On the one hand, it's a great playbook that we've run for many years, a tuck-in acquisition that we can get in the hands of our sales teams and get out to our installed base but also in areas like ResourceX, for example, I mean, it's a differentiator for us in our new enterprise ERP sales. So, it's both a competitive advantage in new sales but also a huge opportunity to deploy through our installed base."
},
{
"speaker": "Operator",
"content": "Next question is from the line of Josh Reilly with Needham & Company. Your line is now open."
},
{
"speaker": "Josh Reilly",
"content": "Just on the Dallas data center closure, can you just remind us in the income statement where the expenses for that data center lie? And what's the implication for our second half modeling with that shutting down? And then just secondarily, along the margin front, can you just give us some color on what drove the margin improvement in services?"
},
{
"speaker": "Brian Miller",
"content": "I'll take the first part of it. Most of the cost for the data center are up in cost of subscriptions. So, they're up in the gross margin line, there's also -- I mean there's depreciation, there's operating costs and there's some personnel costs. Those -- the first data center that closed, the Dallas data center is a colo facility. So, there's not a real estate impact there. So those costs will be part of our margin profile in the second half of the year. But also remind you that around the second data center, which we expect to close around the end of next year, the bubble costs or the duplicate costs of running that data center and incurring costs in AWS as we migrate customers out, those costs continue to increase until they go away because we continue to move more customers out of that data center as we progress towards its closure. The impact of the closing of the first data center is somewhat offset by the ongoing impact of the second data center. And then we'll get a bigger bump at the end of -- after that data center closes in '25. So again, I think overall, I think operating margins are probably pretty consistent in the second half of the year with where they are here in Q2."
},
{
"speaker": "Lynn Moore",
"content": "Yes, I'd say -- I'd add to that, Josh. One of the things that's gratifying to me is we outlined this vision of closing the data centers a couple of years ago, and we're basically hit it on track. And that takes a lot of work by a lot of people. And again, it continues to validate some of the things that we've outlined a couple of years ago as we started our cloud transformation. So that's gratifying to see. The other obvious upside of getting out of the Dallas data center and eventually out of the [indiscernible] data center is all the future CapEx savings. We would spend a lot of money over the next five, seven years, adding to those capabilities had we not done that. Your question on pro services gross margins, it's a couple of things. I would say, one, it's been an enhanced focus, sort of a top-down focus from the management team over the last year plus. It's something that we're dissecting and continue to dissect and look at things around really focusing on those gross margins, utilization, things like that. The other thing that's been driving it is we're starting to see a little more stability in our workforce, and we've been seeing that for several quarters. So turnover is a lot lower. And in the Pro Services area, when you experience elevated turnover, which we did coming out of COVID, we did during sort of that period post COVID when people were transferring out and going through -- the grass is always greener. It's tough because it takes a long time to get people trained, up to speed and get to a point where they can be out in the field and be billable. And so, I think it's part of what we're seeing overall in the labor market. But having that return of more stability and more consistent, historical Tyler turnover levels is certainly helping. But it's also been an enhanced focus from the management team."
},
{
"speaker": "Brian Miller",
"content": "I think the ongoing move to the cloud helps us there as well because in a general sense, we're able to deploy software more efficiently in the cloud. And version consolidation helps us as well to some extent there on both services and support."
},
{
"speaker": "Lynn Moore",
"content": "And to that point, Brian, I guess, remote delivery of services, it's something we really started around COVID and clients continue to have more and more acceptance of that delivery model."
},
{
"speaker": "Operator",
"content": "Next question is from the line of Peter Heckmann with D.A. Davidson. Your line is now open."
},
{
"speaker": "Peter Heckmann",
"content": "Most of my questions have been answered. I just wanted to follow up on the NIC transaction and just see if you're seeing any changes in terms of those self-funded, state-level IT portal deals. If the states are looking for something different, something more and then just curious about the -- it looks like you had good renewal activity here in the first half. But do you -- I guess, what's your perception of other states migrating to that self-funded portal model in the future? Or do you think it's more likely that you do something more on an agency-by-agency basis at the state level?"
},
{
"speaker": "Lynn Moore",
"content": "Well, it's a little bit of both. Peter, the state-funded model is what old NIC now DSD grew up with. And there's -- I think there's going to be continued demand for that type of model as budgets are constrained. We talked about it, last quarter the significant deal we signed with -- last quarter, quarter before the California State Parks, which that deal could not have happened. It's the largest contract in Tyler's history, and that deal could not have happened absent the self-funded model. I do think you're going to -- we're also going to continue to see more and more agency by agency. That's part of our strategy, getting more products in on a targeted agency basis that's probably more aligned with the more historical Tyler model. We've done some things internally over the last couple of quarters really consummated in the last year. We've done an internal realignment between our Platform Solutions division and our Digital Solutions division so that we can take advantage of both of those opportunities, align our sales teams, eliminate some overlap but really start to drive both types of sales as we go forward."
},
{
"speaker": "Operator",
"content": "Next question is from the line of Jonathan Ho with William Blair. Your line is now open."
},
{
"speaker": "Jonathan Ho",
"content": "Can you give us a little bit of additional color about your thoughts around cybersecurity and what this could potentially mean in terms of either upsell opportunities or accelerated transition to the cloud? Just want to get a sense for how much this is sort of impacting the industry as a whole."
},
{
"speaker": "Lynn Moore",
"content": "Yes, Jonathan. I mean, as we know, it's a reality. We always say it's even -- it's not a matter of if, it's when. And cybersecurity event has certainly impacted both our clients and other public sector agencies that aren't our clients. It is a natural opportunity to accelerate discussions around moving to the cloud and flipping to the cloud. We've had a number of those. We don't necessarily -- I talked about a couple of public safety that happened last quarter. I don't really like to highlight them too much. but that's -- it's a reality that's going on in the market. And one of the things that I think we're getting better at is as we're flipping clients to the cloud for whatever reason but certainly in the cyber -- as a result, cybersecurity is, it is an opportunity to get them more modern and add some more products in the mix. So again, it's out there. we're all dealing with it. And our goal really is to be as responsive to our clients as possible, and we've gotten better. I've mentioned at public safety -- we've also gotten better about being able to stand up clients really quickly, maybe not with the full functionality that they might have had in an on-premise system out of the box but enough to get them going, which also gives us an opportunity to sort of reevaluate all of their requirements and potentially upsell other items. And so yes, it's just out there."
},
{
"speaker": "Operator",
"content": "Next question is from the line of Kirk Materne with Evercore. Your line is now open."
},
{
"speaker": "Kirk Materne",
"content": "Yes. Congrats on the quarter. Lynn, I was wondering, on the public safety side, when customers are now flipping in a bigger way towards cloud, how does that change the competitive environment for you? Meaning, I'd imagine there are a lot of smaller competitors that don't necessarily either have the scale on the cloud side or potentially or as advanced as you all, is that leading to better, I guess, win rates in that particular segment of your business as well?"
},
{
"speaker": "Lynn Moore",
"content": "Yes. I think, Kirk, it's certainly a competitive differentiator right now. And I think we've seen this historically across different business lines. There's always times when competitors sort of make a move and then we make a move. I'd say right now, I like where we sit with public safety. We have the most comprehensive offering. We have the most comprehensive offering that can be deployed in the cloud. There are some smaller players who certainly have some cloud-native offerings but may not have the depth of functionality and may not really be good candidates for some of these larger deals and whether or not their ability to execute on it. What's been impressive, I think over the last 18 months or so -- 12, 18 months at public safety is the execution on this strategy. It's a shift in mindset for that sales team, it's a shift in mindset for all the operational teams and messaging that out to the market, it's resonating, and it's something that's exciting to see. I remember a couple of years ago talking about how it could be several years, maybe five, six years before we were even at 50% SaaS levels at public safety. And it just shows you that the changing dynamics in the market. And fortunately, we've been in a position through some of the work we've done over the years to not only capitalize on it but also help lead it."
},
{
"speaker": "Operator",
"content": "Next question is from the line of Gabriela Borges with Goldman Sachs. Your line is now open."
},
{
"speaker": "Kelly Galanis",
"content": "This is Kelly Galanis on for Gabriela. Congrats on the quarter as well. Given that a lot of your customers are now kind of on a new fiscal year, can you share some early observations on what customer budgets are looking like this year relative to last year? And then, how much of this stronger demand that you're seeing is tied to these healthy budgets versus kind of just demand for cloud and these other the factors you're talking about."
},
{
"speaker": "Lynn Moore",
"content": "Yes. I don't know that -- yes, we -- for a lot of our clients are on June 30 fiscal year. But I don't know that we necessarily have significant insight in those budgets. They're pretty steady. They're pretty healthy. Most of our sales procurement cycles are multiple years long or certainly long, not all multiple years but they tend to be lengthy. I think -- I'm sorry, I lost my more train of thought there. So yes, I think the budgets are healthy right now. And I think our win rates are good. One of the things that I've -- we have noticed this year is, I think, probably a leading indicator is when you look across our product lines, all of the indicators are still strong. And really, most of our divisions, almost all of our products are either at or above sort of what their sales projection was for the year in terms of being midyear. So that's a good tailwind as we look out over the next several quarters. And right now, we're not seeing any -- certainly no negative changes in the public sector budgets."
},
{
"speaker": "Brian Miller",
"content": "Yes. And I think the other -- the other side of that strong demand is this increasing desire for digital modernization, and it's really how governments increasingly do -- address doing more with less resources. So, to the extent that they have really struggling with understaffing, a lot of workers left the public sector space during COVID and in general, government has not rebuilt its workforce. So, they're trying to perform these essential services with staffing constraints and really turning to technology as how they do that. So I think it's a little bit even more than just the traditional replacing a 20-year-old system that's at end of life and is dying but being more strategic about it and saying, okay, the new technology will help me do the things I have to do with either the budget or the personnel constraints that I'm forced to deal with."
},
{
"speaker": "Operator",
"content": "Next question is from the line of Mark Schappel with Loop Capital Markets. Your line is now open."
},
{
"speaker": "Mark Schappel",
"content": "Nice job on the quarter. John, question for you in your prepared remarks, you noted continued progress you're making around your product version consolidation efforts. Just wondering if you could elaborate on the progress you made during the quarter on that front and also what we can expect maybe in the coming quarters here."
},
{
"speaker": "John Marr",
"content": "Yes, sure, Mark, obviously, version consolidation has been a big part of what I've been calling sort of Phase 1 of our cloud transformation. Phase 1 is selecting AWS. It's a product optimization, it's version consolidation. It's the flips, it's exiting the data centers. Version consolidation is critical for a lot of reasons. One is we need to get down to a single product. We need to get down to a cloud release. We need to get our clients up-to-date on the modern versions. Otherwise, they're not really going to be flipping the cloud. That's part of the foundation for that. We don't really go I don't know that you see necessarily quarter-by-quarter progress, but you see goals that are being hit and attained. Anecdotally, for example, in our enterprise ERP division, which is formerly our munis product we now have about 95% of our clients down on a single version, whereas a couple of years ago, there were several versions with maybe hundreds of clients on different types of versions. So that's significant progress that's been made, and it's a focus across all of our divisions and all of our operating units, and they're making similar progress."
},
{
"speaker": "Operator",
"content": "Thank you for your question. There are no additional questions waiting at this time. So, I'll pass the call back to Lynn Moore for any closing remarks."
},
{
"speaker": "Lynn Moore",
"content": "Thanks, Matt. And thanks, everybody, for joining us today. If you have any further questions, please feel free to contact Brian Miller or myself. Thanks, everybody. Have a great day."
},
{
"speaker": "Operator",
"content": "That concludes the conference call. Thank you for your participation. You may now disconnect your lines."
}
] |
tyl | 2,024 | 1 | [
{
"speaker": "Operator",
"content": "Hello, and welcome to today's Tyler Technologies First Quarter 2024 Conference Call. Your host for today's call is Lynn Moore, President and Chief Executive Officer of Tyler Technologies. [Operator Instructions] And as a reminder, this conference is being recorded today, April 25, 2024."
},
{
"speaker": "",
"content": "I would like to turn the call over to Hala Elsherbini, Tyler's Senior Director of Investor Relations. Please go ahead."
},
{
"speaker": "Hala Elsherbini",
"content": "Thank you, Christa, and welcome to our call. With me today is Lynn Moore, our President and Chief Executive Officer; and Brian Miller, our Chief Financial Officer. After I give the safe harbor statement, Lynn will have some initial comments on our quarter and then Brian will review the details of our results and update our annual guidance for 2024. Lynn will end with some additional comments, and then we'll take your questions."
},
{
"speaker": "",
"content": "During this conference call, management may make statements that provide information other than historical information and may include projections concerning the company's future prospects, revenues, expenses and profits. Such statements are considered forward-looking statements under the safe harbor provision of the Private Securities Litigation Reform Act of 1995 and are subject to certain risks and uncertainties which could cause actual results to differ materially from those projections. We would refer you to our Form 10-K and other SEC filings for more information on those risks. Also, in our earnings release, we have included non-GAAP measures that we believe facilitate understanding of our results and comparisons with peers in the software industry."
},
{
"speaker": "",
"content": "A reconciliation of GAAP to non-GAAP measures is provided in our earnings release. We have also posted on the Investor Relations section of our website under the Financials tab, schedules with supplemental information, including information about our quarterly recurring revenues and bookings. On the Events and Presentations tab, we posted an earnings summary slide deck to supplement our prepared remarks. Please note that all growth comparisons we make on the call today will relate to the corresponding period of last year unless we specify otherwise. Lynn?"
},
{
"speaker": "H. Moore",
"content": "Thanks, Hala. Our first quarter results provided an exceptional start to the year, exceeding our expectations across key metrics, including revenues, earnings, operating margin and cash flow. Recurring revenues grew almost 9% and comprised 84% of our total revenues. SaaS revenues grew 22%, our 13th consecutive quarter of SaaS revenue growth of 20% or more, exceeding expectations of a 20% CAGR in SaaS revenues through 2025. In addition, transaction revenue surpassed our plan with higher volumes and positive pricing trends."
},
{
"speaker": "",
"content": "Our performance demonstrates the power of our business model against the backdrop of robust public sector demand, supported by generally healthy budgets. Our leading sales activity indicators remain elevated, and our pipeline reflects growing sales synergies as we execute our integrated go-to-market strategy."
},
{
"speaker": "During our Investor Day last year, we announced our Tyler 2030 Vision, which aligns our strategic focus on 4 key growth drivers",
"content": "leveraging our installed base, expanding into new markets, completing our cloud transition, and growing our payments business."
},
{
"speaker": "",
"content": "Leveraging our unmatched installed base has been a cornerstone of our growth strategy, and we're pleased with the outstanding execution by our sales organization, driving impactful cross-sell and upsell activity that further deepens existing client relationships and expands our market reach with new client engagements. Notable cross-sell and upsell wins during the quarter included a records management and ERP pro contract, including payments with Ada County, Idaho, leveraging our state enterprise relationship. And on-premises contract, for our full enterprise Public Safety suite with the City of Columbus, Georgia, adding to its existing Tyler courts, corrections, ERP, tax and permitting solutions."
},
{
"speaker": "",
"content": "An enterprise ERP win with the Texas Legislative Council facilitated by our existing Digital Solutions division relationship in Texas, which avoided an RFP process to secure a new enterprise ERP client in a nontraditional market. A combined SaaS contract with the city of Juneau, Alaska, for enterprise assessment and tax and enterprise permitting and licensing solutions. By prioritizing the cloud as one of our key growth drivers, we are unlocking new levels of innovation and responsiveness in making the cloud accessible for our clients, while providing enhanced security. Our new software SaaS mix continue to expand and comprised 93% of Q1 new software contract value."
},
{
"speaker": "",
"content": "We're particularly encouraged to see a growing preference for cloud technology in the state and federal market with our application platform and an accelerated shift in Public Safety cloud demand with multiple client-driven SaaS selections. In fact, 75% of our first quarter enterprise Public Safety deals were SaaS. Because the pace of the shift to SaaS in these markets this year is faster than we previously anticipated, we have lowered our expectations for license revenues for the year. And across Tyler, the volume of flip signed in the first quarter was in line with our expectations, with a 21.5% increase in average ARR."
},
{
"speaker": "",
"content": "Key first quarter new SaaS deals and flips included multiyear SaaS arrangements with the Hawaii Department of Natural Resources and land between the Lakes National Recreation area that build on our momentum in the outdoor recreation space. Competitive SaaS wins for Public Safety included a full enterprise Public Safety suite contract with Palm Beach, Florida, which was focused on a cloud-only strategy. We also won a sole-source enterprise Public Safety contract with the city of Evanston, Illinois, which expands our growing footprint in the Chicagoland area. An enterprise appraisal in tax for Fulton County, Georgia, which includes Atlanta. The contracts with ARR of more than $1 million was executed on accelerated timeline with a go-live completed within 1 month. Two Public Safety SaaS flips with Beringham, Alabama and Germantown, Tennessee, both of which were client-driven SaaS selections and accelerated go-lives. The Kansas judicial branch signed an enterprise justice appellate court SaaS flip as we continue to see a growing interest in moving to the cloud from our on-premises courts clients."
},
{
"speaker": "",
"content": "Another key driver of our long-term growth is our transactions and payments business. As I mentioned earlier, better-than-expected transaction volumes contributed to first quarter revenues that exceeded our expectations. In the first quarter, we signed 288 new payments deals across Tyler, representing approximately $9 million in projected ARR. In our state enterprise portal business, we signed a new 3-year enterprise contract with the State of Mississippi, extending our existing 14-year relationship. Our enterprise agreement with the State of Idaho was also renewed for 2 years in a rebid through the NASPO Citizen Engagement agreement."
},
{
"speaker": "",
"content": "We're also very pleased to see early traction and growing demand for the solutions we added to our portfolio through our 2023 acquisitions of CSI, ARInspect and RexourceX, each of which brought us expanded AI capabilities. With CSI, we signed a contract with our existing course client in Dallas County, Texas, adding approximately $900,000 of ARR. We've seen demo activity double over pre-acquisition levels for our augmented field operation solution, formerly ARInspect, with first quarter wins that included the city of Newark manhole inspections and an expansion contract with the New Jersey Department of Environmental Protection."
},
{
"speaker": "",
"content": "For our priority-based budgeting solution powered by RexourceX, we signed contracts with Collier County, Florida and Fort Worth, Texas that added almost $600,000 of ARR."
},
{
"speaker": "",
"content": "Now I'd like Brian to provide more detail on the results for the quarter and our updated annual guidance for 2024."
},
{
"speaker": "Brian Miller",
"content": "Lynn, total revenues for the quarter were $512.4 million, up 8.6% and organically grew to 7.8%. Subscriptions revenue increased 11.7% and organically rose 11.4%. Within subscriptions, our SaaS revenues grew 22% to $148.8 million and grew organically 21.3%. Keep in mind that there's often a lag from the signing of a new SaaS deal or a flip to the start of revenue recognition that can vary from one to several quarters. Because of this, as well as the timing of SaaS renewals and related price increases, SaaS revenue growth, both year-over-year and sequentially may fluctuate from quarter-to-quarter."
},
{
"speaker": "",
"content": "Transaction revenues grew 3.7% to $164.5 million. While transaction revenues exceeded our plan, primarily due to higher transaction volumes from new and existing clients, including driver history records, the year-over-year comparison continues to be impacted by the change last year from the gross model to the net model for payments under one of our state enterprise agreement. SaaS deals comprised approximately 93% of our Q1 new software contract value compared to 87% last year."
},
{
"speaker": "",
"content": "During the quarter, we added 200 new SaaS arrangements and converted 90 existing on-premises SaaS clients -- on-premises clients to SaaS with a total contract value of approximately $86 million. In Q1 of last year, we added 145 new SaaS arrangements and had 73 on-premises conversions with a total contract value of approximately $86 million. More importantly, the average ARR associated with our Q1 flips increased 21.5% over last year. Including transaction revenues, expansions with existing clients and professional services, total bookings increased 15.7% on an organic basis."
},
{
"speaker": "",
"content": "Our total annualized recurring revenue was approximately $1.72 billion, up 8.8% and organically grew 8.2%. In previous quarters, we discussed our expectation that 2023 would be the operating margin trough from our cloud transition and that 2024 would mark a return to operating margin expansion. Our non-GAAP operating margin in the first quarter was 23.8%, up 210 basis points from last year. The margin expansion reflects improved margins for our cloud operations along with effective operating expense management. As we discussed on previous calls, merchant and interchange fees from our payments business under the gross revenue model, have a meaningful impact on our overall margins as they are passed through to clients and are included in both revenues and cost of revenues. We paid merchant fees of approximately $42 million in Q1."
},
{
"speaker": "",
"content": "Both cash flows from operations and free cash flow were above expectations for the quarter at $71.8 million and $57.2 million, respectively, which allowed us to repay the remaining $50 million of term debt outstanding from the NIC acquisition earlier in the year than planned. We ended the quarter with $600 million of convertible debt outstanding and cash and investments of approximately $202 million. Our net leverage at quarter end was approximately 0.79x trailing 12-month pro forma EBITDA with our only remaining debt of $600 million convertible due in 2026."
},
{
"speaker": "",
"content": "Our updated 2024 annual guidance is as follows. We expect total revenues will be between $2.110 billion and $2.140 billion. The midpoint of our guidance implies organic growth of approximately 8.5%. We now expect that merchant fees will be up slightly over last year and that implied organic growth, excluding merchant fees, would be approximately 50 basis points higher. We expect GAAP diluted EPS will be between $5.27 and $5.47 and may vary significantly due to the impact of discrete tax items on the GAAP effective tax rate. We expect non-GAAP diluted EPS will be between $9.10 and $9.30. We expect to see sequential growth in earnings throughout the year with both revenues and EPS slightly weighted towards the second half. We expect our free cash flow margin will be between 17% and 19%, including the estimated impact of approximately $58 million of incremental cash taxes related to Section 174. Other details of our guidance are included in our earnings release and in the Q1 earnings deck posted on our website."
},
{
"speaker": "",
"content": "Now I'd like to turn the call back over to Lynn."
},
{
"speaker": "H. Moore",
"content": "Thanks, Brian. Our performance in the quarter demonstrates strong execution by team members across Tyler in key strategic areas, anchored to our Tyler 2030 Vision. We are starting to see the expected benefits of our cloud transition through progress with version consolidation, cloud optimization of products, cost efficiencies and improved agility as we empower our clients who serve the public through Tyler's next-generation cloud applications."
},
{
"speaker": "",
"content": "Our strong first quarter results and positive outlook for the remainder of the year are reflected in our revised annual guidance. Even with lower expectations for license revenues because of the accelerated shift to SaaS with our Public Safety and application platform solutions, we've raised our revenue guidance while also increasing our earnings outlook."
},
{
"speaker": "",
"content": "We recently published our 2023 corporate responsibility report, our fifth annual sustainability disclosure covering our environmental, social and governance activities. Our sustainability initiatives in 2023 included investments in data management, validation and processes to drive reporting efficiencies. We also undertook a double materiality assessment to understand key insights for multiple constituents on both financial materiality and impact materiality. We hope you take the time to review our report, which is available on our website."
},
{
"speaker": "",
"content": "Finally, we're excited about Tyler Connect 2024, which will take place May 19 to 22 in Indianapolis. Nearly 5,000 Tyler clients and 900 Tyler team members will come together for training, collaboration and networking, and we're looking forward to inspiring our clients with the latest innovations from Tyler."
},
{
"speaker": "",
"content": "Now we'd like to open the line for Q&A."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] And your first question comes from Rob Oliver from Baird."
},
{
"speaker": "Robert Oliver",
"content": "Lynn, mine is for you. You mentioned in the outset of your prepared remarks, kind of your growth focus areas, but you talked about the kind of growing sales synergies and the integrated go-to-market strategy that you guys laid out in more detail last year. And I know this has been a big push of your since you assumed the CEO role. Could you give us a little bit of color on kind of what if some of those growing sales synergies are? Where you're excited about the progress you've had so far? What some of the levers you're pulling are? And what are some areas you still need to improve on? I appreciate it."
},
{
"speaker": "H. Moore",
"content": "Yes. Sure, Rob. It's a good question. Last year, we elevated a couple of people to oversee all of our public admin sales, all of our justice sales. They're working more closely together than ever before. We've done things around aligning some incentive comp plans and changing the way people are comped to make sure that, for example, it's -- in the old days, it's well -- whose P&L is this recognized by. And we wanted to break down some of those barriers so that really, when -- it's all about Tyler, when Tyler wins, everybody wins. And so we've been doing things like that. We've done some things, and we're still in the process of -- and some of that's still work-in-progress."
},
{
"speaker": "",
"content": "I mean when I say that we started these initiatives, they're not by any means finished, but these are things that are work-in-progress. We're doing things around our PSD and DSD divisions, our application platform and formerly NIC, we see a lot of synergies there. So we're doing things right now to start to bring some of those divisions closer together so that they can work more closely with sales and operating efficiencies. We believe the application platform is tailor-made for state government. And so just a number of initiatives like that. It's -- there's a lot going on. And I think we're going to continue to see improvement as we look out forward."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Saket Kalia from Barclays."
},
{
"speaker": "Saket Kalia",
"content": "Lynn, the numbers are pretty straightforward. So maybe I'll ask just a little bit of a higher level question. It sounds like just the spending backdrop in state and local governments continues to sound healthy. But just to make sure the question is asked, can you talk about, Lynn, what you've seen historically from those customers in presidential election years? I mean I imagine that those 2 things aren't terribly related. But again, I just want to ask -- I want to make sure that question is asked as we kind of get deeper into election season."
},
{
"speaker": "H. Moore",
"content": "Yes, I don't know that historically, there's been much of a correlation between our sales and the presidential election year more so than what may be going on in the broader macroeconomic environment. As you note, the budgets for our clients are healthy and strong. Our sales outlook for the year, and we have some pretty aggressive sales plans, but our sales outlook for the year are looking on plan and significant parts of our business actually, may be ahead of plan. Maybe a little bit in the federal space. I don't know that I've got enough experience yet with our federal space as to what impact that may have. But it's normally more so around what's going on with the federal funding and budgets. But I think generally, in our -- if you look at our traditional local and state space, I haven't seen a lot of change in my 25 years plus."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Matt VanVliet from BTIG."
},
{
"speaker": "Matthew VanVliet",
"content": "I said you continue to see a higher and higher mix of business going to set contracts and I believe even see an acceleration to a certain extent on the flips side [indiscernible] Public Safety or maybe holding you back [indiscernible] the case for or, I guess, impetus to try to push forward on more flips, maybe encouraged customers at a little bit more of an accelerated pace to move over and just try to get this done with sort of as quickly as possible? Or any changing in your thinking there of the motivation of customers?"
},
{
"speaker": "H. Moore",
"content": "And you're kind of cutting out, I think I got most of your question, Matt. I'll start. Brian, you can certainly jump in. At Public Safety, I think it's a couple of things. I think actually, as you step back and you go back to 2019, when we sort of announced that we were going to go cloud-first from cloud agnostic, some of the message was we were going -- at least internally was we were going to take our leadership position and start leading the market to where we thought it was going to go and needed to go. In Public Safety, as you know, historically, it's been a little bit slower. We've spent a couple of years. We've got some new leadership Public Safety. Our position in Public Safety is we're very competitive. It's a competitive space, but we're in a very competitive space and a place, excuse me."
},
{
"speaker": "",
"content": "And really starting this year and started more so third quarter, fourth quarter last year, we've taken the approach that we are going to start leading with SaaS with Public Safety. And so that's resonating. We talked about the Palm Beach, Florida contract. That was a deal where they were only looking for a SaaS arrangement. As we look out this year, we're going to continue to do things to push things quicker to SaaS. At the end of the day, it's still the customer's choice. There's a lot of selling things around that. You look at our Public Safety, I think our plan for the year was to do about 50% on-prem licenses, give or take, which was up significantly from last year. And what we're seeing right now, I think we reported 75% in Q1."
},
{
"speaker": "",
"content": "As it relates to flips, there's a lot of selling messages generally around flips and where all our sales folks are armed with those. I think one thing that you're also starting to see, and we've talked about it before on earnings calls is the continued rise of cybersecurity and ransomware attacks are also sort of triggering clients to want to push to SaaS faster. And the more that they see that out in their community, which aren't always publicized, I think that's also sort of starting to grease the wheels a little bit to make that decision to move to SaaS."
},
{
"speaker": "Brian Miller",
"content": "I guess, the only thing I'd add to that is, in terms of our ability to significantly increase, the pace of flips beyond the sales efforts that Lynn talked about. We have talked about in the past the need for clients who aren't on the current version of our products generally to upgrade to that version either before or when they look to the cloud as we drive towards having one version of each product in the cloud. And we've made a lot of progress with version consolidation and sunsetting old versions and moving clients along, but that continues to be a gating factor in the pace of flips."
},
{
"speaker": "",
"content": "And so as we continue to make progress with that, it opens up more opportunities from clients being in a position to flip. But as we've talked about, especially as we move into the larger flips, they're complicated processes from a planning perspective. And so the timing leading up to the flip from the time we start engaging with clients, sometimes can be kind of lengthy. So we're certainly pushing it as fast as possible. We've talked about a road map that varies by product, but across all of our products, converges on us being at 80%, 85% of our on-prem customer base having moved to the cloud by 2030, and all of our business units have road maps that are aligned with that goal."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Ken Wong from Oppenheimer."
},
{
"speaker": "Hoi-Fung Wong",
"content": "This one for you, Lynn. When we look at the number of subscription contracts, it looks like it took a really big step up this quarter. I think you touched on some of the highlights. Just wondering if that's more of a kind of a lumpy volatile seasonality type of a situation we're seeing there from the jump up to 200? Or do you think that, that is perhaps a closer reflection of the run rate we can expect going forward?"
},
{
"speaker": "H. Moore",
"content": "It's probably a little bit of both. I think one -- obviously, with 200 new deals are going to vary in size and scope. But if you step back generally, when I think about 200 new contracts a year -- a quarter, that plays out to over 800 a year. That's a lot of business we're doing, and that's a lot of business we're executing on. It's great work by our sales teams. It's great work by our ProServe teams to then turn that into revenue. But I think it's -- I don't know that that's the new -- it's certainly higher than it was coming out of Q4 last year and most of last year. I think last year, we did about 750 new deals, give or take for the year. So we're on pace a little better. But as I said, right now, markets are healthy, budgets are strong. Our sales outlook, all indicators are positive and our sales outlook looks good for the year."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Alexei Gogolev of JPMorgan."
},
{
"speaker": "Alexei Gogolev",
"content": "Considering the elevated level of demand that Lynn, you just referred to, has your win rate remained relatively consistent at around 50%? And if it has, it feels like you should be taking more market share. Do you feel that you could show acceleration of organic revenue growth in the near term?"
},
{
"speaker": "H. Moore",
"content": "Yes. Thanks, Alexei. I'd say, generally, our win rates across the board are consistent. And when you say 50%, that's -- you got to look by each sort of major products. So there's certainly some areas where our win rates are 80%, 85%, some that are more competitive spaces, we talk about Public Safety, we talk about sort of the mid- to higher ERP space where there's -- it's a lot more competitive market, and they may sort of be around there. So those really haven't changed. There's still -- we still have some of the same lag factors that we talked about before between time of getting a deal to contract to getting them up and running. But yes, I mean, we -- as we look out, we've -- our overall revenue growth sort of slowed over the last 2 years, and I think we've said we expect that to pick back up, and we're starting to see some of that."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Joshua Reilly from Needham & Company."
},
{
"speaker": "Joshua Reilly",
"content": "So we're hearing some of your venture-backed start-up competitors in Public Safety, specifically records management are having challenges getting customers live. Are you using this as an opportunity to go back to these customers and highlight the Tyler value proposition? And then just more broadly, how often have you seen this across other product lines where some of the venture-backed start-ups are making promises about getting customers live on timelines that they are unable to execute on?"
},
{
"speaker": "H. Moore",
"content": "Yes, Joshua, that's a good question. And it's something we've seen, I'd say, really, over the 25-plus years I've been at Tyler. There's always seems to be little periods where someone comes up, makes little splash, they have a little spotlight on them. They certainly have a demo that looks good. They wouldn't have the depth of functionality and products that we've had because they haven't been in the space for as long as we have, but they win some business, but that's only part of the battle. We've always said part of Tyler secrets sauce is not just winning the business, but executing on the business. And it's hard stuff. Take, for example, our municipal and schools division, which really sells more on the low end of ERP and has some courts and things like that."
},
{
"speaker": "",
"content": "They did, I think, last year -- I mean last quarter, they did 207 go-lives in 1 quarter. Now obviously, that's a -- those are small deals, but that's a lot of business. And that's the hard part. And people, I think, from the outside, generally sort of look at Tyler's results and say, boy, this is an easy business. This business is something we ought to invest in and get into. And what we found, not just with venture-backed, but some PE money that's come in, is they didn't really understand the market, and it's a lot more difficult than it may look at times from the outside. And it's a testament to all our hardworking people at Tyler, it's testament to our culture, it's a testament how we view our relationships with our clients. So no, it's -- I appreciate you bringing that up because it's not something we spend a lot of time talking about. But it's -- you're only successful as your last implementation in this business and all our clients talk. So when you fail, everybody knows."
},
{
"speaker": "Operator",
"content": "Your next question comes from Clarke Jeffries from Piper Sandler."
},
{
"speaker": "Clarke Jeffries",
"content": "Brian, very encouraging to see operating margins up substantially, and operating income dollars up 19% year-over-year. You talked about improved cloud operations as a driver of that. Does that mean that some of the capacity in the private cloud is already being reduced? And you're taking up EPS today, but could you talk a little bit about the expectations for full year, how operating margins pan out for the rest of the year?"
},
{
"speaker": "Brian Miller",
"content": "Yes. It's not so much of the capacity. We do continue to move clients to AWS, and we are on track with our plans to evacuate our first data center midyear of this year. But really, that -- a lot of those costs don't go out until after that data center is closed. So that's not really the biggest factor. Some of the things driving those improved cloud efficiencies are the releases we've had over recent quarters of the cloud optimized versions of our product, which improves the efficiencies and lowers our hosting costs at AWS. The progress we've made with version consolidation, and we made significant progress last year and continue to have aggressive plans this year about sunsetting older versions of products and getting the benefits from both support costs and development costs around the expenses associated with supporting multiple versions of multiple products."
},
{
"speaker": "",
"content": "And the new AWS agreement that we talked about last quarter has provided us with increased efficiencies or increased cost efficiencies around our hosting costs. So all of those are continuing to play out. And then on the revenue side, the outperformance in terms of revenues, especially on the payment side, where we were able to cover fixed costs in a better way with incremental revenues from things like driver history records above our plan that contributed there. And then lastly, we mentioned briefly, but continue to have effective expense management of OpEx. So both sales and marketing and G&A costs are growing at a slower rate than our than our overall revenues. So we're getting efficiencies there and those factor into the rest of the year as well."
},
{
"speaker": "H. Moore",
"content": "Yes. Clarke, I'd add, we are seeing efficiencies through the cloud, but there's still a runway to go in the efficiencies that we're going to achieve. And there's some other internal initiatives, we don't talk a lot about, things like improving our gross margins on pro services. We've seen -- we saw an uptick of that in Q1. That's really a function of a few different things. It's more of -- it's a strategic focus that we started working on last year. But it's also a function of that we've had a more stable labor market. Our turnover has been much lower and sort of returned back to pre-COVID levels. And that really helps. It helps drive billable utilization. Other internal initiatives around things like rationalization of some internal IT costs and real estate costs. Things that we've been working on behind the scenes are all starting to show some results in addition to the cloud. But I want to emphasize that the efficiencies that we're going to see from further version consolidation and optimization and all the things that we're going to do in the cloud are still out there for us to go capture."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Michael Turrin from Wells Fargo Securities."
},
{
"speaker": "Michael Turrin",
"content": "Maybe on transaction revenue, the prepared materials mentioned a customer change from gross to net. Would be curious on the rationale there, whether that's something we could see other customers elect for? And Brian, maybe you can just walk through both the margin impacts for us to consider there as well as the increased growth guide. Fast start came up a couple of times on the call, but if there's any supporting commentary on what's driving that, also helpful."
},
{
"speaker": "Brian Miller",
"content": "Sure. Yes, last year, and we talked about this some last year, we actually had 2 clients last year, state enterprise clients that had changes from the gross to the net model. And still, the vast majority of our payments business is on the gross model, and we expect that to continue to be the case. So we really don't see sort of large-scale changes like that ahead. It is a client decision. Most of our clients prefer the certainty and predictability they get from having a growth arrangement with us, where we're responsible for the merchant fees and interchange fees and bear the risk of the fluctuation of those. And -- so most of our clients prefer that."
},
{
"speaker": "",
"content": "These two clients, one changed towards the beginning of the year. The one that's still impacting our comparisons changed midyear last year, and they had roughly between $4 million and $5 million, a quarter of merchant fees associated with that account. So it will impact us in terms of our comparison for the first half of this year, and then it will lap itself and it won't be a factor. So as a result, our growth in transaction revenues because of that impact, and again, an impact on revenues, it actually improves margins by going to the gross model and the merchant fees for the first half of the year will just be up -- or transaction fees for the first half of the year, grow in the low single digits. But the second half of the year, we expect low to mid-teens when that impact has lapped. But again, I don't see that as a real trend going forward, but it is a client decision on an individual basis and different clients have different approaches to the risk they're willing to take and whether they're willing to manage those and pay those merchant interchange fees directly themselves."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Jonathan Ho from William Blair."
},
{
"speaker": "Jonathan Ho",
"content": "Just wanted to maybe understand a little bit better the progress that you're seeing, I guess, adding more transaction-based systems to your existing customers. Can you give us a sense of how penetrated you are in terms of those transaction systems? And whether you're sort of on plan or on track in terms of adding more content to these existing contracts?"
},
{
"speaker": "H. Moore",
"content": "Yes, that's a good question, Jonathan. I don't have those numbers just off here off the top of my head, we certainly can get back to you with those. I would say that generally speaking, we got a long runway left. We're still pretty early in our transactions business. You can point to our presentation at Tyler 2030 for how we saw transactions revenue to grow and the cash flow from that over the next 5 to 6 years."
},
{
"speaker": "Brian Miller",
"content": "Yes. We're still in the very early stages, very early innings of driving that cross-sell. We've done a lot of work with integrating the payments platform into our software products that have significant payments capabilities, things like utility billing and traffic court and licensing and permitting. And then as Lynn talked about earlier, the initiatives we've had to -- that in place more effective cross-selling sales motions. And we're starting to see the impact of that with, I think, we see 288 new payments deals across Tyler's customer base, but it's a very small fraction that we've penetrated so far of our software customer base with our payments platform, and that continues to build momentum, and we're really pleased with -- I'd say we're at least on track with our plans for this year. But again, in the very early innings of that."
},
{
"speaker": "H. Moore",
"content": "Yes. And I'd add to that, Jonathan. I mean, last -- I guess, now 2 years ago, we acquired Rapid Financial, which is the disbursements world. We are -- we barely scratched the surface with that. So still a lot to do on both sides. I would say if you look -- again, point you to our 2030 presentation, I'd say we're kind of on track right now for that."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Keith Housum from Northcoast Research."
},
{
"speaker": "Keith Housum",
"content": "I want to unpack a comment you made earlier in terms of cybersecurity as a driver of public agencies moving to the cloud. Are we seeing like the concerns about ransomware and cybersecurity is perhaps a tailwind that you guys are dealing now with just for public safety, but across the board? And are you seeing the life cycle of the systems that you're replacing, is that shrinking? So are we seeing an acceleration in the refresh cycle, albeit it might be small, but are we seeing some level of that, you think?"
},
{
"speaker": "H. Moore",
"content": "I don't know about that. I guess I would just say that -- so my comment before on cybersecurity is look, we all know what's out there. It's a big event when it happens to a client. Generally, they -- as I said, they view us and we view them as their trusted partner, and we're usually there to help them. And one of the things that they realize quickly is getting them into the cloud will make them much more secure. It's -- to say that there's driving flips, it is. It's not a huge tailwind, but it's out there. And it's not necessarily something that we're hoping for. But it's just a fact of life. It's a fact of doing business in today's world."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Kirk Materne from Evercore ISI."
},
{
"speaker": "S. Kirk Materne",
"content": "Brian, on the 21% growth in ARR and the flip, is that just largely pricing? Does that include cross-sell, upsell? I guess what does that entail? Is that -- I'm just trying to get a sense of it, that's sort of apples-to-apples or if you're seeing some of the sales synergies Lynn discussed earlier, factoring into that growth as well."
},
{
"speaker": "Brian Miller",
"content": "Yes. I think the biggest factor is larger average deal size. So we're seeing at least in the mix this quarter, and it won't necessarily be consistent every quarter because that can be kind of lumpy what that mix is. But we saw more bigger customers move we highlighted one of them, Fulton County, Georgia, with their tax solution. I think $1.3 million in ARR from that one. So seeing generally more larger customers in the mix. Last quarter, we had our first court flip. This quarter, we had the pellet court in Kansas flipping."
},
{
"speaker": "",
"content": "So it's more around the average size of the clients. But there also is upsell in those as well. So I think the average we've talked about still tends to be about 1.7, 1.8x uplift relative to the maintenance, but in some of these -- especially some of the larger ones, we've seen a bigger uplift where we've added new services or additional products when they flip. So a combination of both of those things."
},
{
"speaker": "H. Moore",
"content": "Yes. And Kirk, I think there's also been a few occasions where we may have won business a while ago. And to get that business, we had some contract concessions, maybe had some fixed pricing for a period of time. And the SaaS flip is an opportunity to sort of revisit that."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Gabriela Borges from Goldman Sachs."
},
{
"speaker": "Gabriela Borges",
"content": "And Brian, I want to reconcile some of the commentary you're making on transaction -- on the transaction business. You commented specifically around higher transaction volumes and better pricing. So maybe just help us understand, is the volume is a function of the traction you're making in cross-sell and the run rate that you talked about earlier? Or is there an underlying dynamic going on as well? And then if you could touch on the pricing as well. Is there an additional dynamic around better pricing, independent of some of the specific contracts you talked about changing from gross to net and vice versa?"
},
{
"speaker": "Brian Miller",
"content": "Yes. On the pricing side, specifically, we've talked about that as we continue to drive more business into the Tyler software customer base, we're able to generally achieve premium pricing or better pricing than a sort of a commodities type payment arrangement where we provide additional value from things like automated reconciliations. So having the software or the payments platform embedded with the software creates additional value for the customer and lets us get better pricing than some of the just payments-only type contracts."
},
{
"speaker": "",
"content": "So as we continue to add those, we're seeing improvements there. We've seen as well some price increases in some of our revenue-sharing arrangements with third-party payment processors that have also benefited us. And then we also saw, even though they're down year-over-year, we saw better-than-expected revenues from some of the other transaction volumes like driver history records, which tend to be a higher margin business as well. So sort of a combination of things driving that pricing."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Mark Schappel from Loop Capital Markets."
},
{
"speaker": "Mark Schappel",
"content": "John, I believe the remaining ARPA funds must be allocated by year-end. I was wondering if you could just comment on the impact ARPA funds are having on your business today. And whether you anticipate any demand falling off next year as these funds come to an end?"
},
{
"speaker": "John Marr",
"content": "Yes. The ARPU funds generally have to be committed by the end of 2024 and spent by the end of 2026. And so the commitments -- I mean, largely, I think, at this point across the universe of our customers and prospects, I think the majority of those have been committed probably a strong majority, I think, 80%, 85%, maybe more than that. But committed and sort of an internal commitment and doesn't necessarily mean that they've even started a buying process. So they may have committed funds for a new ERP system, but they haven't even issued the RFP yet."
},
{
"speaker": "",
"content": "We've said that we believe it is a factor in the strong market conditions we've talked about, but not the biggest factor. And so we expect it to continue to be a tailwind of some sort, really through 2026 as those commitments turn into purchases and then turn into deliveries and revenue recognition for us. But we don't expect a big drop-off after that. Most -- we think some of them -- some of the funds used for things like hardware purchases around our school transportation solution that are sort of onetime purchases. But generally, when they're buying something from us, it creates a recurring revenue stream that they may fund the first 2 or 3 years out of ARPA funds, and then they have an ongoing expense with us for a subscription. So I think it's a tailwind, not the biggest factor in the market, we're seeing the one that we'll continue for a while."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Terry Tillman from Truist Securities."
},
{
"speaker": "Terrell Tillman",
"content": "Most of my questions have been asked -- answered. But one question I still had was, maybe we could talk about traction with AI-powered acquisitions. I think it was called out and it's on your slide deck. Just kind of curious, I know these were probably small acquisitions, but I'm curious about the revenue size of these products. And maybe kind of stack rank in terms of -- in your possession and with your size and scale and go-to-market, how would these opportunities stack up versus maybe what you did in the parks and recreation area or the vend engine and stuff in jails in the recent past? Just trying to better understand how meaningful these could be."
},
{
"speaker": "H. Moore",
"content": "Yes. Thanks, Terry. So I guess, first of all, like I said, we're early with these acquisitions. These acquisitions really fit the mold of acquisitions that we've done that have been very successful, which is a product differentiator that we can take into our installed base where we've got a really commanding position to leverage. I think each one of these 3 are -- have different growth trajectories, which is another one of our criteria is can this grow at a rate faster than Tyler's overall rate? And I think all 3 of these clearly ticked that box. I think the acquisition of CSI probably has a little bit bigger near-term market opportunity. The RexourceX will drive sufficient -- a lot of revenue in its own right, but it's also going to drive higher win rates for our ERP solutions, which is not necessarily as measurable."
},
{
"speaker": "",
"content": "AR Inspect our field operations, new product. Again, we talked about there's a lot of interest there, a lot of excitement. And I'd expect that to really sort of all of them to outperform our expectations coming in. But based on those -- the criteria that I sort of originally outlined. So we're excited about all three of these. We're generally excited about every acquisition we do. But we -- these are off and running and off to a good start, and we're already seeing movements in the market based on these three acquisitions, and that's what's really appealing to me."
},
{
"speaker": "Brian Miller",
"content": "And collectively, those 3 are around $4 million of revenues for the quarter. So yes, small compared to Tyler's total. But interestingly, a couple of those deals we called out were significantly sized deals with large customers. So the Dallas County CSI, almost $1 million of ARR from the CSI product. So you see how that -- relative to a business group that are collectively doing around $4 million a quarter in revenues, adding single contracts that add $1 million of ARR is off to a nice start."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Alex Zukin from Wolfe Research."
},
{
"speaker": "Aleksandr Zukin",
"content": "So correct me if I'm wrong, but this is, I think, the first time since almost like 2014 that you've actually raised the top line guide for the full year after Q1. So maybe Lynn, just talk about and walk through what's giving you that confidence to do that? You guys don't usually do that. Is it improving demand from new arrangements as it flips? Is it transaction revenue expectations? It might be all of the above. It might be the M&A. But like what is driving that incremental confidence and conviction to kind of do something you don't usually do?"
},
{
"speaker": "H. Moore",
"content": "Yes, it's a good point, Alex. And I was actually thinking to myself, when was the last time we'd ever done it, because I couldn't recall and you did my homework and told me it was 10 years ago. We just come off our management quarterly meetings. We've got really good visibility on what we see out there. And I would say it's improved. I talked earlier about not just the demand in the market, but what we're seeing for our sales outlook. We're just seeing a lot of things lining up in a way that gives us that confidence to do it, as you point out, I mean, it's not something we typically do. We were -- I wouldn't say we were conservative, but we like to not get ahead of our skis. And we'd like to tell you what we're going to do then we're going to go do it. And it's just -- it's a combination of a lot of factors."
},
{
"speaker": "",
"content": "I can tell you that for the last couple of years, one of the mantras I've been saying within Tyler to not just the management team, but to all the employees, whether it's in a town hall or what is, I would say, the last couple of years, I have never been more excited about Tyler's future than I am today. And coming into this year and really the last couple of months, I've switched that a little bit. So I've never been more confident in Tyler's future then I am today. And again, it's just a lot of things going right. We're clicking on all cylinders right now, and we've got an aligned management team with a singular vision, singular focus. There's a lot of initiatives going on at Tyler. I mean we're not just sitting back. There's a lot of things going on, but I just like where we sit right now."
},
{
"speaker": "Brian Miller",
"content": "And just generally, the revenue outperformance in Q1, obviously, it was not sort of pull forward or timing of things that we might have seen in the later quarter, especially around the transaction-based revenue, truly was additive to what we expected for the rest of the year. And so that drove us raising the outlook for the full year."
},
{
"speaker": "Aleksandr Zukin",
"content": "And I usually never asked this follow-up question, particularly because we love margins, and we love efficiency. But I guess, given this, call it, once in a decade incrementally higher level of confidence and conviction this early in a year. Is there a world where you do maybe push the throttle a little bit more on investments, both organic and/or inorganic as it does seem like the market seems to be coming to you at a faster pace?"
},
{
"speaker": "H. Moore",
"content": "It's a good question, Alex. I think we -- I mean I don't know that we'll deviate from our historical practice of just taking a disciplined approach. We've got plans in place as it relates to margin and investment. I like our balance right now, I like our capital allocation where we sit right now. So I don't think you're going to hear us say this isn't 2017, 2018, where we're going to say, hey, this is now the time for elevated investment. We've got plenty of investments going on. And like I said, a lot of initiatives and both around revenue growth and margin expansion. So I don't think you'll hear that out of us over the next several quarters."
},
{
"speaker": "Operator",
"content": "This does conclude our question-and-answer session. I will now turn the call back over to Lynn Moore for closing remarks."
},
{
"speaker": "H. Moore",
"content": "Thanks, Krista, and thanks, everybody, for joining us today. If you have any further questions, please feel free to contact Brian Miller or myself. Thanks again, and have a great day."
},
{
"speaker": "Operator",
"content": "This concludes today's conference call. Thank you for your participation, and you may now disconnect."
}
] |
ual | 2,024 | 4 | [
{
"speaker": "Operator",
"content": "Good morning, and welcome to United Airlines Holdings Earnings Conference Call for the Fourth Quarter and Full Year 2024. My name is Regina, and I will be your conference facilitator today. Following the initial remarks from management, we will open the lines for questions. [Operator Instructions] This call is being recorded and is copyrighted. Please note that no portion of the call may be recorded, transcribed, or rebroadcast without the company's permission. Your participation implies your consent to our recording of this call. If you do not agree with these terms, simply drop off the line. I will now turn the presentation over to your host for today's call, Kristina Edwards, Managing Director of Investor Relations. Please go ahead."
},
{
"speaker": "Kristina Edwards",
"content": "Thank you, Regina. Good morning, and welcome to United's Fourth Quarter and Full Year 2024 Earnings Conference Call. Yesterday, we issued our earnings release, which is available on our website at ir.united.com. Information in yesterday's release and the remarks made during this conference call may contain forward-looking statements, which represent the company's current expectations, which are based upon information currently available to the company. A number of factors could cause actual results to differ materially from our current expectations. Please refer to our earnings release, Form 10-K and 10-Q, and other reports filed with the SEC by United Airlines Holdings and United Airlines for a more thorough description of these factors. Unless otherwise noted, we will be discussing our financial metrics on a non-GAAP basis on this call. Please refer to the related definitions and reconciliations in our press release. For a reconciliation of these non-GAAP measures to the most directly comparable GAAP measures, please refer to the tables at the end of our earnings release. Joining us today on the call to discuss our results and outlook are Chief Executive Officer, Scott Kirby; President, Brett Hart; Executive Vice President and Chief Commercial Officer, Andrew Nocella; and Executive Vice President and Chief Financial Officer, Mike Leskinen. In addition, we have other members of the executive team on the line available to assist with the Q&A. And now I'd like to turn the call over to Scott."
},
{
"speaker": "Scott Kirby",
"content": "Thanks, Kristina, and thanks to everyone for joining us today. I want to begin by saying that our thoughts are with those affected by the wildfires in the Los Angeles area. We've been in close touch with our employees and communities in the area to offer them support. We'll continue to monitor the situation to see if there are more ways that we can help. Turning to earnings, 2024 was another solid proof point on our way to double digit margins. By the fall of 2020, several months after COVID struck, we at United had a clear vision of how our airline and the industry were going to evolve. And 2024 seems to have been the year that we gained broad recognition from others that the vision is playing out as we expected. Our outlook has always been based on a realistic view of how the economics of the industry were going to change and how those changes had the potential to drive structural, permanent and irreversible changes in the entire industry. Our 2024 plan developed from that vision and our results were the culmination of years of thoughtful planning, bold action, and strategic investment. I'd like to thank our employees for these stellar results and I'm proud to say that we'll be paying out $713 million in profit sharing this year. In 2024, United continued to make progress with our United Next plan and once again delivered earnings within our original range. Our investments over the last several years have further differentiated United from the rest of the industry and led to strong customer preference for the United brand. But the bigger point here is that the changes that led to this moment are structural and durable. Cost convergence, which we first talked publicly about on this call in Houston two years ago, combined with effective revenue diversity at United for the first time ever, and industry-leading product and service causing customers to choose United are just irreversible structural changes that have created a competitive moat for United. Answering an analyst question two quarters ago, I talked about how this feels very much like 2012 to 2014, but today I'll add that there are two additional tailwinds this time around. The international environment, which Andrew will discuss in more detail, is going to be far stronger for longer because of the structural supply constraints that are going to last at least for the rest of this decade. Wide body supply, both airframes and engines, is even more challenged than narrow bodies. And second -- domestically, the seeds of the 2012 to 2014 era's demise were being sown at the time with 15% to 20% growth from the ULCC. It's very hard to see that happening again. Importantly, all of this means that the industry is [evolving] (ph) into an equilibrium where each airline driven by economic necessity will be primarily focused on flying where they have a competitive advantage. Different airlines have different competitive strengths and weaknesses in the post-COVID era. Cost convergence has been the most impactful at the big, high-cost airports in the country. The cost per passenger in the three New York City airports is $48 compared to the average ULCC fare of $67 in those three airports. When an airline is spending 72% of their fare on airport costs, it's hard for me to imagine that they could ever be profitable in those airports. At the same time, ULCC do have an advantage and will always be able to be more profitable than United in point-to-point, low-cost airports. It really is a transformed industry, and United more than anyone is leading the way. We have seven great hubs. We got well ahead of the curve in investing for the future, and we're focusing all of our efforts and growth in our hubs where we have the competitive advantage. The combined virtues of our size and our innovative culture make us a competitive Juggernaut. We know who we are, we know our strengths, we also know our weaknesses, and we're going to focus on our strengths and nothing else. But we won't rest on our laurels and will never be complacent or satisfied with our results. We'll continue to be an airline where good leads the way by focusing on ways to be even better airline for our customers. Starlink is one of the most obvious high-profile investments for customers, but it is really just the visible tip of the iceberg. Our digital team is expanding our best-in-the-world technology by making further improvements to make the airline even more transparent and easy to do business with. And our ops team is focused on changing the unchangeable and trying to solve problems that no other airline in the world has ever even tried to fix. And we'll continue to invest in a brand that inspires pride in employees and customers alike. This year, we expect to grow our EPS by approximately 18% at the midpoint, and we'll deliver strong free cash flow while continuing to invest in the future. That includes signing industry-leading contracts with our United team, which is made up of the best aviation professionals in the world. We are the best airline in the history of aviation and we're going to continue to raise that bar. That's been and will continue to be increasingly good for our employees, customers, and our shareholders. And with that, I'll turn it over to Brett."
},
{
"speaker": "Brett Hart",
"content": "Thank you, Scott, and good morning. 2024 was an exceptional year for United. The investments we've made to improve our operational reliability and resilience have driven top-tier results. We served a record nearly 174 million customers last year and finished the year first in on-time departures at all seven of our hubs. We had the busiest December in our history, flying on average 511,000 people a day. And when so many of our customers were counting on us to get them home safely for the holidays, we closed out the month of December ranked number #1 in on-time departures. I want to thank the incredible professionals at United who worked through the holidays and through tough weather to deliver for our customers. Thanks to enhanced processes for recovering crews during our regular operation events, we achieved an 82% reduction in crew-related cancellations compared to prior years. Additionally, we continued refining our aircraft turn process, focusing on key components such as aircraft cleaner time and boarding efficiency, driving improved turnaround speed and overall operational performance. In 2024, we had the company's best post-pandemic turn execution, reducing cancellations and improving efficiency, both meaningfully cut costs and results in a much better experience for our customers. Despite that progress, staffing at the FAA remains a challenge for the airline industry and most importantly, the traveling public. In 2024, even on clear blue sky days, 66% of United's delays were driven by ATC challenges in technology and staffing. We remain engaged with leaders in Washington and in both parties to get the FAA the resources they need, and will look for opportunities to work with the new Congress and new administration to achieve that goal. Over the last several years, our culture of innovation has fueled countless advancements in technology and empower our employees and improve customers' experiences. In just the last several months, our team has developed new capabilities for our award-winning app, like integrating Apple AirTag data to help us reunite customers with their bags and allowing customers to select seat preferences, so they can get moved to the seat they prefer automatically as soon as it becomes available. Translating our entire app in the Spanish drove usage even higher and now nearly 90% of customers engage with our digital channels on the day they travel. In 2024, these and other app enhancements enabled half of our customers who experienced a cancellation to utilize a self-service or automated method to get back on their way, a 28% increase year-over-year. Our industry leading app has led to happier customers who have more control over their travels and employees who have more time to help customers who most need it. At United, we're proud of this culture of innovation because it's central to our effort to differentiate our good leads away brand and give our customers even more reasons to choose United. With that, I'll hand it over to Andrew to review our strong revenue performance in 2024 and discuss our expectations for revenue environment in 2025."
},
{
"speaker": "Andrew Nocella",
"content": "Thanks, Brett. The fourth quarter revenue environment materially improved as the capacity backdrop for the industry became more constructive. United's Q4 TRASM increased 1.6% year-over-year, on a 6.2% increase in capacity. The Sunday after Thanksgiving was our best revenue day in history, shattering the former record by 25%. United's domestic capacity increased 7.8% in Q4, with RASM down 1.9%. We project domestic RASM will turn solidly positive in Q1. The domestic pricing environment is improving as underperforming airlines remove unprofitable capacity at an increase in rate and business traffic growth accelerates. Industry fair sales are less prevalent with lower discount rates, as airlines are prioritizing profitability. All United's hubs were profitable in Q4 and for the last 12 months with only a 7 point pre-tax margin difference between the best and the worst performance hub, the narrowest spread we've recorded in a quarter since 2016. Our network health is very strong with room for margin expansion as we continue our United Next Plan. After years of waiting, we're also finally starting to gain a critical mass of larger narrow-body aircraft, which allows us to execute on our plans to increase gauge. United's international capacity was clearly the star of the quarter in terms of RASM growth relative to Q3. As a result, international margins continue to outpace domestic margins in 2024. United's plan during the pandemic was to double down on international flying and it's proven to be the right move. Q4 Pacific capacity moderated and China headwinds slowed versus Q3 resulting in PRASM flipping from down 15.7% to up 4.1%. Pacific PRASM was up high single digits for the last two-thirds of the quarter versus last year. United has profitably digested a 31% increase in Pacific capacity in 2024, and we have now fully reinstated our pre-pandemic capacity levels across the region with margins that are now above system averages. In the past, the Pacific margins routinely lagged. We plan to moderate our Pacific growth as we head into the first half of 2025 [indiscernible] capacity added in 2024 mature. During 2025, we are excited to launch a new initiative to operate 737s, on a small number of Narita [feed] (ph) flights to destinations in Asia that do not support nonstop service to the U.S. We anticipate this unique initiative made possible by our Guam base will extend our lead, as the largest trans-Pac carrier to build an unmatchable network scope. We're going to redeploy underperforming assets and efficiently grow load factors from Japan to the U.S. where local origin demand still is not fully recovered from the pandemic. 2024 was also a great year for the United Atlantic network, and Q4 was no exception with PRASM up 7.1% on flat capacity. We entered 2024 PRASM capacity growth for the year in the Atlantic after a rapid growth in the region post-pandemic. Our plan for 2024 worked extremely well. All months in Q4 are PRASM positive year-over-year with December RASM up double digit. United is the largest U.S. carrier flying over the Atlantic by ASMs. And in 2025, we plan to have low to minimal capacity growth in Q1 to support continued RASM strength. From what we see today, we expect the first quarter to be our best Atlantic financial result in the company's first quarter history. Latin America trailed the other regions throughout 2024. However, it is important to note that United continued to operate profitably in the region despite these challenges. PRASM was up slightly in Q4, and the outlook for early 2025 is positive. Overall, the momentum for international flying in the fourth quarter was exceptionally strong. We believe the [pandemic] (ph) era global long-haul reset along with a sluggish delivery rate of new wide-body jets sets up the industry really well for years to come in international flying. Cargo also had a very strong showing in 2024. Cargo revenues for the year were up nearly 17% and up almost 30% in Q4 versus last year. It was a very good quarter and year for cargo. The business traffic recovery was a nice tailwind in Q4. Results in Q4 and our outlook for Q1 clearly shows this strength in higher yield corporate traffic volumes. Flown business revenue grew 16% in Q4 year-over-year. We expect that trend to continue in Q1, which is a tailwind for our business-focused network. Contracted business sales in the quarter for all future travel were up 14% year-over-year. Premium passenger revenues increased 10% year-over-year, and premium cabin unit revenues were positive. Both trends have persisted throughout the year. We see no change in consumer behavior seeking out increased premium experiences, but we also remain committed to our most basic product. In Q4, Basic Economy passengers increased 21% year-over-year and now represents 15% of domestic passengers, up 2 points versus 2023. Loyalty revenues grew at a healthy pace at 12% in 2024. Co-brand spend was up 9% with 1 million new card acquisitions. Turning to the product. We reached a milestone of deployment of our signature interior with nearly 50% of the fleet were complete as of year-end 2024. With installation work moving quickly now, we expect to be at 70% by the end of 2025. Across the entire United network, we expect to have 150,000 seatback [indiscernible], full of rich content available to all of our passengers with a better ability to personalize everyone's experience by the end of 2025. As you can see from our first quarter outlook, we continue to make progress on improving the financial performance of that quarter. Changes to our capacity deployment across hubs, days of week and time of day have been very effective. Return to more corporate traffic and the desirability of the Southern European vacation in the winter is also a tailwind. As we announced a few weeks ago, we are tracking ahead of our schedule on Starlink installation, which we think will be a material advantage versus slower [for-pay] (ph) Wi-Fi services offered by other U.S. carriers. United's Starlink plan is yet one more action to elevate our product, creating a brand customers choose more and more often. We will share more on product innovation, merchandising and capacity optimization in the coming year, furthering our lead. We will also talk about how we believe Starlink will unlock a host of new digital benefits for our customers and shareholders. We believe that creating more choice, more segmentation and enhancing our products is the winning formula. Merchandising, sell-in and managing the complexity of these multiple experiences is our proven expertise. With that, I want to say thanks to the entire United team for an amazing 2024, and I'll hand it off to Mike to talk about our financial results. Mike?"
},
{
"speaker": "Mike Leskinen",
"content": "Thanks, Andrew. We delivered record fourth quarter earnings with earnings per share of $3.26 ahead of expectations and a fourth quarter pretax margin of 9.7%, up 3.5 points year-over-year. These strong fourth quarter results brought our full year earnings per share to $10.61, above the midpoint of our initial guidance range of $9 to $11. Much of this success is due to the strong revenue performance that Andrew just discussed. But the foundation of our success is a strong operation, and I'm incredibly grateful for the tremendous efforts of our operations team this quarter. Our hubs are in some of the most congested airspace in the world, and still we delivered industry-leading operational performance during the quarter. Importantly, an operation that runs on time and with few cancellations is also a more cost-efficient operation. Finally, I'd like to celebrate our stock performance over the last 12 months. In 2024, we were the fourth best-performing stock in the S&P 500. I've long believed in the potential for stock to re-rate given the structural improvements in our business. It's nice that the market is beginning to recognize the shareholder value we've delivered. For the first quarter of 2025, we expect earnings per share of $0.75 to $1.25, an approximately $400 million improvement from the first quarter of last year at the midpoint, implying an approximately 3.5 point improvement in pre-tax margin. The commercial team has done a great job of continuing to shape the network to match demand in what has historically been our seasonally weakest quarter. Further building off first quarter momentum, we expect full year 2025 earnings per share to be between $11.50 and $13.50. At the midpoint, this represents 18% growth in earnings per share versus 2024. We expect a similar pace of earnings growth is sustainable as we march toward low double-digit pretax margin. We have decommoditized air travel. Our operation is strong and the United Next plan continues to deliver both higher and more sustainable profits. Airlines with less competitive offerings are cutting money-losing routes and frequencies. The industry setup has never been better, and we believe United is uniquely positioned to succeed. On costs, CASM-ex was up 5% on 6.2% capacity growth versus the fourth quarter of last year. As we look ahead to 2025, we are focused on driving efficiency improvements throughout the business, while also improving the experience for our customers and enabling our employees to be more effective at their jobs. For the year, we continue to expect 2 to 3 points of CASM-ex pressure from our labor agreements not yet signed. Shifting gears to the fleet. In the fourth quarter, we took delivery of five Boeing MAX aircraft, 14 Airbus A321neo aircraft and three Boeing 787s. In 2025, we are planning to take delivery of 71 narrow-body aircraft and 10 wide-body aircraft. Recall, we had been planning for approximately 100 narrow-body aircraft deliveries in 2025. But due to the OEM production delays, we are planning for less, which leads to our expected full year CapEx spend to be below $7 billion. That's below the low end of our $7 billion to $9 billion multiyear guidance. Turning to the balance sheet. We ended the year with $17.4 billion in liquidity, including our undrawn revolver. We generated $3.4 billion of free cash flow. In 2024, we paid down $7.4 billion of debt, $3.6 billion of which we voluntarily prepaid. We've now prepaid or refinanced our remaining high-cost COVID era debt, bringing our total cost of debt down to 4.6%. Our net leverage was 2.4 times at year-end, an improvement as we make progress to our long-term net leverage target of less than 2 times. On to buybacks. In the quarter, we repurchased $81 million worth of shares, leaving over $1.4 billion left in the authorization. We remain firm believers that United stock is undervalued as we continue to grow earnings and margins year after year with further room for multiple expansion. Finally, I want to reiterate the consistent and growing free cash flow generation remains a top priority. And in 2025, we are targeting free cash flow around the $3.4 billion we delivered in 2024. The future at United Airlines has never looked brighter, and I'm excited to continue to build upon our competitive advantages in 2025 and beyond. Now back to Kristina to start the Q&A."
},
{
"speaker": "Kristina Edwards",
"content": "Thank you, Mike. We will now take questions from the analyst community. Please limit yourself to one question and if needed one follow-up questions. Regina, please describe the procedure to ask a question."
},
{
"speaker": "Operator",
"content": "Thank you. [Operator Instructions] Our first question comes from the line of David Vernon with Bernstein. Please go ahead."
},
{
"speaker": "David Vernon",
"content": "Hi, good morning guys. Thanks for taking the question. So Mike, maybe could you talk a little bit about how much of the trend improvement you are seeing in 1Q and how that extends kind of into the full year guide? I'm trying to get a sense for whether the range that you are putting out there for us for the year contemplates things continuing to get better from where we are today or kind of just a reflection of where we are today?"
},
{
"speaker": "Mike Leskinen",
"content": "Hi, Thanks, David. I love the question. We've had a long-standing policy of setting guidance with a no-excuses philosophy, and that has served us well. We delivered over three points of margin expansion in Q4, and I expect to deliver 3 to 4 points of margin expansion again in Q1. We'll continue to build a single act of God into our longer-term guidance, so that we deliver even in imperfect conditions. That's kind of a hallmark of our guidance strategy. It is pretty easy, however for us to sit here and think there is opportunity in the back half of the year and that we could do even better than our full year guidance."
},
{
"speaker": "David Vernon",
"content": "All right. Thanks for that. And then just to be clear about the guidance range as well, that includes the incorporation of some potential flight intended deal in the course of the year, correct?"
},
{
"speaker": "Mike Leskinen",
"content": "Yes, it does, and it always does."
},
{
"speaker": "David Vernon",
"content": "All right. Thanks very much for the time guys."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Sheila Kahyaoglu with Jefferies. Please go ahead."
},
{
"speaker": "Sheila Kahyaoglu",
"content": "Good morning. Congrats, team, on great results. So Mike, maybe this one is for you since you ended your script with the stock is undervalued, but bought back only $81 million in Q4. So great free cash flow in 2024, $3.4 billion. The guide is for 20% earnings growth and CapEx is up less than expected. So it would suggest free cash flow north of $2.5 billion to $3 billion in '25. How are you thinking about your deployment priorities towards your leverage targets with the voluntary prepayments as well versus share repurchases?"
},
{
"speaker": "Mike Leskinen",
"content": "Thanks Sheila. Let me remind everyone that over the last four years, we've also invested $32 billion in our business and our people, which has been central to our success. The strong performance in our valuation, it was a steep increase just as soon as we announced the share buyback authorization late last year. And so this first quarter out of the gate regarding the buyback, we started conservatively. It seems like a reasonable approach. Right now, we have to balance our improvement in our balance sheet and repurchasing shares. And so I think that was the right approach. We are really pleased to see the stock moving so strongly. We were #4 out of the S&P 500 last year. I mentioned that in my script. And you'll continue to see an opportunistic repurchase of shares as we move forward through 2025. I'll remind you that we've got $1.4 billion in authorization, expect continued multiple expansion. We are going to be really, really deliberate about that. I'll also add that the deleveraging that we -- this journey that we're on, we expect to reach below 2 times net leverage during this calendar year."
},
{
"speaker": "Sheila Kahyaoglu",
"content": "Great. Thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Conor Cunningham with Melius Research. Please go ahead."
},
{
"speaker": "Conor Cunningham",
"content": "Hi, everyone thank you. On Basic Economy, can you talk a little bit about -- I mean, in the script, you talked about how the industry is discounting a lot less, and there's obviously a big move in premium from the low-cost guys. Can you just talk about how you are going to deploy Basic Economy? Is there an evolution in how that changes? It just seems like there is going to be -- the barbell approach that you had this last couple of years before the industry really structurally changed is -- maybe that evolves on how you deploy the Basic Economy side of the equation overall. Thank you."
},
{
"speaker": "Andrew Nocella",
"content": "Thanks, Conor. It's Andrew. I would say as we look out into the next 12 months, we don't intend to change that, that we're incredibly happy with the effectiveness of Basic Economy, particularly as we grow our gauge. As a competitive tool, it's done exactly what we wanted it to do. And it does seem to me the more of it we do, actually the better off we are. Obviously, there are points. We are clearly balancing multiple product types in our quiver here and many of it premium, but also basic and we truly believe that a broad spectrum of choice for consumers and being able to offer the lowest possible fare to fly in United where you get a signature interior seatback entertainment, free Wi-Fi is the winning recipe. And we are not going to change that recipe, as we go through 2025."
},
{
"speaker": "Conor Cunningham",
"content": "Okay. And then maybe big picture, your relative margin performance obviously speaks to your willingness to adapt to the environment overall. But the United Next Day, we talked a ton about up-gauging. And obviously, there's been a lot of delivery delays and so on. So I'm just trying to understand on your conviction level around the up-gauging strategy. Do you have a lot of that baked into 2025? It just seems like there is still multiple margin points that you have from these uniquely United opportunities that you have going forward. Just any thoughts there. Thank you."
},
{
"speaker": "Andrew Nocella",
"content": "Yes. Look, I think gauge is – it is not a secret weapon, but gauge is, I think, really important to us. For 2025, gauge is not moving a lot. The delivery delays have been extensive, and our ability to put RJs back to full utilization proved to be the right decision for 2025. What I can say is, as we look out through the end of the decade, I believe we have the highest gauge possibilities, which is going to be great for the business, great for our unit cost and great for our customers because these new aircraft have incredibly high NPS scores as we bring them online. So we think there's an incredible amount of runway related to gauge. We obviously operate in hubs that are gigantic from local population base, but they are also now gigantic from a connectivity base, allowing us to use these larger gauge aircraft. We are behind on this. I think this summer, we had 12 A321s that seat 200 people. Next summer, we have, I think in the mid-40s. And that's probably still 150 aircraft behind our nearest competitor and as we said over and over again. The large gauge narrow-body aircraft are the highest-margin aircraft flying in the country, and that is going to be a meaningful tailwind to United's margin acceleration as we head into 2026 and 2027. So 2025 is a bit of a pause year, but we look forward to getting back on the gauge bandwagon in 2026 and beyond."
},
{
"speaker": "Mike Leskinen",
"content": "Hi Brandon, this is Mike. I just want to add an extra point there. As we look into '26 and '27, as Andrew said, the gauge really starts to accelerate. And so it becomes an idiosyncratic CASM-ex benefit for United in '26 and really starts to kick in, in '27. So you're not seeing the benefit of that in any of our guidance for this calendar year, but you will see it in coming years."
},
{
"speaker": "Conor Cunningham",
"content": "Great. Thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Brandon Oglenski with Barclays."
},
{
"speaker": "Brandon Oglenski",
"content": "Hi, congratulations team, on what was a great year and obviously, a good outlook here. And Mike, maybe just following up on that, I presume with that comment about gauge, looking out years ahead, that's including some expectation that MAX 10 is in the mix?"
},
{
"speaker": "Mike Leskinen",
"content": "We are becoming more hopeful that the MAX 10 will be an important gauge for United. We like the MAX 9. The MAX 9 is a great aircraft, but we are with Boeing starting to make some real progress in improving their business. We are becoming more bullish on the MAX 10. That's correct."
},
{
"speaker": "Andrew Nocella",
"content": "I'll just add, whether it's the MAX 9 or 10, our gauge is going to increase a lot. So the 10 would be great. But I'm counting on the 9 and the A321 to do what I described a few minutes ago. If we have the 10 available to us, that only helps us even further."
},
{
"speaker": "Brandon Oglenski",
"content": "Well, and Andrew, maybe for my follow-up, on those lines, your domestic capacity growth is a little bit elevated here. What are the priorities in the network as you look in 2025 domestically, especially with those constraints on gauge? And it looks like the solidly positive PRASM comment on domestic is pretty bullish for 1Q. So can you elaborate on those?"
},
{
"speaker": "Andrew Nocella",
"content": "Sure. We've been working really hard, particularly for off-peak months and quarters like Q1, to readjust how we deploy our capacity, whether it be by day or week or hub. And I think it is been incredibly effective, and you see that in the guidance along with the fact that business traffic is coming back. So we are pretty optimistic that this is moving in the right direction, and we can really close margin gaps by making the off-peak periods better. As we think about 2025 and I've said this in the past and I'll say it again, we are really focused on building connectivity in our bank structures, particularly in Chicago, Houston and Denver, where our hubs are fantastic, but they lack the same level of connectivity that we see at some of our larger OA competitor hubs. And so we are going to be able to close that gap materially in 2025, which I think is going to be really good for our relative RASM results as we go forward. So that will be our focus in 2025 at this point."
},
{
"speaker": "Brandon Oglenski",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Ravi Shanker with Morgan Stanley. Please go ahead."
},
{
"speaker": "Ravi Shanker",
"content": "Great. Thanks good morning everyone. Just a question on Starlink. Obviously, you guys mentioned that a couple of times in your prepared remarks. Any thoughts on kind of rolling that out? How much of a differentiator do you think that will be, what the initial performance has been like and maybe how we can monetize that?"
},
{
"speaker": "Andrew Nocella",
"content": "Sure. It is an excellent question. And I have to say this is one of the things we are absolutely most excited about at United. We did a ton of research on this product and all the alternative products and feel, a 100% convinced that this is going to be a game changer. Fast and free Wi-Fi available to our customers, including the ability to game -- to have games on the -- on your personal device is going to be amazing. But look, I think the big question here is with Kinective, and our ability to grow MileagePlus, and you're going to see us, I think unleash a lot of really unique things on this front. And in particular, I think we see an opportunity maybe where others don't. And I think that comes from a number of factors that are probably unique to United. One is we have an advanced screens on the vast majority of our fleet. We need advanced screens to be able to personalize service and deliver content in the way that we are going to be doing in the future, which we can obviously make the service for our customers better, travel with less friction, but also monetize the media sales. Second, with Starlink connectivity, which we'll have, which I don't think any of our major competitors will have, it allows us to do that in a way that really older Wi-Fi services could not do. And then you combine that with size of MileagePlus, a legacy program size and I think our innovative spirit here at United, it is a very good recipe. I think we need to prove out this as we go forward. But we are very excited to do this. We are very excited that it's United being unique on this front. And we hope to show you in the coming quarters and years what can be made possible with these investments."
},
{
"speaker": "Ravi Shanker",
"content": "That's really helpful. Thank you. Maybe for a follow-up. Obviously, lots of momentum with the story. Stock's doing great. Everything is going to set up pretty well. Can it possibly be greater? Kind of you guys hinted last year at potential creative options with the loyalty program. Obviously, it's been a long time since you gave us United Next, and a lot has changed with the world since. Any thoughts on hosting that Investor Day potentially at some point this year? Or kind of -- how do you think about giving us updates on some of those big picture items?"
},
{
"speaker": "Mike Leskinen",
"content": "Hi, Ravi, thanks for the question. And we still -- we continue to see tremendous value in the loyalty program, but we are going to start to disclose data on that when it makes sense for the business. We're still discussing the timing of an Investor Day. However, we've been really effective getting our message to all of you during these earnings calls and investor conferences. Unlike other airlines, our investor calls are much closer to many Investor Days. We give you a long-term guidance. We're giving you a lot more free cash flow commentary as well. We manage our earnings calls like we manage our business with a focus on the long term. And today's call is a good example of that. So stay tuned. An Investor Day is an important tool, but no update on precise timing today."
},
{
"speaker": "Ravi Shanker",
"content": "Understood. Thanks Mike."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Jamie Baker with JPMorgan. Please go ahead."
},
{
"speaker": "Jamie Baker",
"content": "Hi, good morning everybody. So Andrew, in the past, I think it was last summer you talked about that life cycle for discounted airlines. Obviously, since that time, we've seen a bankruptcy. Domestic capacity has tightened. We are seeing discounters experiment with new LOPAs. Do your original comments still stand? Or has there been enough evolution in that particular business model that maybe the outlook from United's perspective is a little bit brighter than what you articulated last year? Any thoughts on that?"
},
{
"speaker": "Andrew Nocella",
"content": "Look, I think it largely still stands. I think as Scott said earlier, we each have our expertises, what we're great at and what we're less great at maybe. At United, we think we are great at a lot of things, but there is a few things we don't do and we don't intend to do. But we manage the complexity of many product types from basic to premium and I think do very well in the premium space. And it's because of generations of investment that came before me and the management team here in the room today. And you just can't snap your fingers and make those generational investments overnight. So I'm a bit surprised by the amount of change, but the effectiveness of that change remains to be seen. The effectiveness of what we've been putting in place for years now has been proven. We're going to do more of it in 2025. So I think that life cycle I went through still holds. And I don't expect that we are going to see airlines compete at the level of United in terms of this broad range of products and experiences anytime soon."
},
{
"speaker": "Jamie Baker",
"content": "Thank you for that. And then quickly for Scott, it was several years ago, I think it was at a conference, that I asked you if you could clear up one analyst or investor misperception, what would it be? And I don't remember your exact words, but basically, you said that you'd confront the idea that all capacity is created equal, and all capacity is equally bad. You and Mike spend a lot of time in front of clients. I know I have my opinions on this, but where do you think you are in terms of addressing that capacity topic? And would your answer be the same if I had simply asked the question a second time? Thanks."
},
{
"speaker": "Scott Kirby",
"content": "Well, I don't know if the answer would have been the same, but it's a good answer regardless. And I think what I'd say, on that is all capacity is definitely not created equal. And if you look -- even if you look -- if you just look at total industry capacity in the fourth quarter or in the first quarter, you'd probably reach a different conclusion than if you disaggregate it by who is doing the growing. The difference is an airline like United, Delta is the same, we tend to add service, add route frequency because that's good for customers. We don't chase load factor. We've been running lower load factors. We maintain pricing integrity. And because we don't chase load factor and are willing to run lower loads if that's appropriate, it just has a much less negative impact on industry RASM than growth from some carriers who manage only load factor. And so I think not all growth is anywhere close to created equal and the -- and you are seeing that in the results today. Results in the fourth quarter and the first quarter proved that, that thesis was correct. I also think that it is going to continue for years to come, which could be a long discussion, but it's going to continue for years to come."
},
{
"speaker": "Jamie Baker",
"content": "All right, good stuff. Thanks, Scott. Appreciate it."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Andrew Didora with Bank of America. Please go ahead."
},
{
"speaker": "Andrew Didora",
"content": "Hi, good morning everyone. Maybe coming back to loyalty a little bit. Scott, Andrew, revenues up kind of double digits in 4Q. And you continue to invest a few billion dollars each year into your product, whether that be Starlink, Kinective, lounges, et cetera. That's more than most airlines spend in total per year. So maybe can you help frame the growth opportunity over the next few years, as these investments come online? And maybe speak to how you think these -- this changes the value provision for a traveler and drive them into the loyalty program over time? Any thoughts that would be appreciated. Thanks."
},
{
"speaker": "Andrew Nocella",
"content": "Look, I talked about it a few minutes ago, but we are -- the whole MileagePlus Kinective foundation is incredibly strong. And I couldn't be more bullish on the opportunity. It does require some investment and some technology, and we are well on our way. But look, we did I think 12% growth last year in loyalty revenue. And that was pretty amazing. I think hopefully, we'll show that we lead the industry with that number. And our goal for this year is more than that in percentage terms. And so we believe this is an accelerating momentum at this point. We need to prove it, as we head into 2025 and beyond. But Kinective Media in particular, like our media sales, we intend to double them next year and double them again the following year. And so it is a lot of opportunities, a lot of work. We have a brand-new team on board to help us execute on that. And as we do all that and personalize the service more and more, I just think we make MileagePlus even that much more attractive to our customer base. We have a flywheel effect with more credit cards that are issued. I think we did about 1 million last year. We'll do more this year. So it's just going exceedingly well, and I think there's a lot more to come. And we look forward to, at the appropriate time, disclose it more and more. But look, it's an interesting story. I gave you many of the unique things that I think are in our quiver related to this. And we intend to fully exploit that to the best of our ability while delivering, I think the more personalized experience for our customers, which we think will reduce friction in air travel a lot, particularly when you are onboard the aircraft. So there's a lot more to say on how we are going to use these screens and how we're going to deliver great service to our customers, and we're going to do that in the due course."
},
{
"speaker": "Andrew Didora",
"content": "Great. Thank you."
},
{
"speaker": "Scott Kirby",
"content": "I'm going to pile on that real quickly. Just the quality of the earnings from MileagePlus, the -- not only are they growing rapidly, but the stability of those earnings, a high-margin business. As we grow that business, I do think it is important that you all think about that differentiated stability, and it is something we are going to work hard to highlight in our disclosures as time goes on. Thanks for the question."
},
{
"speaker": "Andrew Didora",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Duane Pfennigwerth with Evercore ISI. Please go ahead."
},
{
"speaker": "Duane Pfennigwerth",
"content": "Hi thanks. Just on seasonality of margins, maybe you can remind us about some of the network changes you've made over the years. Historically, we didn't really think of the first quarter as a breakout quarter for relative margins for United. So what changes have you made? Is it geographies? Is it how you're flying? What's changed versus maybe pre-COVID?"
},
{
"speaker": "Andrew Nocella",
"content": "Well, look, I would say, it's a lot of things and definitely how we fly is pretty meaningful to that. But I -- look, first of all, I think you have a brand that is rising across the board, as we invest in multiple products and multiple experiences. And we are just an airline people are choosing more and more often. So like that's just foundational. And I think we are really proud of that. Now in the nuts and bolts, yes the schedule has changed a lot. We are very, very careful, in particular, how we work with utilization. Just adding flights for the sake of ASMs, we proved that last year in first quarter was not a great idea from the industry perspective, and we didn't do it. And we are not doing it this year. In fact, our utilization rate for this year is actually probably lower than last year at the current rate. So we are being very careful on how we deploy capacity, and I think we're the best in the business at it. But that goes not only within the quarter, but it's by day, week, it's by hub, and it's by aircraft type. And all those changes, including more sunshine capacity, I think have been really important. And then the last thing, Q1 was always a strength point for corporate traffic that didn't exist during the pandemic or right after the pandemic. And what we see today is corporate traffic coming back very strongly in Q1, which I think will be uniquely beneficial to the business-centric airlines, which obviously United is one of them. So that's really important. And then the last thing that I think is maybe underappreciated is the fact that Europe is becoming more of a year-round destination. And so Europe always did not so great is the polite way to say it, particularly from January 15 through mid-March. And now we are seeing a totally different result where people are willing to go on a Southern European vacation, and so that's just great. And that really helps deseasonalize Europe, at the same time that our connectivity with our Lufthansa hubs builds back to normal. At the same time, the business traffic builds back to London Heathrow. And you put all those factors together, a lot of them created by United through schedule changes, some of them created by industry dynamics and were deseasonalized in Q1 and make it look a lot better. That was our goal a number of years ago, and we're really proud to say we've come a long way. We have a long way to go still, but we've come a long way."
},
{
"speaker": "Duane Pfennigwerth",
"content": "That's really helpful, Andrew. And then just on the path to double-digit margins and which implies a bit of improvement relative to pre-COVID. You touched on in your prepared remarks. Is this really about structurally higher margins in international and maybe holding serve on domestic? Or do you see it more balanced? And again, not necessarily a 2025 answer, but over the next few years. Thanks for taking the questions."
},
{
"speaker": "Andrew Nocella",
"content": "Well, as I said in my opening, international margins are higher, but we think they have room to expand, particularly by making the off-peak periods better. So we remain excited about that, but there is an opportunity on international. There's also a bigger opportunity on domestic as our Mid-Continent hubs, in particular reached that critical mass of connectivity and gauge that we're seeking. We're still a bit off from where we want to be on gauge. As we said, this year is a bit of a gauge pause year. But starting in 2026 and beyond, we are going to really focus on gauge, which is incredibly efficient. It's going to unlock the connectivity in our hubs even further. And so I'm actually more optimistic that margin growth in the domestic system, given all the structural changes we're putting in place and what's happening around us by our competitors has an incredible amount of upside. And we can start to close the gap with international. But I have to say international the strength is just unbelievably strong right now. And I -- well, we'll close the gap. I don't -- we'll close some of the gap. I don't think we'll close all of the gap from the way I look at it at this point. So international is going to continue to lead the way, I think, for the coming years. And as we said at the beginning, there's just a significant supply constraint when it comes to wide-body aircraft and wide-body engines that we think confidently last through the end of the decade at this point."
},
{
"speaker": "Duane Pfennigwerth",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Scott Group with Wolfe Research. Please go ahead."
},
{
"speaker": "Scott Group",
"content": "Hi, thanks good morning. Scott, on one of the earlier questions, you said that you think the current industry backdrop has years to go. I guess what gives you the confidence in the duration part of the story? I guess what's the risk in your mind that as domestic pricing turns positive and others start maybe making a little bit more money that they start chasing it and adding capacity again?"
},
{
"speaker": "Scott Kirby",
"content": "Well, the short answer is it's just math. And this has been driven by economic reality. As I said in my prepared remarks, I gave some stats on the expense of flying at big airports in New York, like that doesn't mean things won't get a little more positive and people will try to put the smart capacity back one or two quarters. But I just don't see how it's possible to be a low-cost carrier and fly profitably to the New York airports or Chicago or Los Angeles or San Francisco. Like the business model just doesn't work because the governments in those entities have priced low-cost carriers out of the market. And it is just math. Like every airline that has low margins that don't look like Delta and United, has unprofitable capacity. And the only way to solve that is to not fly it. That didn't mean they'll do it overnight. There will be some ups and downs along the way. There'll be ego involved in that. But ultimately, it is math, and it is going to come out because it cannot be profitable."
},
{
"speaker": "Scott Group",
"content": "Okay. And then maybe just, Mike a numbers question. 1Q clearly has RASM outperforming CASM. Does the guidance contemplate that you have a positive spread all year? Or is there something unique about the 1Q strength? And I know you talked about 2 to 3 points from labor. Anything else on the cost side you want to add some color on? Thank you."
},
{
"speaker": "Mike Leskinen",
"content": "Thanks, Scott. Let me try to be clear about it. For the full year, we expect RASM to exceed CASM. We expect continued margin expansion. I expect continued margin expansion into '26 as well. Regarding costs, I think about costs in 3 buckets. I think about industry-wide inflationary pressures, whether that be labor, whether that be airport costs, whether that be food costs, fuel costs. Those costs are going to be passed through to the consumer, 100%. It's frustrating that those inflationary costs have been persistent. We need to make sure that we do at least as well as the industry regarding those -- that #1 bucket of costs, but those costs should not interfere with our long-term profitability. The second bucket I'll break into two categories in A and B. And that is what can we do as an airline to drive efficiency into the operation. Gauge at United is the largest measure of efficiency that will really kick in and as I said earlier, in '26 and '27. But we are doing lots more with our app. We've got the best digital technology team in the business to drive efficiency. We are doing a great job with tech ops in the operation driving efficiency, and we feel we will do better than average in that category. There is a 2B though, and that is driving efficiency by flying more in red-eye situations, flying more during the off-peak. And some of our competitors are doing that. We feel that, that is -- and I think our results prove that flying in that way to drive utilization, it does drive down CASM, but it is -- it does not maximize profits. So you will not see United Airlines drive efficiency in that way. And then the third bucket is one that United has been on a mission for, for several years, and that is investing in the product and service to differentiate to de-commoditize the business. And it is clearer than it has ever been that, that de-commoditization of the product is driving higher margins and I think more stability to this business. So you'll see continued investment by United that will drive CASM, but we think it will also expand margins."
},
{
"speaker": "Scott Group",
"content": "Thank you guys."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Tom Fitzgerald with TD Cowen. Please go ahead."
},
{
"speaker": "Tom Fitzgerald",
"content": "Thanks so much for the time. And congrats on the great results. There was a line in the press release that caught my eye on utilizing GenAI to expedite customer search. And I'm wondering if you could update us on other areas you are already deploying GenAI in the business or thinking about and how you are thinking about the impact, whether on the revenue side or in the operations?"
},
{
"speaker": "Scott Kirby",
"content": "We do have the leading digital team in the business. You can see in the app, you see in all kinds of places. And we have been, I think, done a Yeoman's effort, but really using GenAI in all kinds of ways that maybe not be as [indiscernible] as some of the big high-profile analysis, but a whole lot more impactful for the airline and operations. You talked about some of them. One of the things that I'm most proud of is how much better we are than any airline in history has ever been at communicating with customers when there are delays to choice and explaining it in terms of they understand. And we are getting better and better in that. I think we're the first inning of that. We are the only ones on the field. No one else is even trying to do it. But GenAI has been an important unlock in that. All kinds of other -- maybe one of the interesting applications. We have these old labor contracts that go back decades. And they've got all these provisions that have built up over decades. And you have people that have 25, 30 years of experience trying to interpret what the labor contracts mean when a pilot or a flight [attender] (ph) someone calls in with some unusual situation. And some of the provisions are hard to know and always hard to figure out -- literally a team of people that try to interpret and get those right, and they didn't always know. Amazingly, GenAI can read the contract and give you a really good answer of what the output is. That's just a small example. But really, what that means to me is our team is down in the entire organization. This isn't like some one cool, [indiscernible] project that we talk about on an earnings call or some other forum, but really throughout the organization, embedded in the organization. It is part of what's driving us to be, without question, the leading technology innovator of any airline around the world."
},
{
"speaker": "Tom Fitzgerald",
"content": "Thanks so much. That's really helpful color. And then just as a follow-up, Andrew, you talked about adding sunshine capacity being part of the success in improving 1Q. And I'm just curious how you're thinking about Florida and the broader domestic network? And if there's -- if opportunities present themselves to maybe get larger in that region, whether a focus city or possibly a new hub, just love to hear your thoughts there. Thanks again for the time."
},
{
"speaker": "Andrew Nocella",
"content": "We -- good question. We have seven great hubs. And for all my years here, we've been focused on making those hubs as great as it can be. And I don't think we're anywhere close to that. And you can look at our relative market shares in our hubs relative to other hub competitors around the country, and you can see our shares are still low. And I think as our brand rises, people want to fly us more, and our gauge is going to increase. So we continue to be very focused on our hubs. That's not to say that it will always be that way. But for now and for the foreseeable future, our opportunities in our hubs, there's a lot of growth. And that's how we're going to grow earnings and grow our margins as Mike talked about earlier. But we will continue to build on what is a very successful Florida franchise. I think it is done incredibly well, and we are tilting a higher percent of our capacity into it. But at least in the short term, there is no plans for a hub in the Southeastern Florida."
},
{
"speaker": "Operator",
"content": "Our next question will come from the line of Catherine O'Brien with Goldman Sachs. Please go ahead."
},
{
"speaker": "Catherine O’Brien",
"content": "Good morning everyone. Thanks for the time. Mike, one for you. While respecting you don't give a CASM guide, and you've already given us your high-level thoughts on the different buckets of costs we should be thinking about over the next couple of years, just was hoping to get some more color on the puts and takes for '25. If you don't have a ratified flight attendant contract, for instance, how does that impact the timing of that 2 to 3 points of labor headwind you've spoken to? And anything else potentially lumpy we should be aware of quarter-to-quarter?"
},
{
"speaker": "Mike Leskinen",
"content": "Hi, Catie, thanks for the question. And let me try to expand around the edges. We talked about 2 to 3 points of labor headwind that we expect in 2025. That anticipates a labor deal with the flight attendants, the timing of which we aren't going to discuss today, but it expects that if that timing were to push to the right, there would be less of a headwind. If it pushes to the left, pushes earlier, then we'd have a little bit more of a headwind. I would say we have a 0.5 point to 1 point of pressure from investments that are driving even more revenue into the business. And so we feel really good about that as well. It does seem like the inflationary pressures overall at the industry level have started to -- have peaked and have started to abate. But as we sit here, I think that they persist longer than we might have thought 6 months or 12 months ago. So hopefully, that helps."
},
{
"speaker": "Catherine O’Brien",
"content": "Yes, it does. Thanks. And Andrew, maybe one for you as well. You talked about managing the complexity of more products and more choices being an area of expertise for the team. Can you help us think through where the opportunities are to lean into this more going forward? Is this adding more cabins? Is this adding more varied soft products to your existing cabins, something else that we haven't even maybe thought of yet? Anything there would be super helpful. Thanks."
},
{
"speaker": "Andrew Nocella",
"content": "Well, that's a really good question, and I'm not going to answer it today. I'm going to say that other than to say, as I said in my opening script, I think product choice has won the day. And it's kind of ironic because if you go back a few years ago, there are people saying the opposite, which I never ever understood. But product choice has won the day. We think we have some innovative ideas to expand on all that, including the merchandise and the product choice, as we go forward. And when I convince Mike to do an Investor Day, hopefully, we'll talk about that more. That was a joke obviously. But the point of all that is we are not going to give it away today, but we are working on a bunch of innovative things that I think are going to be very exciting for our customers. So there is a lot more to come. There's a lot more investment occurring. We wish we could announce it today and bring it to the marketplace even sooner. But these things take time. And I said earlier, I think United has a multigenerational lead. And we've been working over the last few years to make sure that lead expands and accelerates, as we head into the latter part of this decade. So there's quite a bit more to announce, but just not today."
},
{
"speaker": "Catherine O'Brien",
"content": "Great. So I look forward to it. Thanks for the time."
},
{
"speaker": "Operator",
"content": "We will now switch to the media portion of the call. [Operator Instructions] Our first question will come from the line of Mary Schlangenstein with Bloomberg News. Please go ahead."
},
{
"speaker": "Mary Schlangenstein",
"content": "Hi, thanks good morning. The Trump administration has ordered the DOT and the FAA to rescind their DEI policies and review the job performance of individuals in critical safety positions. I'm wondering if you are concerned that, that may cause some churn of employees and increase the problems that are -- exist with ATC and the staffing issues? And then secondly, I wanted to ask if United is considering, rescinding its own DEI policies?"
},
{
"speaker": "Scott Kirby",
"content": "So I will answer for United and let DOT answer for themselves. Although we're positive -- feel good about the DOT and administration and the impact that they will have on the air traffic control. I think there is a ton of upside there. But at United, we have always have today and we'll continue to hire based on merit. But we are in the fortunate position that we're a very high-quality employer, and we make efforts to cast a wide net for people coming into United. In fact, last year, we had over 600,000 applications for fewer than 10,000 positions. And because of that, we can be incredibly selective about who we pick. And [while] (ph), we do hire on merit. We can hire the absolute best of the best and have a naturally diverse workforce. So at United we can do -- and the proof is in the results. We are performing better coming out of the COVID for the last few years than any other airline in the world. And our workforce having a diverse but also very best people is a huge part of the reason why we are the best airline in the world."
},
{
"speaker": "Mary Schlangenstein",
"content": "And what do you say that there's a ton of upside with the new administration FAA and DOT?"
},
{
"speaker": "Scott Kirby",
"content": "Well, last year even on clear blue sky days, 68% of our delays were because of air traffic control restrictions on the airspace. That impacted millions of customers. And it is just basic blocking and tackling. And when I talk to the President, he knows a lot about airplanes. He knows a lot about the airspace. He is focused even at his level on fixing it. Incoming Secretary Duffy, I spoke to this weekend, also focused on fixing it. And I think that they will do the basic blocking and tackling, get the FAA the right resources, the right technology to run effectively. And there is -- like everything else combined is not as big for airline customers as running the FAA effectively and efficiently. That is bigger than everything else combined. And I think we are going to be off to the races on that."
},
{
"speaker": "Operator",
"content": "Our next question will come from the line of Rajesh Singh with Reuters. Please go ahead."
},
{
"speaker": "Rajesh Singh",
"content": "Hi, thanks for taking my question. I have a two part question. Scott, some people are calling it the new golden age of U.S. airlines because of the capacity discipline, as well as improved pricing. Do you subscribe to this view? And second, do you see any risk for the industry due to the increasing macro uncertainty, not just from the demand perspective because of high inflation and interest rates, but also from supply perspective because of trade and tariffs? Thank you."
},
{
"speaker": "Scott Kirby",
"content": "So I think this is the golden age for airline customers. The -- particularly at an airline like United. The amount we've invested in the product and the service, the loyalty program. The amount of customers who are brand loyal to United today, I think is bigger than it's ever been in history, the wide array of products for premium all the way down to Basic Economy. And so I think it's the golden age of customers. And because customers like that and because customers choose United Airlines, it makes it really good for United Airlines as well. That is a symbiotic relationship. On the question about supply chain, we are early into the Trump administration. So we'll see what happens with tariffs and such. But just like my comments about what's going to happen at the FAA, I have a lot of confidence in this administration that we're – they are focused on doing things that unlock American innovation and entrepreneurialism. And that create -- remove regulatory burdens and expand the economy. And so I think, my base case is that the net-net of that is going to be a strong, robust economy and strong, robust demand for United Airlines."
},
{
"speaker": "Operator",
"content": "And I will now turn the call back over to Kristina Edwards for closing remarks."
},
{
"speaker": "Kristina Edwards",
"content": "Thanks for joining the call today. Please contact Investor Media Relations if you have any further questions, and we look forward to talking to you next quarter. Stay warm."
},
{
"speaker": "Operator",
"content": "Thank you, ladies and gentlemen. This concludes today's conference. You may now disconnect."
}
] |
ual | 2,024 | 3 | [
{
"speaker": "Operator",
"content": "Good morning. And welcome to United Airlines Holdings' Earnings Conference Call for the Third Quarter 2024. My name is Krista, and I will be your conference facilitator today. Following the initial remarks from management, we will open the lines for questions [Operator Instructions]. This call is being recorded and is copyrighted. Please note that no portion of the call may be recorded, transcribed or rebroadcast without the company's permission. Your participation implies your consent to our recording of this call. If you do not agree with these terms, simply drop off the line. I will now turn the presentation over to your host for today's call, Kristina Edwards, Managing Director of Investor Relations. Please go ahead."
},
{
"speaker": "Kristina Edwards",
"content": "Thank you, Krista. Good morning, everyone. And welcome to United's Third Quarter 2024 Earnings Conference Call. Yesterday, we issued our earnings release, which is available on our Web site at ir.united.com. Information in yesterday's release and the remarks made during this conference call may contain forward-looking statements, which represent the company's current expectations. All forward-looking statements are based upon information currently available to the company. A number of these factors could cause actual results to differ materially from our current expectations. Please refer to our earnings release, Form 10-K and 10-Q and other reports filed with the SEC by United Airlines Holdings and United Airlines for a more thorough description of these factors. Unless otherwise noted, we will be discussing our financial metrics on a non-GAAP basis on this call. Please refer to the related definitions and reconciliations in our press release. For a reconciliation of these non-GAAP measures to the most directly comparable GAAP measures, please refer to the tables at the end of our earnings release. Joining us on the call today to discuss our results and outlook are Chief Executive Officer, Scott Kirby; President, Brett Hart; Executive Vice President and Chief Customer Officer, Linda Jojo; Executive Vice President and Chief Commercial Officer, Andrew Nocella; and Executive Vice President and Chief Financial Officer, Mike Leskinen. In addition, we have other members of the executive team on the line available to assist with the Q&A. And now I'd like to turn the call over to Scott."
},
{
"speaker": "Scott Kirby",
"content": "All right. Thanks, Kristina. And good morning, everyone. Before we start, I want to acknowledge the devastation that has occurred in the Southeast due to severe hurricanes that impacted the region. The United team has been working overtime to get our customers and employees safely in and out of the impacted areas. We've also raised hurricane relief funds and transported humanitarian aid to the region. Turning to the quarter. The inflection we spoke about on our last call has happened and we're seeing unprofitable capacity to begin to exit the market, leading to the expected domestic yield improvement. We once again delivered a solid quarter, and I want to thank the United team for taking care of our customers and producing these strong results all while strengthening the culture that puts the safety of our customers and employees first. Today's results are another proof point of what we've been outlining was going to happen on these calls for several years now, both at United and in the industry more broadly. So how have we gotten here? Over the last several years, United has worked hard to improve the customer experience. That starts with a great culture and great people that are proud to be a part of United and want you, our customers, to feel the same way. Over a multiyear period, we've also made significant product investments that are important to our customers, like new aircraft with seatback screens and power in every seat, expanding clubs and the fastest WiFi in the industry with Starlink. United is also the clear innovation leader in global aviation and our technology is now without question the best of any airline in the world and by a wide margin. One of the most common comments I get from customers now is about how much better the United app is than any other airline. But no investment has been more important than the almost $10 billion investment we've made in our people over the last four years. During this time, we also reached industry leading contracts with four of our five major work groups. We're currently in federal mediation with the AFA who are committed to reaching the same kind of agreement for our flight attendants. But we knew that doing all of that following COVID would be difficult, we could have just hoped that the world would revert to pre-covid norms. That's allowed us to be consistently ahead of the curve and often move opposite the consensus and we've been consistently right. All of these actions and investments combined with our United Next plan have propelled United to a leadership position operationally, financially and for our customers' employees. All these actions position United to provide benefits to all of our stakeholders, financially stable, secure careers for our people, improved experience for customers. And now that we've done those two things, we can return value to our shareholders. This success has led to our strong financial results that have facilitated our ability to restore our balance sheet and position us to take the next step in solidifying our leadership position in the industry. Our Board of Directors has approved a $1.5 billion share repurchase program. Mike will go into the details about our capital allocation framework but this is a critical next step for United as we work to create value for all of our stakeholders. We're proud of our current results and excited about the innovation that we have ahead for customers. We're also glad to see that the industry inflection point, which we've been predicting, has actually happened. We believe that all sets United up to expand margin in the years to come. And with that, I'll hand it to Brett."
},
{
"speaker": "Brett Hart",
"content": "Thank you, Scott. And good morning. I'd also like to thank the United team for closing out this summer on a high note. This quarter was the busiest third quarter in company history, setting the company records for the most ever passengers carried on the July 4th and Labor Day holidays and for the highest number of customers carried in a day at 552,000 in July. Despite record numbers of passengers and challenging weather across our network, we ranked first in on-time departure and second in on-time arrival amongst major US airlines for the third quarter with the best on-time departure in the months of August and September. These results are a testament to the investments we have made in our operations, resources and tools to bolster the durability and resilience of our operation. These investments, along with what we've learned from operating in challenging geographies, has further improved our recovery during weather and irregular operations events. In addition, our safety measures have only become stronger this year with additional investments in our people and technology. This year, we launched training for our pilots focused on safety and professionalism and more will be rolled out next year. We added additional safety resources across the operation and we are investing in new technology that will make it easier for employees to engage with our safety programs. Running a safe and reliable operation is the backbone of this airline and one of the many contributors to the success of our business. Investing in the customer experience has also been key to widening our competitive advantage. Our NPS scores continue to reflect the benefit from these investments. Our third quarter NPS was up 5 points versus the same period last year and is up 24 points versus 2019 year-to-date. These results would not have been possible without the vision and leadership of our Executive Vice President and Chief Customer Officer, Linda Jojo. Last month, Linda shared the news that she will retire at the end of this year. In her 10 years, Linda led a team that revolutionized air travel and has enabled so many of our industry leading customer innovations. These innovations have continued to set United apart and have delivered real value to our brand and our business. But the most lasting element of her legacy is likely to be the impact that she had on our culture and is well known across the company. Her commitment to mentoring the next generation of leaders at United, especially women. Countless people, men and women across the airline, not just on her team, have benefited from Linda's wisdom and her willingness to generously share it. Her leadership will not be easily replaced but it's certainly an example we'll aim to follow. Now that I have thoroughly embarrassed her, let me hand it off to Linda to talk about the changes she has seen at United in her 10 years."
},
{
"speaker": "Linda Jojo",
"content": "Thanks, Brett. We believe that United has the best hub cities, the best network and the best people. But to create an airline that customers choose to fly, we need to deliver a great customer experience. That's why over the last decade, we've invested over $14 billion in technology to help our employees work more efficiently and deliver outstanding service. We believe these investments give United a unique competitive advantage further strengthening our brand and foster a culture of innovation that's hard to match. For example, one of the first decisions we made when I joined United was to issue iPhones to our flight attendants. Once these devices were in our employees' hands, it unlocked a new way of thinking for both our frontline and our digital technology teams. These devices now help our flight attendants deliver more personalized service, from recognizing someone's birthday to offering in the moment care, to sharing connecting gate information, building a stronger connections with our customers and drive our higher NPS scores along the way. We've also moved to a paperless flight deck, issued iPads to our technicians, upgraded our contact center, crew scheduling and airport tools, resulting in more efficient aircraft turns and better crew communication, especially during our regular operations. This culture of innovation, combined with our investments in our technology infrastructure, enabled us to launch dozens of industry first capabilities for our customers and employees. For example, we launched Connection Saver more than five years ago, saving the day for over 3 million customers since then. This is a customer benefit still not copied by other airlines. Like Scott, I'm very proud of our app. It's used by nearly 90% of our customers on the day of travel where they can save up to 30 minutes at the airport. And when things don't go as planned, we take steps to automatically rebook you and we've introduced new features like allowing customers to list standby for earlier flights and access to hotel and meal vouchers. Our self-service success rates in the app have doubled since making these changes, which translates to customers getting on their way faster and our employees freed up to assist those customers who need more help. Our patented Agent on Demand technology gives customers the option to text, talk or video call a live agent from the United app and enables our teams to collaborate across airports, aligning our people resources to where they're needed most. During a recent storm in Houston, over 7,000 customers got help from live United Airport agents already on duty in other airports who were not impacted by the storm. Our pace of innovation continues. So far this year, we've allowed customers to be automatically moved to a preferred seat, created a flight filter so travelers can confirm that aircraft can accommodate their wheelchair, expanded live activities to Apple Watch and signed the industry's largest deal with Starlink for in-flight WiFi. The Starlink announcement was a full circle moment for me. Finding a way to improve in flight WiFi has been a year's long challenge. And like when we gave iPhones to our flight attendants nearly a decade ago, I think this will completely transform the onboard experience in ways we probably can't imagine today. And that's why I can't wait to see what the team will do next. I'll now hand it over to Andrew to talk about the revenue environment."
},
{
"speaker": "Andrew Nocella",
"content": "It's been an exciting decade at United. Thank you, Linda. At United, we take great pride in our leading RASM results over the last few years. Our segmentation strategies, multiple product choices from basics to Polaris and network capacity deployment decisions have created strong relative margins for United versus others. Elimination of change fees and the swapping out of single class RJs for mainland jets has been very positive for United and negative for our competitors. Turning to our third quarter revenue results. United's top line revenue grew 2.5% year-over-year to $14.8 billion on 4.1% more capacity versus the third quarter of '23. Consolidated TRASM was down 1.6% year-over-year aligned with our expectations of a challenging domestic industry capacity dynamic in July. As expected, we reached the domestic inflection point. Domestic PRASM was slightly positive in August and September year-over-year, which was a material improvement from earlier in the quarter where it was down 4%. United's domestic capacity in 2024 was shaped with the expectation that the industry would remove unprofitable capacity in earnest in Q4. As a result, United expanded slower than most during the first three quarters of the year when capacity dynamics were less favorable, but importantly, our timing was right, tilting our growth to the quarter where the industry conditions would be the best. Network and business model changes due to large financial losses by others are resulting in an improving domestic and near Latin America pricing and yield environment. We expect more of the same in 2025. The timing of our growth push in Europe in 2022 and 2023 proved to be spot on with the recovery in demand post pandemic. This year, we allowed capacity added in 2022 and 2023 to mature creating good RASM results. We entered Q4 with momentum across the Atlantic as RASM growth was strongest as we exited Q3 at plus 4%. We've gotten pretty good at knowing when and where to grow and just as importantly knowing when and where not to grow. While our Asia Pacific network is solidly profitable, Asia RASM was challenged in the quarter as we continue to face China and South Pacific headwinds driven by simply returning to a more numeralized revenue environment. United expanded Asia capacity by 27% year-over-year in Q3 and 50% in the last 12 months. Pivoting capacity across the network remains a focus as we enter Q4. We're in the process of reallocating underperforming narrowbody capacity in our Guam operation to create new revenue pools and connectivity in Tokyo. United's planned Pacific growth will moderate to 7% in Q4 and further again in 2025. We plan to return to a more typical Pacific growth rate once our post pandemic network is fully restored. With stronger year-over-year performance expected across the Atlantic and Pacific in Q4, United is also seeing a much better global year-over-year RASM outlook versus Q3. We remain bullish about the long-term growth prospects of our global [long offline]. The structural shift in profitability is evident in two of the three international entities at United so far in 2024. We're optimistic that performance to Latin America will improve in the coming quarters as the region is seeing significant capacity rationalization by low margin airlines. United’s network health remained strong. All United hubs and all four entities produce profits in Q3, produce profits year-to-date and produce profits over the last 12 months. Corporate demand acceleration was nice to see in September across all regions and is expected to continue into Q4. Contracted corporate revenues were up 13% in September, at 95% of 2019 revenues, which is 13 points higher than July and August. United is centered in the largest business markets as corporate demand expands and we expect a material tailwind. Load factor for managed business was down nearly 2.5 points in Q3 still versus 2019 and we look forward to a slow but steady gains as we enter 2025. We've seen eight of the top 10 biggest post pandemic corporate revenue booking days since the start of September, including the biggest day in United's history. RASM in United's premium cabins was up 2% in Q3. Premium cabin RASMs performed better than main cabin in all entities during the quarter. On the other end of the spectrum, basic economy remains an important product with volumes up 21% year-over-year. MileagePlus revenue was up 11% and our Connected Media business continues to spool up as we invest in technology and seatback screens to create new high margin revenue streams. Active membership at MileagePlus was up 13% year-over-year and holders of our credit card have reached a new penetration record with credit card spend reaching new records up 9% year-over-year showing flyers increasingly engaged with all United has to offer. I will end with a quick view of the revenue setup for early 2025. Much of the revenue challenges we have seen in Q3 on weak [leisure] yields for domestic leisure customers who book travel far out. As we look into Q1, we're selling these very same tickets yields that are much higher. We believe Q1 yield strength will be possible due to the significant schedule changes and business model changes that will continue to be implemented by low margin airlines. While there's still a bunch of noise in Q4 due to the multiple calendar shifts that make the positive magnitude of the domestic revenue pivot a bit difficult to see for some, the environment is improving rapidly just as we anticipated. In addition to the positive leisure yields we expect in Q1, we're clearly seeing an acceleration of return to office policies, which are driving corporate traffic revenue growth at an accelerated level and creating a great setup for 2025. Further, as I said earlier, Asia unit revenues have clearly pivoted in Q4. Thanks to the entire team for a job well done. With that, I'll turn it over to Mike to discuss our financial results."
},
{
"speaker": "Mike Leskinen",
"content": "Thanks, Andrew. And thank you to the United team for another solid quarter. In the third quarter, we delivered a pretax margin of 9.7% and earnings per share of $3.33, above the high end of our guidance range despite challenges from the CrowdStrike outage and suspension of our flights to Tel Aviv and Aman. Revenue trends improved across most geographies as industry capacity rationalized, all while we saw a relief in fuel prices. Customers continue to choose United as we invest in our hard product, our people and a resilient operation. Turning to costs in the quarter. CASM ex was up 6.5% on 4.1% capacity growth versus the third quarter of last year. We expected CASM ex to be pressured in the quarter with lower capacity growth. This was further amplified with an approximately 1 point reduction in capacity from CrowdStrike and suspension of Tel Aviv and Aman. As we look to the fourth quarter, we expect some unit cost improvement as labor headwinds moderate and our capacity growth steps back up. We expect that our costs will remain pressured from previous capacity reductions in both our domestic and Atlantic schedules and delivery delays from Airbus and Boeing. As we look ahead to CASM ex in 2025, we expect to see tailwinds from better utilization and firmer capacity plans, assuming OEM delivery delays moderate. We expect to continue to see pressure from our labor agreements of around 2 to 3 points, which should be an industry headwind as well. For the fourth quarter, we expect earnings per share to be between $2.50 and $3. Turning to the fleet. In the quarter, we took delivery of 17 Boeing MAX aircraft and three A321neo aircraft. In the fourth quarter, we expect to take delivery of 19 narrowbody aircraft and three widebody aircraft, our estimate accounts for our current assessment of the impact of delays at both Airbus and Boeing. With these deliveries, we now expect full year adjusted capital expenditures to be less than $6.5 billion. On capital allocation, our United Next plan is working and the airline industry is in the midst of a positive transformation. A decommoditization of customers are choosing United based on the wide selection of products from premium international seats to flexible travel for domestic business travelers and basic economy for our price sensitive customers. Our investments have solidified a leading position for us in the industry. As our strategy has worked, our relative profitability has improved materially but our stock hasn't kept up. We believe there's tremendous value in our shares and now have the balance sheet and free cash flow to opportunistically repurchase those shares. Our Board of Directors has approved a $1.5 billion share repurchase program that we intend to execute beginning this quarter and throughout 2025. This program will be funded by free cash flow generation as we expect our profitability to improve. It's imperative that we balance our priorities of investing in the business and consistently returning value to our shareholders while also deleveraging. Our current net leverage is 2.7 times and we are targeting below 2 times in the next few years. In parallel with this new buyback authorization, I'm happy to share that we've already repurchased approximately $82 million of shares that were issued when a portion of the warrants originally granted to the US Treasury under the Cares Act and Payroll Support Program were exercised during the quarter. The repurchase of just over 2 million shares fully offsets the dilution associated with these exercise warrants. The shares were purchased at an average price of $39.99. We are delivering on our financial commitments and expect to deliver on our EPS guidance for the second year in a row. We are greatly encouraged by our third quarter performance and the progress we've made to positively differentiate our product, increase TRASM, improve our balance sheet and now return cash to shareholders. The future at United Airlines is incredibly bright. With that, I'll pass it over to Kristina to start the Q&A."
},
{
"speaker": "Kristina Edwards",
"content": "We'll now take questions from the analyst community. Please limit yourself to one question and if needed one follow-up question. Krista, please describe the procedure to ask the question."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] And the first question comes from Conor Cunningham with Melius Research."
},
{
"speaker": "Conor Cunningham",
"content": "A question I get pretty often from investors is just how you plan to capitalize on an evolving industry backdrop in '25. Many of your competitors are making significant changes to the network and product. When you take a step back where do you see the biggest opportunity in the US domestic market next year?"
},
{
"speaker": "Scott Kirby",
"content": "I'll try to take it. We're focused on United and our outlook and continuing to develop the United Next plan. And so there's a lot of opportunity. I think, first of all, we're going to continue to build connectivity in our Mid-Con hubs. We've had that as one of our north stars for a long time and we'll continue to do that. But we're also going to continue to invest in the customer to make our product one that they choose more and more often and we continue to see market share gains related to that. And then I think the last point I would say is particularly from a corporate point of view, we see corporate traffic accelerating that's United’s bread and butter, we've been waiting for that to happen for a while. It's particularly important in Q1 and we think it's going to happen in Q1, and that creates a great set up for us. So we're going to stay focused on building products that customers want to buy. We're going to stay focused on building our high yield share as we go forward and building connectivity and, of course, building our global network, which has done incredibly well over the last few years."
},
{
"speaker": "Conor Cunningham",
"content": "And then maybe just sticking with or going back to United Next. When you first laid that plan out in 2021, obviously, a lot has changed, you're forecasting double digit pretax margin by 2026. I was just curious if you could update us on your thought process and how you get to that double digit margin? You've obviously done a very good job of pivoting and driving margins relative to others. But just any thoughts there would be helpful."
},
{
"speaker": "Scott Kirby",
"content": "For the past couple of years, we've been describing an industry evolution that we're confident will lead to higher margins. We anticipated that we'd reach an inflection point that would kick off a multiyear run that looked a lot like the 2012 to 2014 for airline earnings and investors. For some history, in 2011, each of Delta, United and Southwest had pretax margins between 3% and 4%. Southwest committed to low growth until they rolled -- to hit a certain target, and they lived up to that commitment for the next three years. Three years later, their margins have expanded by 9 points. So the network carriers had expanded by an average of about 8 points. That all happened even while the ULCCs were growing 15% to 20% per year. Fast forward to today, Southwest and one other airline, one of the large airlines, start with margins that are actually even lower in absolute than they were in 2011 and relative margins that are significantly worse than they were in 2011. In response, Southwest has once again made a long term capacity commitment at the same time that the ULCC may not even survive much less grow 15% to 20%. And while we've been predicting this scenario would happen, it's no longer theoretical. It happened in mid-August. The only question now is how much margins expand compared to what happened in the 2012 to 2014 time period. I suppose you can have a reasonable debate about whether it will be the same 8 to 9 points or something less. But regardless, there's likely going to be a meaningful expansion of margins in each of the next three years."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of David Vernon from Bernstein."
},
{
"speaker": "David Vernon",
"content": "I had a question on sort of the international expansion. This sounds like a differentiated strategy that sort of leans into the idea of [wanderlust]. Can you just talk a little bit about the rationale here and maybe your process for picking, I don't know, Nuuk, Greenland, to add to the system versus any other city? And what kind of impact seasoning some of these newer routes that are kind of undiscovered country may have on results for next year?"
},
{
"speaker": "Scott Kirby",
"content": "We spend a lot of time debating how and where we'll grow. And this announcement has clearly caught the attention of a lot of people, most importantly, our customers, and I think it's a very exciting announcement. But the backdrop for the announcement is the fact that United Airlines simply has the best global gateways in the business. And those global gateways allow us to fly successfully to a broad range of destinations. We heavily fly into our partner hubs, which is the traditional model in our business but we're also able to do just as well financially outside of our partner hubs. And so we look across the globe, we look for new destinations, we look for hot destinations and destinations, most importantly, we can make money in. We have a really good track record of this, very little of what we've added over the last few years we have canceled. And so as we look forward, we look for those new destinations. And at the end of the day, Greenland has got a lot of attention but it is only two 373s per week. So its impact on our system will be small. But its impact on United, our brand and our customer profile and sign-ups for MileagePlus will be great. And there is so much more possible on this front than even I thought it was possible five or six years ago. As the United Next plan builds the connectivity, as our global hubs are just in these great cities with high volumes of cargo, high volumes of leisure traffic and most importantly, high volumes of business traffic, we just have a lot to unlock out there. We'll do it very carefully. We'll make sure we're growing profitably but expect more to come on this front."
},
{
"speaker": "David Vernon",
"content": "And then maybe just as a brief follow-up on the widebody situation. Boeing's announced they're going to have another delay on the 777X. How do you think that's going to affect sort of supply demand as you're looking out the next couple of years, the delays in that production platform for the next generation widebody?"
},
{
"speaker": "Scott Kirby",
"content": "So we've talked about this many times since -- even in the middle of the pandemic, we thought there is a structural shift in global capacity, a lot of A380s and other widebodies are grounded and many of those aircraft remain grounded, although airlines are bringing some back, there's no doubt about that. The fact is that the production lines for widebody aircraft probably will not keep up with demand over the next three to five years based on everything we see. And that, in turn, I think, creates a better setup for the global long haul network. We obviously remain bullish on it based on our announcement last week and we'll do it prudently, but we think the setup is pretty good and the 777X appears to be delayed yet again."
},
{
"speaker": "Mike Leskinen",
"content": "I'll just pile on. We're more focused on the 787 delays as you might expect us to be. And we're rooting for Boeing and they are certainly making some smart decisions. We would applaud their -- at least the rumor decision to raise some equity in the capital markets to stabilize the business. But as we see delays on the 787s, we would expect that there's a bias downward in CapEx if those delivery delays continue."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Andrew Dedorio with Bank of America."
},
{
"speaker": "Andrew Dedorio",
"content": "Kind of piggybacking off of that last question, maybe Scott or Mike. I mean, bigger picture, what do you see as the implications across your company from the Boeing strike? And then Mike, just kind of following up on your last answer. Like -- is it fair -- is it reasonable to expect something in the lower end of your $7 billion to $9 billion CapEx range next year just given everything we know from a production perspective?"
},
{
"speaker": "Scott Kirby",
"content": "Well, I'll start big picture and then let Mike give you the CapEx answers. What I care about with Boeing is the long term. We're trying to build the best airline in the history of Aviation for the long term, and I'm very focused on the long term. And I am actually encouraged with Boeing. Mike already referenced it, but the challenge at Boeing, to my view, for decades been that the cultural challenge where they focused on short term profitability and the short term stock price at the expense of what made Boeing great, which is building great products, great engineering, great quality, reliability, safety that you could count on. And I think Kelly Ortberg is pivoting the company back to their roots. I think all the employees of Boeing will rally around that. To me, the biggest news in the last couple of decades, really at Boeing is the willingness -- reported willingness to sell equity that's making the right long term decision regardless of what the Street thinks about it in the short term. So I applaud them for doing that as a long term customer, it's right thing to do for the shareholders long term also. And so I'm encouraged with the changes that they're making. The strike is, in a lot of ways, a cultural legacy of the same issues that have happened over the past couple of decades. It's tough but they will get through it. I'm confident they will. I certain that all of the folks that are out on the picket line now along with the management team all share a desire to make Boeing great and be part of a great company that's one of the most important companies in the world. And so they'll ultimately work through this. It's going to be -- we're going to have two airplanes in the near term than we would have been hoping for, but our eye is focused on the long term. I wanted to get through it and build a company that can work for the long term. And then I think we're -- have a really good set up."
},
{
"speaker": "Mike Leskinen",
"content": "Andrew, let me pile on, and let me be clear. The aircraft we have on order with Boeing and Airbus based on the profitability that you're seeing in our results for the third quarter based off our forward expectation for profitability, we want those aircraft and we want them as soon as Boeing can complete them and deliver them. That said, pragmatically, as these delays are unlikely to be resolved quickly, we would expect down -- we do have a downward bias to CapEx. I expect it to stay within that range and we'll give more precise guidance on the January call when we normally would. But you're correct to assume downward bias based on production delays."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of James Baker with JPMorgan."
},
{
"speaker": "James Baker",
"content": "So a couple for Andrew. Looking back at this past summer, the elevated capacity, the associated pressure on yields. I'm sympathetic, I guess, for lack of a better term, that several of your competitors threw as much capacity at the peak as they could, particularly airlines that are struggling for even the scantest taste of profitability. I know a lot can change between now and next summer. But shouldn’t we assume that maybe this is the new normal? So as LMAs continue to struggle they'll just throw as much capacity at the peaks. So those peaks become a little bit softer, off peaks become firmer, more than the seasonal trends that we've seen in the past? Any thoughts on that?"
},
{
"speaker": "Andrew Nocella",
"content": "I didn't know you're so sympathetic, James…"
},
{
"speaker": "James Baker",
"content": "Well, I just kind of get their logic. I mean, it obviously didn't help, but no, I'm not claiming to be a chair or anything…"
},
{
"speaker": "Andrew Nocella",
"content": "Well, look, I'm not an expert on their business model other than their business models are clearly struggling and they are changing them as rapidly as they can. However, it is hard to change the -- it's hard to change your spots that quickly. Of course, they did exactly what you described. I think I went through the stages of grief on what you do in [that situation] a couple of quarters ago, quarters ago, and I think that is one of the stages of grief. When you wind up at an airline that has this complete imbalance of utilization where you have unproductive uses for a majority of our aircraft for six or seven months per year, and I'm not sure that financial model works either. We'll have to wait and see. The point of all that is there's an incredible amount of unprofitable capacity in the United States marketplace. We've seen that exiting at a rapid pace starting in mid-August, that continues into next year. And my expectation is that we'll continue, at the same time that international remains strong, that business traffic, which is our bread and butter remains strong, and we can march towards higher margins, as Scott talked about, as this evolution occur. So I remain bullish that where we are right now is only getting better and the changes we've seen so far only -- actually the tip of the iceberg is the models just don't work in that way in my mind that you can work for six months and not the other six months."
},
{
"speaker": "James Baker",
"content": "And then on the 20 -- I think you said 21% rise in basic economy volumes. So my ability to track basic economy supply is obviously limited. I'm assuming you track it internally. Can you comment on how your basic economy inventory compares with that of Delta and American? And with growth of this magnitude, I mean, is it United's intent to essentially become the largest supplier of discount capacity domestically down the road, although by some measures perhaps that's already been achieved?"
},
{
"speaker": "Andrew Nocella",
"content": "Well, look, our intent is to expand our margins, to be really clear. Our intent is to offer a full range of products to customers, particularly in our hubs that want everything from basic to Polaris. And we will pivot the amount of capacity we offer in all those categories based on expanding our margins. But we have come to the firm conclusion that offering basic and offered in a substantial amount of volume is good to United, is profitable for United and is bad for our competitors. And so we are going to continue to do what's good for United. It expanded. I think it's in the neighborhood of 15% to 16% of our domestic passenger volumes right now. As we grow our gauge with lower marginal costs, I think it could go higher as we go forward. But again, we'll pivot and do what's right for the bottom line at the end of the day. But I would say that the experiment with basic, which was an experiment seven, eight or nine years ago, is a solid home run and has changed the business dramatically to our benefit."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Tom Fitzgerald with TD Cowen."
},
{
"speaker": "Tom Fitzgerald",
"content": "Would you help us understand the sizing of the contribution from MileagePlus and Kinective Media on margin expansion in 2025?"
},
{
"speaker": "Andrew Nocella",
"content": "I don't think we're prepared to do that today. MileagePlus is a jewel in our business and has not been focused on enough over the last few years. And we took a different path about a year ago when we hired Richard Nunn. We took a different path as we invest in the technology there. That investment in technology is going to do a lot of things for our business first and foremost, it's going to allow us to personalize service to our customers in a way that I don't think any airline has done. Of course, Starlink is a core part of that, which obviously was just recently announced. So we'll have a lot more to say on this but it is going to be material. It's going to spool up starting next year. But I'm going to have to -- I'm not going to give you the details today on that, but it's pretty substantial."
},
{
"speaker": "Scott Kirby",
"content": "Tom, I'm going to give you a little bit of detail. And that is that in '25, this is an investment phase. We're going to -- it's going to not be losing money, we'll make a little bit of money on in ‘25 but this really starts to accelerate in '26 and beyond. So as you think about modeling '25 though, we've got ton of momentum in the core business. I wouldn't layer a bunch of MileagePlus connected revenue on in 2025. I do expect we'll be giving more and more disclosure so you can model this on your own. You don't have that information at this time but I'm committed to getting you more information to allow you to model it for yourself."
},
{
"speaker": "Andrew Nocella",
"content": "And I'll just bring up one other point -- I was going to bring up one other point. The program is doing incredibly well. And again, we don't talk about it enough and we should. But revenue from the premier population in the quarter was up 9% and that drove the majority of the revenue growth at the airline. And so our premier members are heavily engaged with us. As I said earlier, they hold the credit card in record numbers and they're spending record amounts on their credit cards. But the fact that the premier population base is doing that much more revenue on a base that is actually close to flat, because we've made sure that we can deliver benefits to all of our premium members and we held the level of premium members flat, the program is doing incredibly well."
},
{
"speaker": "Tom Fitzgerald",
"content": "And would you mind just elaborating a little bit on what the customer reaction to Kinective has been and then maybe some of the early reactions on brands that are advertising on the platform?"
},
{
"speaker": "Andrew Nocella",
"content": "I think our activities to date have been rather small. There's been no customer reaction that I could speak of."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Scott Group with Wolfe Research."
},
{
"speaker": "Scott Group",
"content": "So when I look at third quarter, CASM ex is up about 6, RASM is down about 1. When do you think we see an inflection with RASM up more than CASM? I don't think it's fourth quarter, but if you have any color on Q4. And ultimately, I guess, do you have confidence that we see that in '25 with RASM up more than CASM?"
},
{
"speaker": "Mike Leskinen",
"content": "Scott, let me answer that simply. In '25, we would expect that inflection. We're not going to give you guidance on quarter-by-quarter at this time as we traditionally wouldn't, but we absolutely expect that inflection in the calendar year 2025. I shared in my prepared remarks the kind of some pacing of CASM ex, but let me repeat for clarity. Q3, I expect will be the peak for CASM ex. We expect CASM ex to decline into the fourth quarter and to decline further into 2025. We're going to work aggressively to cut all the costs that we should to run an efficient operation. And so I'm committed to that personally and the team is working hard to make sure we run a very, very efficient operation. At the same time, we're going to continue to invest in the customer because we're not focused on CASM ex as a metric at United. We're focused on driving profitability. And through no excuses philosophy, we've been really good at delivering on bottom line earnings per share growth and we're committed to continuing to do that, and we have the right balance of cutting the costs that are around efficiency, but adding the costs that are driving customers to increasingly choose United."
},
{
"speaker": "Scott Group",
"content": "And just a follow-up, maybe just some directional color on your RASM expectations for Q4, positive, negative, flat and then some of the differences in the regions would be helpful."
},
{
"speaker": "Andrew Nocella",
"content": "Well, I want to answer that question, but I will give you another hint. So January -- and I'm going to talk about Q1 because I can. January is currently 77 days from the start of the month and 107 days from the end of the month. At this same point, domestic yields were down 9% in July, down 2% in September and up 3% in January. And so the yield environment is just looking good, really booked to a small percentage of our booking curve for January. But I just want to say that Q1 is shaping up well as the pricing environment looks better, capacity is, obviously, different across the industry and business traffic continues to rebound."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Duane Pfennigwerth with Evercore ISI."
},
{
"speaker": "Duane Pfennigwerth",
"content": "Domestically, are there any regions that stick out in terms of recovery, specifically as it relates to corporate, are you seeing any signs of recovery in lagging West Coast markets like San Francisco?"
},
{
"speaker": "Scott Kirby",
"content": "It would be the opposite. So the coastal hubs are stronger than the interior hubs. In the corporate bucket, professional services, financial services and tech are growing fastest, where energy and a few other things are growing slow. But all verticals are growing and corporate traffic looks good but the coastal hubs are much stronger than the interior hubs at this point."
},
{
"speaker": "Duane Pfennigwerth",
"content": "And then Mike touched on it and I think it came up in a couple of questions, but just contrasting the setup on the kind of step-up in growth in 2025 or the step up in CapEx in 2025 versus prior years where it was a little bit of a placeholder given OEM constraints. Does the setup feel different now looking into 2025? I know you recast and derisked some of your deliveries. But is your confidence higher into 2025 growth or about the same than it was this time last year into 2024?"
},
{
"speaker": "Mike Leskinen",
"content": "Duane, I think you're asking me about CapEx expectations in '25?"
},
{
"speaker": "Duane Pfennigwerth",
"content": "CapEx and really growth, just that it was -- in prior years, it was a placeholder at this point in time, given OEM constraints and you have a better view into how those work out than we do on the outside. I'm just wondering if the confidence is any higher now into your planned growth than it has been in prior years?"
},
{
"speaker": "Mike Leskinen",
"content": "Let me try to be responsive. We've been very clear about a range of CapEx at $7 billion to $9 billion. And as we sit here today, given the strike at Boeing, given other delays, we'd expect there to be a downward bias within the range for CapEx in 2025. Now separately -- there's a relationship, but separately, thinking about capacity in 2025, we're not going to give guidance for capacity in '25 at this point. But you can trust us, you should expect we have earned that trust that we're going to fly the capacity to maximize profitability for United."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Sheila Kahyaoglu with Jefferies."
},
{
"speaker": "Sheila Kahyaoglu",
"content": "We touched on this a little bit, but maybe we could parse it a little bit more on the domestic RASM down 0.8% in Q3 from 1.9% in Q2. It doesn't seem like much, but Andrew, I think you just gave a little bit of color on how July was and how August trended. It seems a much bigger step improvement. So maybe can you talk about what drove that? Was it the -- how much was capacity, how much was corporate, how much was share gain in economy? Any details you could provide?"
},
{
"speaker": "Andrew Nocella",
"content": "I'll try. I mean, it was a lot of things. I will say that September was dramatically better than July. July was clearly the low point for the year in terms of year-over-year RASM. We saw gains really in all the entities, but September, again, was much better. We expect Pacific market to also improve as we head into Q4. Business traffic was up, I think, about 6% in the whole quarter, but it was up 13% in September to give you an idea of the spool up. So we exited the quarter with some really, I think, much better performance and we were hopeful that, that performance translates into good quality earnings in Q4 and beyond. Hopefully, that -- does that answer your question?"
},
{
"speaker": "Sheila Kahyaoglu",
"content": "A little bit. Maybe I could follow up on the Q1 comments that you made with the bookings being so strong, but only minimally booked. So how do we think about what drove that strength into Q1 and how you're seeing that, is it -- like where is that trend coming from, is it different than what you saw in the Q3 September performance?"
},
{
"speaker": "Andrew Nocella",
"content": "I don't have it by geography. But what we are seeing is that there's just a much better pricing environment for leisure yields that look very early in the booking curve. And we attribute that to changes in capacity, the elimination of unprofitable capacity, better business bookings, although very slim at this point and changes at business models of the low margin airlines. All of these factors are leading to what we anticipate will be a much stronger environment in 2025 for United Airlines."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Brandon Oglenski with Barclays."
},
{
"speaker": "Brandon Oglenski",
"content": "Congrats on retirement Linda and congrats to the team on a pretty strong 3Q outcome here with all the headwinds that you had. Mike, I really like to know excuses attitude here, the share repurchase definitely a vote of confidence. I guess, can you help investors -- because we understand the CapEx dynamics next year. But longer term, you guys are going to be in this range of $7 billion to $9 billion, that is a little elevated compared to others. But how integral is that spending and the investments maybe even outside of the aircraft fleet and to achieving that double digit margin target?"
},
{
"speaker": "Mike Leskinen",
"content": "Brandon, I appreciate the question. It's something we think about a lot in the finance department these days at United. CapEx is elevated that refreshing of the fleet, the growth of the fleet has been absolutely integral though to the United next strategy. The gauge increase from the narrowbodies, that's frankly what's driving our ability to provide basic economy, which is creating a competitive dynamic that is just fundamentally reshaping the industry. So they are intertwined. That said, as the strategy progresses and our margins expand, I am focused on free cash flow conversion. And in the near term, in the next two or three years, we're focused on a free cash flow conversion target of 50%. We're not going to manage perfectly in every individual year. But over the next three years, I would use 50% as a target. Later in the decade, I am aiming higher, I think, 70% to 75% longer term than that, I think there's opportunity. But near term, think about 50% and later in the decade think about a target of 75% for free cash conversion."
},
{
"speaker": "Brandon Oglenski",
"content": "Mike, I appreciate that. It's actually very helpful. And that's within the context of that $7 billion to $9 billion outlook on CapEx for the next few years, right?"
},
{
"speaker": "Mike Leskinen",
"content": "$7 billion to $9 billion remains the target for the next few years, and we'll give you an update to that in the future. But for the next few years, $7 billion to $9 billion remains the target. And let me say for the third time, that has a downward bias next year."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Mike Linenberg with Deutsche Bank."
},
{
"speaker": "Mike Linenberg",
"content": "And obviously, keeping with your no-excuses mantra, I thought it was interesting that there was nothing in the release as it related to CrowdStrike. I know, Mike, you called out 1 point of CASM, but at the end of the day, you did cancel, I want to say, it was like either 2,500 or 2,600 flights on United and its partners. What was the revenue impact? Or is it just with your booking tools, your ability to reaccommodate maybe better than others that the revenue hit maybe was not as much as even worth reporting?"
},
{
"speaker": "Mike Leskinen",
"content": "Scott and Andrew, if they want to provide some detail, obviously, they can. But healthy businesses, healthy industrials, healthy businesses, they'll make excuses about CrowdStrike, they'll make excuses about weather. We build into our guidance, the expectation there will be one act of God in a quarter that impacts the business in a negative way. And if that impact ends up not being so large then we can beat -- coming at the high end or beat our guidance. If you have a series of events in a quarter or a massive event, then of course, you're not always going to hit your guidance. But I think it's just basic setting of targets in a way that expects it not always to be a perfectly sunny day."
},
{
"speaker": "Scott Kirby",
"content": "And I'll -- actually use this to expand on a cultural philosophy that I think is really important here. And when I was a cadet at the United States Air Force Academy, the best thing I learned was no excuses, may have no excuses [Technical Difficulty] it's easy to point to the things that aren't your fault, they don't feel like they're your fault, but that was one of your basic answers. And we have tried to get that philosophy and still throughout United. What that means is it forces you to constantly get better. It's easy to have an MBA in a cubicle somewhere come in at 9:00 a.m. on Monday in an air-conditioned office and calculate how much some event outside of your control cost. And it’s right, I mean it's not that it's wrong. But that -- then that's the end of the story. If you have a no excuses mantra and you don't allow people to even go calculate those numbers, it forces people to go find innovation, creative ways to get better and better and better, so that you can overcome those things when they happen. And we have said it a few times on this call. We are the innovation leader in the airline industry around the globe and second place is far behind. And the no excuses philosophy is a big part of that. It forces us to do things that we wouldn't otherwise do if we let ourselves just look at the calendar or look at the bad things that happen and write those off. And so I think it's a really important cultural point that the team has on both the revenue side and the cost side. And I'm proud of the team for taking it to heart, our Chief Operating Officer is in the room, Toby, and he says it in a different way, but great. He says, -- we're talking about things like the weather. And it may not be our fault but it is our responsibility and that's the attitude we have here at United."
},
{
"speaker": "Mike Linenberg",
"content": "And then just, Andrew, just on -- looking more towards the smaller cities in your network during COVID, I want to say there was probably 30 or 40 markets that you had pulled out of because of the pilot issue. It now feels like that that's been alleviated somewhat. When I think about your competitive moat in some of those markets you serve, you were the only game in town. I know Mike has mentioned some RASM -- or some CASM pressure in 2025, maybe related to some additional regional flying. I suspect that maybe some of those markets are coming back online, anything that you can add to that."
},
{
"speaker": "Andrew Nocella",
"content": "Just briefly, the RJ network -- well, first of all, the RJ flying has pulled back up to its new run rate in Q4. And so that has -- it has come back in line a little bit quicker than we anticipated at the beginning of the year and they are smaller aircraft and they do pressure CASM. We also think they help RASM and profitability, which is, of course, why we've done it. We are back to full utilization on the RJs at our new run rate fleet. We announced a deal, I think, last week for 11 CRJ-550s with SkyWest, that aircraft has been actually much better than expected for United. So we're glad to be able to expand that, which allows us to better serve these smaller communities. But I also don't think there's a large scale change coming at United and how we serve these smaller communities. Our plan over the long run is slightly less scheduled [debt] with lower frequency with aircraft that are bigger that have lower unit costs. We said that with United Next a number of years ago, we continue down that road and down that philosophy. So expect the RJ fleet to still be around and do this thing, but it will become a smaller and smaller percentage of the business. And we will serve the smaller communities with a mixture of RJs and mainline jets and have the lowest cost possible in those communities."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Steve Trent with Citi."
},
{
"speaker": "Steve Trent",
"content": "Linda, best wishes to you on your retirement. I wanted to ask, very good trajectory in terms of reduced leverage. Could you give us some high level view on how this could dovetail with your credit strategy, maybe investment grade rating on the horizon?"
},
{
"speaker": "Mike Leskinen",
"content": "As our margin expands and our leverage decreases, we expect we will have investment grade metrics and we're going to work very hard earn the trust of the credit rating agencies to get investment grade ratings to go along with those metrics. But 2 times -- less than 2 times net debt with margins that are double digit with an industry structure that is more resilient with United as the leader within that industry that's an investment grade company."
},
{
"speaker": "Steve Trent",
"content": "And just one other quick question. You guys have some great partnerships with names like Copa and some of your Star Alliance fellows. Do you anticipate a fair bit of long term growth coming from these partnerships, or are we really going to think about organic drivers for the growth?"
},
{
"speaker": "Mike Leskinen",
"content": "Our partnerships are incredibly important to us and we do have the marquee names across the globe with great hubs that we plan to. However, our approach to growth is balanced. As I said earlier, we have the ability to grow profitably in our partner hubs but we also have the ability to grow just as profitably outside of our partner hubs. We do incredibly well to London Heathrow, for example, which is not a partner hub for us. And so I would expect a balanced approach to this, again, with the idea of expanded margins. But we will look to expand into new regions of the world that I think are uniquely supportable by habit hubs that are in New York and Washington D.C. and San Francisco, in particular. Those hubs just simply unlock the ability to fly to places like Marrakesh or Greenland or other places that we've recently added to the map. So international is an important part of United. We're clearly the largest of the big three flying overseas. We expect that to continue. But most importantly, we have really good margins, at least across two of those big entities today and we look to expand those margins going forward."
},
{
"speaker": "Operator",
"content": "We will now switch to the media portion of the call [Operator Instructions]. Your first question comes from the line of Leslie Josephs."
},
{
"speaker": "Leslie Josephs",
"content": "I just wanted to ask around the election. I know one of your competitors talked about decline maybe a week before and a week after. Can you talk a little bit about what you're seeing? And then also in this quarter, seeing some really, really low fares to Europe kind of across the board, across airlines and destinations. And can you talk a little bit about that, what demand trends you're seeing? And if this is just kind of a maybe a function of a lot of capacity, maybe people traveled already or what -- kind of what's at play there?"
},
{
"speaker": "Scott Kirby",
"content": "In terms of the election, I think what we would say is a presidential election normally has an impact on RASM. Fewer people travel that week for the obvious reasons. And here we are, it's four years later and we are seeing the same thing. So I don't think there's anything to be surprised by. In terms of Europe, Europe has a very good outlook. We've had a very good nine months so far in Europe. We expect it to be good one for the rest of the year. If you see a great fare out there, I urge you and all your friends to buy it and take a trip to Europe. It's great in the winter, particularly Southern Europe, Rome is excellent in the winter."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Mary Schlangenstein with Bloomberg."
},
{
"speaker": "Mary Schlangenstein",
"content": "I wanted to see if you could go back a little bit on some of your comments about the outlook for Asia and China, and how that might be changing and whether United plans to add back any additional China, US routes anytime soon?"
},
{
"speaker": "Scott Kirby",
"content": "I'd say and I've said this in the past, China is just completely different for United today than it was pre-pandemic. We used to fly, I think, roughly 10 flights a day to China, and I think those days are gone. The demand environment is just entirely different. We just recently resumed Los Angeles to Shanghai and we're bringing that up to daily, that will bring us to three daily flights. And I really don't anticipate based on the demand we're seeing a lot more than that anytime soon. It's just a completely different world. The situation in terms of the RASM, which I was talking about earlier is, as we've gone back to what is now a full schedule to China, we're back to what I would describe as normal RASMs. And those RASMs came down significantly from -- during the pandemic time period where we used to fly a few flights per week. And so that has had a negative impact on our year-over-year RASM results across the Pacific for a number of quarters. However, that comes to an end in Q4 and in Q1 when we lap that completely. And therefore, the RASM impact -- the negative RASM impact of China will dissipate and we see this pivot that starts in Q4 and hopefully continues into next year."
},
{
"speaker": "Mary Schlangenstein",
"content": "And can you give us an idea of the load factor on your China flights?"
},
{
"speaker": "Scott Kirby",
"content": "I don't have that in front of me, but not high enough."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Rajesh Singh with Reuters."
},
{
"speaker": "Rajesh Singh",
"content": "I have a question about Boeing's price. When does it start affecting your United schedule? And secondly, Emirates President, Tim Clark, recently said that Chapter 11 is looming on the horizon for Boeing. Do you share that view and have you done any contingency planning around that possibility?"
},
{
"speaker": "Scott Kirby",
"content": "It's hard to hear all of that, but we're not anticipating the outcome you described."
},
{
"speaker": "Rajesh Singh",
"content": "And do you expect -- when does this strike start having an impact on your schedule?"
},
{
"speaker": "Scott Kirby",
"content": "It really does, it’s that's immediate when the aircraft have stopped delivering. But as I said in my earlier comments, we have -- we're encouraged that Boeing is focused on the long term. We want them focused on the long term. I talked to Kelly as recently as yesterday and appreciate his focus on the long term, and that's what we care about. It has a short-term impact but I think Boeing is positioning themselves for a strong turnaround in the long term."
},
{
"speaker": "Operator",
"content": "That concludes our question-and-answer session. And I will now turn the call back over to Kristina Edwards for closing remarks."
},
{
"speaker": "Kristina Edwards",
"content": "Thanks, Krista. And thanks to everyone joining the call today. Please contact Investor Media Relations if you have any further questions, and we look forward to talking to you next quarter. Happy Halloween."
},
{
"speaker": "Operator",
"content": "Ladies and gentlemen, this does conclude today's conference call. Thank you for your participation and you may now disconnect."
}
] |
ual | 2,024 | 2 | [
{
"speaker": "Operator",
"content": "Good morning. And welcome to the United Airlines Holdings Earnings Conference Call for the Second Quarter 2024. My name is Brianna, and I will be your conference facilitator today [Operator Instructions]. This call is being recorded and is copyrighted. Please note that no portion of the call may be recorded, transcribed or rebroadcast without the company's permission. Your participation implies your consent to our recording of this call. If you do not agree with these terms, simply drop off the line. I will now turn the presentation over to your host for today's call, Kristina Edwards, Managing Director of Investor Relations. Please go ahead."
},
{
"speaker": "Kristina Edwards",
"content": "Thank you, Brianna. Good morning, everyone. And welcome to United's Second Quarter 2024 Earnings Conference Call. Yesterday, we issued our earnings release, which is available on our Web site at ir.united.com. Information in yesterday's release and the remarks made during this conference call may contain forward-looking statements. All forward-looking statements are based upon information currently available to the company. A number of factors could cause actual results to differ materially from our current expectations. Please refer to our earnings release, Form 10-K and 10-Q and other reports filed with the SEC by United Airlines Holdings and United Airlines for a more thorough description of these factors. Unless otherwise noted, we will be discussing our financial metrics on a non-GAAP basis on this call. Please refer to the related definitions and reconciliations in our press release. For a reconciliation of these non-GAAP measures to the most directly comparable GAAP measures, please refer to the tables at the end of our earnings release. Joining us on the call today to discuss our results and outlook are Chief Executive Officer, Scott Kirby; President, Brett Hart; Executive Vice President and Chief Commercial Officer, Andrew Nocella; and Executive Vice President and Chief Financial Officer, Mike Leskinen. In addition, we have other members of the executive team on the line and available to assist in the Q&A. And now I'd like to turn the call over to Scott."
},
{
"speaker": "Scott Kirby",
"content": "Thank you. Good morning, and thank you, Kristina. The United team produced another solid quarter. We did that while further sharpening our focus on improving our already strong safety culture over the last several months. Looking at a wide variety of metrics, our airline is safer than ever before with our culture rooted in constantly striving to make our airline safer for our employees and our customers. So we're continuing to work closely with the FAA and other partners to do exactly that. Additionally, thank you to our employees for delivering top tier operational performance amidst challenging weather, including Hurricane Beryl in Houston and getting our customers to their destinations safe and on time. While this is a quarter where industry capacity growth exceeded still solid demand, it was also a quarter that continued to show the industry developing along the lines that we've been anticipating for the past couple of years. The pressure other US airlines are experiencing today is due in large part to their unprofitable flying in many domestic markets. It was always inevitable that carriers would begin to cancel this unprofitable flying and you see that happening in earnest in the second half of August in the schedules. As a result, it appears that the domestic industry capacity growth will moderate by roughly 5 points by the fourth quarter compared to where we were in the second quarter, which should provide a constructive setup as we close out the year and a particularly beneficial backdrop heading into 2025. Since COVID began in early 2020, United has consistently been ahead of the curve on the big picture developments driving the industry. We're running the best operation in our history despite operating in the most difficult hubs in the world, Chicago, Newark and San Francisco and despite having more exposure to the issues at Boeing than any other airline in the world. Our people are proud of United and they have completely transformed the service and care for our customers. And we have the best commercial and revenue management teams in the world that are always on top of the demand environment, making strategic and technical adjustments to drive revenue. And the proof is in the pudding. We've now led the industry in domestic PRASM growth three years in a row, that cannot happen by accident. United Next was a great strategy but a great strategy only works with great execution. And that has allowed us to structurally and permanently change our position within the industry. And while we are proud of our relative outperformance to the industry, we also know that our absolute results are all that really matter. They're solid right now but I can already see the impact that the schedule changes are having on our advanced bookings and yields as we hit the mid-August industry capacity inflection point. And we are absolutely committed to our no excuses philosophy and controlling what we can to hit our guidance. And so while the industry is developing as we expected and our relative results are outperforming as we expected, we are not going to rely just on industry changes outside of our immediate control. We're also taking steps in the short term to ensure that we meet our targets. That includes aggressive cost management and reducing domestic capacity 300 basis points in the fourth quarter. The industry rationalization that we expected is beginning to play out, and we've reached the inflection point. The United Next plan continues to be the winning strategy for United. And as a result, we continue to expect to be within our full year 2024 EPS guidance range of $9 to $11 despite the tough industry environment around us. And with that, I'll hand it over to Brett."
},
{
"speaker": "Brett Hart",
"content": "Thank you, Scott, and good morning. This quarter, we continued to achieve record operational performance, delivering the best on-time performance, completion factor and seat cancellation rate for a second quarter since the pandemic, while flying the most passengers in the quarter ever in our history, over 44 million. Looking across our network, Newark, our largest hub, broke several of its own records in 2Q with its April and May on-time departures being the best in company history. The FAA waiver allowing for better balance between the number of flights and with the runways, facilities in aerospace and safely and efficiently handle at Newark has enabled us to produce these results for our customers. Operational excellence was not limited to Newark. Six out of our seven hubs departed more on-time flights than our primary competitors. The improvements were made over the last year to adapt to a more challenging operating environment, have shown meaningful benefits to our reliability, particularly during times of the regular operations. Our strong operation, underpinned by our safety culture is translating into an even better customer experience and driving efficiency benefits to the bottom line. This would not have been possible without the commitment to operational excellence from our frontline employees. So thank you to all of them for their hard work. As I mentioned before, our strong operation is not only driving efficiency, but it is also positively impacting our customer experience. As a result, our NPS scores were the highest second quarter results since the pandemic. We're investing in all aspects of our product, including the introduction of Tillamook ice cream on board our aircraft. Additionally, the United app continues to be the most downloaded airline app with new features like seat preferences that automatically reseat customers when their preferred seat becomes available. This summer, we also started texting live radar maps to customers during weather delays, so they can stay informed about how increment weather in one part of the country can impact their journey. Investment in our leading product and customer experience will remain a key priority to United and will continue to differentiate us as a premier global US carrier. Shifting gears to our employees, I'm pleased to share that after a brief pause in pilot and flight attendant hiring classes due to the Boeing delivery delays for the months of May and June, we resumed these classes in July. Looking ahead, we have a busy end of summer in front of us. The United team continues to innovate and adapt to a complex operating environment. While Andrew will describe some of the near term trends, it's clear that United has a bright future, and we remain on track to deliver $9 to $11 in earnings per share this year. I'll now hand it over to Andrew."
},
{
"speaker": "Andrew Nocella",
"content": "Thanks, Brett. United today reported total revenues in Q2 of $15 billion, up 5.7% year-over-year. TRASM was down 2.4% on 8.3% more capacity year-over-year. We expect United's year-over-year unit revenues in Q2 to be the best of all our large peers. Domestic PRASM fell by 1.9% on 5.3% more capacity. As widely discussed, unprofitable industry capacity that exceeded still solid demand put pressure on domestic PRASM in 2Q. International PRASM fell by 3.6% on 12% more capacity year-over-year. Flights across the Atlantic had a small PRASM gain, while flights to Latin America and Asia continue to see declines year-over-year. Cargo yields have also stabilized at higher levels than forecasted, which is helping cushion some of the PRASM declines we have seen. MileagePlus had yet another strong quarter with revenues up 13%. Our three key revenue segments continue to gain ground. United gained ground in our key markets among frequent business road warrior travelers, which we continue to believe is due to our no-change fee policy, our diverse set of products, our leading global network and our award winning MileagePlus program. Revenue from these road warriors was up 11% in the quarter, while total passenger revenue was up 5%. Consolidated premium revenues increased by 8.5% to $7.4 billion. Premium capacity was up 9.1%. Demand for United's premium capacity, including the Economy Plus, was strong in the quarter, outperforming non-premium seats. Business load factor contribution in the Polaris cabin increased year-over-year by 2.6 points. Polaris and Premium Plus RASMs were up 1.4 points year-over-year. We also continue to see strong demand for our premium domestic first class product with sold load factors up 13 points versus 2019 and 8 points versus 2023. Contracted business revenues were up 10% year-over-year. Basic Economy revenues remained strong and were up 38% year-over-year. United plans to continue to increase the total number of seats we offer in basic as we grow our mainline gauge. However, basic as a percent of sales will likely stay stable or decline as we continue to expand higher margin premium capacity faster. When United offers basic fares for sale at competitive rates, we believe customers will always choose United first over a ULCC or an LCC, given the features of our product, which includes seat power and seatback entertainment along with the unmatched benefits of MileagePlus. Q2 revenue results for United and the industry did trail expectations. Looking back at the quarter now, it is increasingly clear that demand was, in fact, strong. It just could not keep up with the incremental industry domestic capacity added in 2024. Excess capacity, in turn, pressured yields. While July domestic industry capacity growth is published at similar levels to June, published capacity levels pivot in the second half of the quarter and beyond. Based on these schedules, we estimate that Q2 2024 industry scheduled domestic capacity increased by 6.6%. As we head into Q3, we expect July and the first half of August will look very much like June and Q2. We do see a step down in the second half of the quarter to 2.5% to 3% and through the overall quarter at about 4%. We also see the industry altering capacity on peak travel days more than usual later this summer. Peak day spill traffic is no longer filling up excess capacity on off-peak days such as Tuesday, Wednesday and Saturday as it did in 2023 for leisure focused lower margin airlines. We can also see from our internal data that Latin America unit revenue trends have stabilized in Q3 and PRASM declines will moderate significantly for the first time since 2Q 2023. But Latin America and Deep South unit revenues were strong in Q2 and look good going forward. In the third quarter, we do expect Pacific PRASM to remain negative. We do not lap our 2023 expansion wave until the fourth quarter. During the fourth quarter, we'll also lap China's return and expect more normal unit revenues from China, which is currently a material headwind in the region. Growth rates for the Pacific will also moderate as we end the year. We expect premium cabin RASM in Q3 will once again outperform coach at a level stronger than Q2 as we continue to see growth of road warrior customers in United and the continued popularity of the many elevated products that we offer. Mid-August is clearly the pivot point we're expecting for some time as others race to adjust with what we believe is unprofitable flying heading into the period of seasonally less leisure demand. Competitive capacity overlap on United nonstop routes peaked in Q2, which will also help build better unit revenues for the second half of 2024 for United. We believe it's clear in our internal advanced revenue data for August that the pivot will be beneficial to United. Advanced PRASM for United are currently booked 4 to 5 points better in the second half of the quarter than the first. Unfortunately, this expected pivot occurs only for about half of Q3. So the revenue quality will continue to be impacted for the time being. We're encouraged by the yield improvement we see booked in the second half of the quarter. As we look towards Q4, we estimate that industry domestic capacity will only be up about 1.5% to 2.5% based on what's currently offered for sale. On off-peak days, capacity could be flat year-over-year. While our relative results indicate that United Next plan is working, we have decided to cut approximately 300 basis points of planned domestic capacity in the fourth quarter. While there are many macro issues outside of our control, the amount of capacity we offer is within it. This change will help us accelerate RASMs we see in the second half of Q3 into Q4 and beyond. As noted in our published schedules, we will be optimizing our capacity in Q4 by time of day and day week, similarly to what we did in Q1 of 2024, which was very successful in increasing our relative RASM results. With that, I'll say a great thanks to the United team for another strong quarter with industry leading financial and operational results. And I will hand it over to Mike to discuss our financial details."
},
{
"speaker": "Mike Leskinen",
"content": "Thanks, Andrew. And thank you to the United team for all of their hard work this busy summer season. In the second quarter, we delivered pretax income of $1.8 billion. Our earnings per share of $4.14 came in ahead of expectations driven by good cost performance. In the quarter, we continued our no-excuses approach to managing the business to maximize profitability and to consistently deliver on our earnings guidance. The second quarter is another solid result despite some capacity headwinds to the industry. We have never been more confident that our United Next strategy is working. We've successfully differentiated our business and that will support sustainably higher profitability. Turning to costs in the quarter. Unit costs, excluding fuel, were up 2.1% year-over-year on 8.3% capacity growth versus the second quarter of last year. Our strong second quarter CASM-ex performance was driven by three factors. First, over the year our operations team has invested in technology and improved their processes to better recover from irregular operations. Our ability to recover faster leads to a more reliable operation, and a more reliable operation is a more cost efficient operation. Notably, crew related disruption expenses such as premium pay and deadheading costs are much lower than we have seen during similar events in prior years. The full impact of these improvements drove approximately 1 point of CASM-ex improvement in 2Q compared to our own expectations. Second, as yields softened throughout the quarter, we doubled down on expense management to ensure we hit our EPS guidance. As we've discussed before, we have a no-excuses mentality with respect to hitting our EPS guidance and we will do what is necessary in the quarter to achieve that. These specific actions led to another 0.5 point of CASM-ex improvement in the quarter versus our plan. Finally, approximately 0.5 point of CASM-ex is associated with the timing of maintenance events, which were delayed and will likely be seen in the second half of 2024. As we look to the third quarter, we expect industry capacity rationalization is beginning to take effect starting in mid-August. Money losing flights across the industry are being cut rapidly, thus supporting our confidence in our trajectory for both the third quarter and the full year. Our own third quarter system capacity plan moderates by approximately 3 points versus the second quarter on a year-over-year basis. While this is the correct action to take for United, this reduction in capacity along with the impact from Hurricane Beryl in Houston puts pressure on CASM-ex and makes the third quarter the high point for CASM-ex for the year. Altogether, with the revenue backdrop that Andrew described, we expect our third quarter earnings per share to be in the $2.75 to $3.25 range. As for the full year, we continue to expect to fall within our original EPS range of $9 to $11. I realize that many of you will immediately point out that this implies a better than normal seasonal pattern for Q4 versus Q3 earnings per share. That's accurate and it's what we expect. It has nothing to do with seasonality and everything to do with a better balance between supply and demand in the fourth quarter, which should lead to significantly higher yields and therefore, improved profitability. Andrew already touched on this, but I'd like to reiterate it. We aren't hoping for moderating industry supply. It's already happened and you can see it in published schedules and with our own reductions. Despite the excess industry capacity, it's clear demand for the United product remains strong and we expect our revenue growth to outperform the industry. Coupled with disciplined cost management, we expect United and one other airline to represent the vast majority of industry profits in 2024. On the fleet, in the second quarter, we took delivery of four Boeing MAX aircraft and five Airbus A321neo aircraft. We expect 66 aircraft deliveries in 2024. And with the movement of certain PDPs related to deliveries in future years, we now expect total adjusted capital expenditures to be less than $6.5 billion for the year. In the quarter, we generated $1.9 billion of free cash flow, while also continuing to invest in the business with almost $1 billion in capital expenditures. Earlier this month, we took advantage of this position to improve our balance sheet by voluntarily prepaying the $1.8 billion outstanding balance of MileagePlus term loan that had an interest rate near 11%. This reduction in high interest rate debt significantly reduces our interest burden. As of the end of the quarter, our adjusted net debt to EBITDAR was 2.6 times. I'm encouraged by our strong performance in the second quarter. Our team remains nimble as we've demonstrated our ability to adjust to an evolving environment. Thanks to the whole United team for their hard work. The United Next plan continues to run on all cylinders and our confidence has never been higher about the trajectory of our business. With that, I'll pass it over to Kristina to start the Q&A."
},
{
"speaker": "Kristina Edwards",
"content": "Thanks, Mike. We will now take questions from the analyst community. Please limit yourselves to one question and if needed one follow up question. Brianna, please describe the procedure to ask a question."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] The first question comes from Jamie Baker with JPMorgan."
},
{
"speaker": "Jamie Baker",
"content": "First one for Andrew. So look, American is still in the early innings of back paddling on some, not all, but some of the distribution and corporate contract revisions that they made last year. Curious what United is experiencing and what you're seeing and hearing, your conversations with corporate partners, how you expect commissions to trend over time, that sort of thing?"
},
{
"speaker": "Andrew Nocella",
"content": "Well, first, I'd say we don't believe there was a sudden material or a significant windfall to United when American attempted to disintermediate travel agencies and force companies to book direct. So I don't think there'll be a windfall as American flip flops again to this side. We've maintained really long term partnerships with our agencies and corporate partners. And what we did during this time period is we made sure that we put in long term arrangements to gain long term market share and make the corporations and the travel agencies more sticky to United. We'll see if that actually occurs. But I think the benefits of that are actually to come more than they are currently and are currently in our current revenue outlook. So that was our perspective on it. And we think that there's no sudden windfall to United as a result of their change."
},
{
"speaker": "Jamie Baker",
"content": "And then second and maybe this is best for Scott. But just looking now at industry revenue to GDP, and I tend to use A4A figures just to remove forecast there. The recovery in this metric clearly stalled in the fourth quarter. It remains stalled in the first quarter. So we're still below that pre-COVID trend line. We've talked about this in the past and the possibility that post COVID increased consumer mobility could allow the metric to exceed the pre-COVID average. I'm just wondering if you still think that's a possibility and whether this even shapes how you think about growth, or perhaps it no longer factors into your thinking at all, which is fine. Just any thoughts on that topic?"
},
{
"speaker": "Scott Kirby",
"content": "Well, this will be a little geeky economics 202…"
},
{
"speaker": "Jamie Baker",
"content": "Bring it on."
},
{
"speaker": "Scott Kirby",
"content": "I think that absolutely, the airline revenue to GDP ratio is going to trend back. I'm not sure where it will close but it is going to trend back upwards. And I think if you went back and looked in history what you'd find is every time capacity gets ahead of demand, this ratio declined. The reason that happens is because demand for air travel is inelastic. Like the very first project I worked on when I was an analyst at American Airlines was estimating demand elasticity, it is inelastic, every bit of analysis you look at says that demand is inelastic. But when airlines get over their skis on capacity, they rush to get the load factors up and they lower prices and that lowers overall revenue. So it really is just as simple as this ratio goes down when supply exceeds demand. And so I'm not at all surprised to see that happen. I am incredibly encouraged to see the rapid response that is happening. We'll probably talk about it more as we go through the call today, but beginning mid-August, I mean I've been through these cycles with capacity many times in my career, this is the fastest response. It's also the biggest gap between the leading airlines and the other airlines, which I think is part of the reason the response is so fast, but the fastest response I've ever seen. So I expect that to close, I think -- but I think it's purely a function of capacity."
},
{
"speaker": "Operator",
"content": "Our next question comes from Andrew Didora with Bank of America."
},
{
"speaker": "Andrew Didora",
"content": "First question probably for Scott. Last night, Alaska announced more premium seating. There are reports out there, JetBlue could do the same. Obviously, a lot of discussion on your premium strength on the call today, certainly a tailwind. Just how do you think some of this premium RASM growth can trend from here, do you think some of it will be competed away? Or is the United product so unique that you feel like you can hold on to most of it here? Just would love your thoughts."
},
{
"speaker": "Andrew Nocella",
"content": "I'll start off with first, and it's really important, United is a premium business airline not because it's the latest fad but because it's core to the hub system we operate from. Our hubs are in premium markets. Given the success of us and one other airline with a similar setup, it's no surprise that others are copying us with new cabins or expanded cabins as we've seen in the last few days. I think attempting to copy our segmentation plan when it's something that we've been implementing in earnest for more than seven years will be a challenge for anyone that does not operate from business center hubs. Our segmentation strategy is built on a complex set of products along with delivering excellent customer service. The ULCC business model in particular is built on simplicity not complexity. So our belief is our lead in the premium front is generational and not short term. And I'm not at all concerned about the changes of others. Maybe we're even a little bit flattered as they copy us."
},
{
"speaker": "Andrew Didora",
"content": "And just a quick question, Mike, for Mike. Very nice cost execution in the quarter. Can you maybe help me understand some of the near term cost levers that you're able to pull as you see those -- the revenues coming in a little bit softer than expected? And are these just kind of timing related or are these costs that kind of permanently come out?"
},
{
"speaker": "Mike Leskinen",
"content": "Yes, it's a mixture. As I said in the call, running a strong operation is the best thing we can do for cost efficiency in the near term and the operational team has done a great job. We have some opportunities within tech ops also in this quarter, though. Some of those costs simply pushed to the right and were timing related. So you will see some pressure in 3Q. As we look longer term, some of the headwinds around CASM include labor deals that we're looking forward to finalize. We also expect to see some uplift in regional flying in the future. That will work against the gauge benefit that we expect over a two to three year time frame. And so that's another headwind. And look, as Andrew spoke about, our premium product is in great demand. And so we continue to make investments in our product, in our airports, in our catering. And those will add costs but we expect to add even more revenue. So those are some of the headwinds. Now tailwinds and we've been on this for several years but we have an idiosyncratic tailwind of gauge that is like no one else in the industry. And we continue to see some real opportunity from that. As we spoke about last quarter, we've now level loaded our skyline for aircraft. That's going to create a more stable growth pattern, which will allow us to hire more efficiently and make sure that every asset is staffed appropriately, allowing for more efficient growth. And then longer term, I do expect to have a more efficient maintenance operation. So a little bit of the puts and takes."
},
{
"speaker": "Scott Kirby",
"content": "I'm going to actually pile on and give kudos to Mike, Jonathan Ireland and Toby, because much of what you see in this is a real structural changes. I mean Mike talked about the benefit that we've gotten from irregular operations. That team, the three of them combined with a lot of support from Jason Birnbaum, our Chief Information Officer, who's sitting in here with technology are really identifying the places where there's opportunity to pull permanent cost out. To me, like there's other places that it's happening, but the irregular operations expense improvement is one of the biggest proof points. And we just have a great team that is doing those kinds of things. We didn't build that into the budget at the start of the year. We didn't realize how successful it would be, they're doing a lot of other work like that. And I think we should have a really solid process and team for cost. And so while it was great to hit that in these quarters, that's something that is an example that is permanent and we'll always spend less on irregular operations than we did in the past. And I think there's a lot more of that to come."
},
{
"speaker": "Operator",
"content": "Our next question comes from Conor Cunningham with Melius Research."
},
{
"speaker": "Conor Cunningham",
"content": "I think that many of us can buy into the idea that capacity is going to be rationalized near term, but the fear over the longer term is that someone is going to start to cheat again. So what's United's plan if the capacity reductions are just short term? Clearly, your margin structure has slipped, you're playing from an area of strength. But just curious on how you're going to approach a competitor set that's always looking to add supply at some point."
},
{
"speaker": "Andrew Nocella",
"content": "Well, let me start off with my views. I mean the unprofitable capacity is just not sustainable. And we see the changes occurring, as Scott said. But as you think about this question, you normally look at the pretax margins and liquidity and margins. But we did the same. However, I think even more insightful is looking at the network health of our competitors and how that is different today than it's ever been in the past to answer your question about will the capacity come back. Our estimate is margins for the worst quartile of fly in for the five least profitable domestic centric airlines is negative 25% to 35% today. We estimate that the severely unprofitable capacity is almost 10% of domestic ASMs. In the past, the magnitude of the worst line, in my view, has never been this bad and from the lower margin airlines and the lower margin airlines never had such an overall gap to the higher margin airlines like United. I don't think one low margin airline failing or shrinking dramatically in any way will change the outcome for the others at this point, given the magnitude of the losses of the worst fly in. And the other thing that's really occurred that's very interesting is the gross fly ins by these carriers is also extremely unprofitable, the -- just the business plans, in some cases, they largely run their course and there's just no new opportunities available today. And so that set up is just really different and provides us with a backstop that we think that permanent change is on its way. Exactly when it occurred over the next quarter or two or three, it is hard to say. But it does feel like when you look at these facts and the magnitude of the worst quartile profitability that this is a very different environment and the capacity hopefully will be slow to come back. But it's -- only time will tell."
},
{
"speaker": "Conor Cunningham",
"content": "And then I realized it's early, but you're making adjustments for the fourth quarter and the implications for 2025 could be significant. I know -- again, I realize you're not trying to give '25 capacity plans, but the United Next plan called for like 4% to 6% annual growth. Has that thought process changed given what's happening in the current environment today?"
},
{
"speaker": "Andrew Nocella",
"content": "You're right. We're not going to give the capacity guidance. What we are going to say is we're going to continue with some of the fundamentals of United Next, which improved -- improving connectivity was really, really important and we'll continue to do that as we go forward. The other thing to bear in mind is one of the key ingredients to United Next was the large narrow-body gauge and fleet size. And as of today, we're a 110 aircraft short on that. We kept smaller aircraft around to compensate for that. But the A321 at United today is operating with 8 margin points above that of the rest of the narrow-body lead. And we're really bullish as we get to the right fleet mix, one that all of our competitors already have in their business plans. We are going to continue to push the margins in the right direction. I think if you have anybody in the commercial team, they realize the importance of getting to a double digit margin soon and we're all rowing the boat in the same direction to achieve that."
},
{
"speaker": "Operator",
"content": "Our next question comes from Michael Linenberg with Deutsche Bank."
},
{
"speaker": "Michael Linenberg",
"content": "I know we have focused a lot on domestic capacity and it does feel pretty good as we move through the year. I guess one question on domestic. The 3 point reduction that you talked about in the fourth quarter, what's kind of the base or is that already loaded in the schedule or is that on the come?"
},
{
"speaker": "Andrew Nocella",
"content": "We're not going to give guidance for Q4 at this point. We haven't finalized our Q4 schedules but we’ll [Multiple Speakers] that…"
},
{
"speaker": "Michael Linenberg",
"content": "And then, Andrew, since I have you on flipping over to international. I'm sure you've seen the headlines recently from Lufthansa, even Qatar Airways, making a deal about too much capacity, although at times, it seems like pot calling the kettle black here. But what are you seeing internationally as from, I guess, competitively as things move over time? And I do realize that some of the [grade] coming out of the European carriers is in influx of capacity from Asian carriers to Europe. But maybe what are you seeing in some of your other major traffic lanes, is that a potential issue as we move from '24 to '25?"
},
{
"speaker": "Andrew Nocella",
"content": "And obviously, the Asia-European dynamic that I think a lot of airlines have cited now is not really one that all that relevant to United Airlines. So I don't think that negativity translates through to where we are. But what I would say is -- and we've been saying this for a while, but we do see a pivot. First, in the Pacific, last Q4, we were up 83% year-over-year in capacity. We more or less have got the Pacific back to pre-pandemic levels. And this year, we're going to be up high single digits. So we're obviously bullish about that transition. And then Latin America, South America has already pivoted to positive and we expect to close in Latin America to pivot as well and do dramatically better. And then the last point is we have said over and over again, we were taking a pause year on the Atlantic. Clearly, others did not choose to do so and our results across the Atlantic, I think, are a shining star of our plan, it worked. And so we are really happy with Atlantic. The Atlantic continues to look good going forward with extremely solid profitability. And so overall, I think international is fundamentally different than it was pre-pandemic and our results show that."
},
{
"speaker": "Operator",
"content": "Our next question comes from Scott Group with Wolfe Research."
},
{
"speaker": "Scott Group",
"content": "Mike, just want to clarify a couple of things. So you had a comment about the implied fourth quarter guidance. Just want to make sure you feel like we should be tracking towards the midpoint of the full year guide. And then there was a comment in the release that says that you guys expect to have leading unit revenue performance among peers in the second half of the quarter. I know Delta talked about domestic RASM inflecting back positive in September. So I just want to make sure we're all on the same page and you think that you'll be positive on RASM exiting the quarter."
},
{
"speaker": "Mike Leskinen",
"content": "I'll let Andrew talk about September PRASM. I will say that at this point in the year, $2 range on earnings per share, $9 to $11, so that's a range that in a more normal environment, I would have liked to narrow. You would expect to have more certainty now than we had back in January when we initially said it. But while we see this incredible inflection upon us in the industry, the precise timing in magnitude is difficult to call. And so as we look out to the third quarter and fourth quarter, current trends based on current yields, based on the current published capacity would put us at the low end of the $9 -- in the lower half of the $9 to $11 for the full year. But there are a ton of reasons to expect further reductions of unprofitable flying to push us higher. And so we very deliberately and had significant discussions internally, but very deliberately left the range wide and we are committing to hit something in that range. And you can all read the tea leaves as the data develops to decide where you want to make your own estimate. We're committing to the range."
},
{
"speaker": "Andrew Nocella",
"content": "I'll just -- yes, I'll confirm the point. We do think that September PRASM for domestic will flip positive at this point based on the 4 to 5 point improvement we're seeing so far. We think that's going to hold. We also -- July will be the worst quarter of the year probably -- July will be the worst month for the year."
},
{
"speaker": "Scott Group",
"content": "And then I don't know if you have any early thoughts on CapEx for next year, less than $6.5 billion this year. Any thoughts on directionally higher, lower or similar for next year?"
},
{
"speaker": "Mike Leskinen",
"content": "I think very little change from our prior guidance. We're targeting that 100 narrow bodies per year as we rebaseline the skyline, and nothing that we see right now would cause me to change that today."
},
{
"speaker": "Operator",
"content": "Our next question comes from Duane Pfennigwerth with Evercore ISI."
},
{
"speaker": "Duane Pfennigwerth",
"content": "Just on corporate, I think the last time we were together, you talked about improvement in the March quarter and basically holding serve in 2Q. I wonder if you could remind us your view on how recovered it is, both on a volume and on a revenue basis and your thoughts on potential improvement from here. Basically, what's baked into the guidance in terms of incremental improvement on corporate?"
},
{
"speaker": "Andrew Nocella",
"content": "The most important thing is it's a slow but steady improvement. I don't think we see a rapid change occurring anytime soon. It's recovered roughly to 100%. Obviously, that's far behind where it would otherwise be on a typical GDP relationship. And the load factor contribution of corporate is down more than a few points relative to 2019. So it is a much smaller percentage on the airplane. But as we look, for example, in Polaris this last few months, we found the Polaris business load factor to be up a point and the leisure -- premium leisure demand was down a point as we slowly transition back to corporate. But it's going to take a while but it is happening."
},
{
"speaker": "Duane Pfennigwerth",
"content": "And then maybe one for Mike. Can you just remind us what the next opportunities might be to pay down a high coupon debt? Obviously, you took down loyalty debt, high coupon loyalty debt as soon as it was prepayable. What are the next two to three opportunities on that front?"
},
{
"speaker": "Mike Leskinen",
"content": "As I mentioned in my prepared remarks, we're now at 2.6 times trailing 12 month net debt-to-EBITDAR. Back in 2019, we were at 2.5 times. So we're already at pre-pandemic levels of leverage. We've got a tremendous amount of cash on the balance sheet, feel really good about the balance sheet for those reasons. We are also funding all of the organic growth to drive United Next. We are investing in our airplanes. We are investing in our people. Those two buckets are the first two priorities and calls on cash. The third call on cash is investor returns. And given where our balance sheet is and given the level of organic growth that we are funding, we now have a lot of flexibility to start to consider investor returns and to start to look at some further deleveraging. And so we'll see -- I see a mix of that going forward. Specifically to your question really there are no instruments that are prepayable right now that are of such high coupon like the 11% debt we just prepaid. There are no near term opportunities of that magnitude to prepay any more debt."
},
{
"speaker": "Operator",
"content": "Our next question comes from Sheila Kahyaoglu with Jefferies."
},
{
"speaker": "Sheila Kahyaoglu",
"content": "Andrew, maybe this one is for you or Scott. I believe you made a comment that the spread of the unit revenue performance is going to [broaden] between the premium mix and the economy cabin. So slightly different than the comment on premium your competitor made. So I think your premium revenues were actually down on a PRASM basis. So I wonder how much of that is premium softening or is that more revenue management actions you guys are taking to help with the economy cabin?"
},
{
"speaker": "Andrew Nocella",
"content": "I'll give you the distinction. The premium cabin RASM was up. The premium RASM contribution was down and that's because of the definition of whether it includes Economy Plus or not. Economy Plus is obviously part of the main cabin. And Economy Plus was infiltrated by the yield weakness of the main cabin. And so we did see that issue and it resulted in the number that you just saw. But if you look at just the PRASM contribution of Polaris and Premium Plus and domestic first class, you would find that was up low single digits year-over-year."
},
{
"speaker": "Sheila Kahyaoglu",
"content": "And then maybe if we could talk about following up on, I think, Mike's question about Atlantic and regional capacity around the world. On Atlantic, how do you think that trends over the next four quarters, do we have the same sort of oversupply issue you don't seem to see that? And is that just given the fleet dynamics with wide-bodies and the premium cabin there can you maybe elaborate on that?"
},
{
"speaker": "Andrew Nocella",
"content": "Look, I think the Atlantic -- well, if you go back to last year, particularly June of last year, had one of the most unbelievable quarters we've ever seen, an unbelievable month in June. And we're actually doing a little bit better year-over-year and so we're really proud of that. And we, again, think we made the right capacity allocation choices to create that outcome better than our competitors did quite frankly. What I would say is capacity to Southern Europe, which is up 31% year-over-year this summer has pushed the limits of demand to Southern Europe. And that's just a fact. But the overall combination for United, including our Southern European performance, I think, has been pretty darn good given the comp from last year. And we are very careful on our scheduled plan for this year. And that careful nature continues all the way through the end of the year with our published schedules. So we feel good about the setup that the Atlantic will continue to look pretty good going forward."
},
{
"speaker": "Operator",
"content": "Our next question comes from Brandon Oglenski with Barclays."
},
{
"speaker": "Brandon Oglenski",
"content": "Mike, just a point of clarification here. I think maybe last quarter or two quarters ago, you said beyond 2024 CapEx should be in the $7 billion to $9 billion range. Is that with that anticipation of 100 narrow-body aircraft deliveries baked in?"
},
{
"speaker": "Mike Leskinen",
"content": "That's precisely correct."
},
{
"speaker": "Brandon Oglenski",
"content": "And I guess maybe for my follow-up for Scott or for Mike. I mean I really appreciate the no-excuses mentality here. I think the Street likes your just EPS guidance and focusing on bottom line results. But I think you both would agree that you're below your next targets on margins right now and you are below profitability of last year, too. And I think part of the challenge for investors here because your multiple is quite low, and I think you both would agree on that as well. Your CapEx outlook here is roughly matching your operating cash flow. And I realize if you hit higher margins that you could offset some of that. But I think what investors are saying is, hey, why can't we see a more balanced capital allocation strategy, maybe a little bit less CapEx? And I think maybe investors are a little bit frustrated that with the Boeing delivery delays, the MAX 10 issues, you guys didn't back off capital spending a little bit more. So can you put that in context for folks and why taking so many aircraft in the future should be relatively beneficial?"
},
{
"speaker": "Mike Leskinen",
"content": "And I 100% understand where you're coming from. I care very deeply about creating shareholder value and free cash flow, driving free cash flow to shareholders over time, it's critical to driving our multiple higher. We get that. But our United Next strategy is working. Our confidence that based on the relative margins, the divergence between the haves and the have-nots, it's never been wider. So all of the evidence, it's not about being in a tunnel and wondering what that light in front of you is. That light in front of us is very bright and it's a sunny day. We don't know exactly how much longer the tunnel is. But we're coming out the other side in a very strong competitive position with a premium product that can't be copied and emulated by competitors with moats around our business that are going to drive higher margins. And so as those margins increase, we're going to have higher free cash flow and you're going to see those returns to our shareholders. I'd ask for a little bit more patience as we drive through. But all evidence is that the strategy is working, and therefore, you're not going to see us pull back."
},
{
"speaker": "Operator",
"content": "Our next question comes from Savi Syth with Raymond James."
},
{
"speaker": "Savi Syth",
"content": "Just on the Pacific comments made earlier, I realize that Pacific is not kind of back to where it was in 2019. But the mix there is different, notably like China is a lot lower. Are there any kind of meaningful implications on that mix change? And just how are you thinking about -- is there an opportunity for China to be much stronger than this or do you think this is kind of the new normal?"
},
{
"speaker": "Andrew Nocella",
"content": "Savi, I think it's the new normal. Demand for China is down dramatically than where it was in 2019. And it's also difficult to fly there because of the lack of Russian overflight ability. So those two combinations just make this the new normal. And so we've [adjusted], we're back to pre-pandemic capacity. We've reallocated the capacity, I think, in a more profitable way. Pacific is generating a solid margin. Obviously, the negative RASMs, particularly driven by China as China has fallen back to normal revenue performance caused year-over-year numbers for the Pacific to look a little funny. We again lapped that later this year and we'll be definitely, I think, beyond that after Q4."
},
{
"speaker": "Savi Syth",
"content": "And maybe if I can ask just on the domestic market. Look, last year, there were a lot of kind of domestic players hurting and maybe an overcapacity situation but United didn't really experience it. I'm just curious about what might be different like second half '23 versus what you're seeing today? Is that just a composition of the capacity, is it kind of passenger behavior, is it pricing behavior? Just why is it -- why are you seeing the pain a little bit more today than -- and not necessarily in the second half of last year?"
},
{
"speaker": "Andrew Nocella",
"content": "Well, I think it's all of the above, all those issues you just said. We've worked very hard to insulate ourselves from the changes, sometimes not very sound changes that are being made in the industry. And I think we did a great job of insuring [ourselves] against that, but it's not 100% insurance plan. And in this particular quarter the capacity growth was just so significant that it pressured yield in a way that it didn't, I mean, for example just in Q1. And our schedule changes in Q1 if you look at our RASM change domestically in Q1 along with the Atlantic, our schedule changes were incredibly effective, particularly during the offtake period and maybe less effective in a peak period as Q2. And that's one of the reasons I think we're excited to see how Q4 turns out because not only we've taken the same recipe book for Q1 and put it into Q4, which again had RASM changes that I don't think anybody in the industry expected out of United. But this time, the industry itself is, I think, even remarkably more different in Q4 of this year than it was in Q1 and how it's reacted and how it's changed. And again, it's changing because that fly in has extremely negative margins by many of our competitors. So that's a long answer to your, I think, very simple question."
},
{
"speaker": "Operator",
"content": "Our next question comes from Ravi Shanker with Morgan Stanley."
},
{
"speaker": "Ravi Shanker",
"content": "Just a couple of follow-ups here. I know you said you didn't want to commit to your own 4Q capacity plans. But do you have a sense of how much industry capacity still needs to come out of the fourth quarter to get that demand and supply in balance, especially kind of that would help push your guidance up to the top half of the range?"
},
{
"speaker": "Andrew Nocella",
"content": "I can't -- I don't know for sure. What I would tell you is our expectation is Q4 domestic capacity to be up approximately 2%, a little above or a little below is kind of our expectation."
},
{
"speaker": "Ravi Shanker",
"content": "And maybe a second one. I think it's pretty clear that investors are looking forward to your Investor Day as a pretty significant catalyst for the stock, especially kind of for long term earnings and kind of updated United Next targets. Do you have a sense of when the timing of that would be and kind of when we'll hear more about that?"
},
{
"speaker": "Mike Leskinen",
"content": "We don't have a date scheduled yet. We're working on it. We are still targeting later this year and we'll be back if and when we schedule and finalize that date."
},
{
"speaker": "Operator",
"content": "Our next question comes from Tom Fitzgerald with TD Cowen."
},
{
"speaker": "Tom Fitzgerald",
"content": "I was wondering if you could talk a little bit about connected media and what the feedback from customers has been, what the feedback from brands has been and just the timeline for that business to ramp?"
},
{
"speaker": "Scott Kirby",
"content": "Before Andrew answers the question, I'll use this, Tom, since you've replaced to say, yes, big shoes to fill in Helane. I wish her the best and I'm jealous of all her travels, tells me she's going to Greenland. I don't know if she's listening. Maybe she's already in Greenland but I can’t get the conference call there and hope to still continue to send me book recommendations. Andrew?"
},
{
"speaker": "Andrew Nocella",
"content": "On connected media, first, I think it's important that from a commercial perspective, we are always trying to innovate and come up with new things to drive earnings. And there's a lot of things on our book here that we haven't even begun to discuss, but connected media is one that we have announced. We expect a significant ramp up next year and we will discuss it in a lot more detail at the Investor Day. But it's going to be innovative, it's going to be really meaningful and really impactful for United Airlines going forward."
},
{
"speaker": "Tom Fitzgerald",
"content": "And then just a quick one. Is there any noise around lapping the Tel Aviv flying in the fourth quarter this year that we should think about in our models?"
},
{
"speaker": "Andrew Nocella",
"content": "I don't think so. I mean Tel Aviv, when we pulled it out was obviously about 2% of United Airlines. I think that number surprised everybody. And obviously, it is lucrative flying for United to say the least. And so its loss was significant. I think we've worked on reestablishing and service safely for our colleagues and we’re flying it double daily today, and we intend to continue to expand to Tel Aviv and get back to our normal schedule. But we don't think resuming Tel Aviv is going to be a drag on RASM if that's the heart of your question."
},
{
"speaker": "Operator",
"content": "We will now switch to the media portion of the call. [Operator Instructions] Our first question comes from Mary Schlangenstein with Bloomberg News."
},
{
"speaker": "Mary Schlangenstein",
"content": "Scott, you've been pretty vocal about your views on the [ULCCs] and the low margin airlines in the industry. But I'm wondering, given the comment earlier about the fact that they seem to be complicating their models now when their model is originally built on simplicity. Do you see that as being sort of an extra step that they're taking that may further speed their demise or whatever their eventual future is?"
},
{
"speaker": "Andrew Nocella",
"content": "Let me try to take it and Scott will correct me where I'm wrong. I think like when you -- first of all, you have to understand that the world has changed fundamentally. With no-change fees in Basic Economy, things are just not as they were pre-pandemic. And I think this core fact is often ignored in how people kind of set up the answer to what's going on today. But I'll give you a rundown of what I think the playbook is, and Scott can kind of add to it. First, when you face this type of problem, airlines generally push to grow out of the problem, but that usually doesn't work and this happened in the previous quarters. And I can recall this back when I worked for Continental Airlines in the late 1990s, quite frankly, in regards to something we called [cow light] at the time. I was just a junior analyst and I remember it very well. The second step is network churn, where you think, well, we picked the wrong markets and we can fix that. But the next set of markets is usually worse than these markets you're flying today. Then the next change is business model changes, right? We noticed Airline X is doing something different from us, let's match. That's really hard and slow. I think the next step is that everybody thinks, well, let's go premium. But that's a generational adjustment that just does not occur over a few quarters. And then the next one is let's push capacity on good days and months but cut hard on off peak and that's really hard to do because it's an inefficient use of assets. And then the next one is closing schedule changes because you're really concerned about your P&L and what's going on. And I think we see a lot of closing schedule changes today from many of our competitors. And then the last part is you just shrink. And so I think these business models are simplistic and it'll be very difficult to make complex without adding a lot of costs. So hopefully, that helps answer the question. Scott, anything to add to that?"
},
{
"speaker": "Scott Kirby",
"content": "The play is almost over."
},
{
"speaker": "Andrew Nocella",
"content": "There you go."
},
{
"speaker": "Operator",
"content": "Our next question comes from Claire Bushey, Financial Times."
},
{
"speaker": "Claire Bushey",
"content": "This is a question for Scott. How worried are you that delays by manufacturers in delivering new, more fuel efficient jets is hampering the industry's progress on cutting emissions as carriers are forced to fly older planes for longer?"
},
{
"speaker": "Scott Kirby",
"content": "I don't think that's really the issue. I think the only way to decarbonize aviation really is sustainable aviation fuel. And the ability to get more efficient airplanes is nice but that's sort of measured in the 1%, 2% kind of improvement across the industry. Really getting a sustainable and viable, [fast] industry is how you get to ultimately 100%, which is our goal to get to 100%. That's why United is leading around the world, our United aviation fund. We're investing -- this is an industry that's still being built, it's in the nascent phases today. It's in the investment, it's in the R&D, it's in the research. We understand the chemistry, we understand the technology but we're now at the point where we've got to commercialize that. And so I think that keeping our eye on that ball is critical to decarbonizing what is an otherwise really hard to decarbonize industry."
},
{
"speaker": "Operator",
"content": "I will now turn the call back over to Kristina Edwards for closing remarks."
},
{
"speaker": "Kristina Edwards",
"content": "Thanks, Brianna. And thanks for everyone joining the call today. Please contact Investor and Media Relations if you have any further questions. Hope everyone has a great summer and look forward to talking to you next quarter."
},
{
"speaker": "Operator",
"content": "Thank you, ladies and gentlemen, this concludes today's conference. You may now disconnect."
}
] |
ual | 2,024 | 1 | [
{
"speaker": "Operator",
"content": "Good morning. And welcome to United Airlines Holdings Earnings Conference Call for the First Quarter 2024. My name is Krista, and I will be your conference facilitator today. Following the initial remarks from management, we will open the lines for questions [Operator Instructions]. This call is being recorded and is copyrighted. Please note that no portion of the call may be recorded, transcribed or rebroadcast without the company's permission. Your participation implies your consent to our recording of this call. If you do not agree with these terms, simply drop off the line. I will now turn the presentation over to your host for today's call, Kristina Edwards, Managing Director of Investor Relations. Please go ahead."
},
{
"speaker": "Kristina Edwards",
"content": "Thank you, Krista. Good morning, everyone. And welcome to United's first quarter 2024 earnings conference call. Yesterday, we issued our earnings release, which is available on our Web site at ir.united.com. Information in yesterday's release and the remarks made during this conference call may contain forward-looking statements, which represent the company's current expectations or beliefs concerning future events and financial performance. All forward-looking statements are based upon information currently available to the company. A number of factors could cause actual results to differ materially from our current expectations. Please refer to our earnings release, Form 10-K and 10-Q and other reports filed with the SEC by United Airlines Holdings and United Airlines for a more thorough description of these factors. Unless otherwise noted, we will be discussing our financial metrics on a non-GAAP basis on this call. Please refer to the related definitions and reconciliations in our press release. For a reconciliation of these non-GAAP measures to the most directly comparable GAAP measures, please refer to the tables at the end of our release. Joining us on the call today to discuss our results and outlook are our Chief Executive Officer, Scott Kirby; President, Brett Hart; Executive Vice President and Chief Commercial Officer, Andrew Nocella; and Executive Vice President and Chief Financial Officer, Mike Leskinen. In addition, we have other members of the executive team on the line available to assist with the Q&A. And now, I'd like to turn the call over to Scott."
},
{
"speaker": "Scott Kirby",
"content": "Thanks Kristina. And good morning to everyone on the call today. Before we dive into our Q1 earnings performance, I want to start by talking about the issue that always comes first at United, safety. Safety is the fundamental pillar of our core for net safe, caring, dependable and efficient, and in that order. Safety is at the core of everything we do at our airline to make United a success. As you've read, the FAA recently began evaluating several elements of our operations to ensure we're doing all we can to drive safety compliance. We welcome the FAA's engagement and we are embracing this review as an opportunity to take our safety culture standards to an even higher level. As we undergo this review, I have confidence that first we have a strong foundation and a culture of safety here at United, including training, systems, processes and reporting culture, and that's backed up by our strong track record and success of our safety protocols. Second, through the FAA review, I'm confident that we will uncover opportunities to make our airline even safer. At United, we have the best team of airline professionals in the world and we're committed to embracing this opportunity to make the best airline in the world even better for our customers and employees. Now to our Q1 earnings. We delivered a strong first quarter and it's clear the United’s Next plan continues to put our airline on a bright path. Notably, we saw meaningful year-over-year margin improvement in the first quarter, and if the Boeing MAX 9 hadn't been grounded, we would've been profitable for the quarter. Our United Next plan continued to demonstrate resilience and challenging industry conditions as we faced further significant aircraft delivery delays. These delays are driving temporarily higher costs this year but we've been able to find ways to offset most of those headwinds. On demand, we see continued positive momentum and bookings across all customer segments from the most price sensitive customers to domestic road warriors and up to the premium global customer. Our cost management and clear demand for the United product continue to support our confidence in the United Next strategy in full year 2024 EPS of $9 to $11. In conclusion, I'm proud of the United team for delivering top tier operational and financial results. Thank you for all the work you do that makes us the airline that customers choose to fly. And with that, I'll hand it over to Brett."
},
{
"speaker": "Brett Hart",
"content": "Thank you, Scott, and good morning. I'd like to thank our employees for their hard work this quarter as we navigated through the grounding of the Boeing MAX 9 fleet. We recovered well and got our customers to their destinations with limited disruption. As Scott mentioned, together with the FAA, we have begun an in-depth review of our processes and procedures. These reviews are being taken very seriously and we will see this as an opportunity to further strengthen our commitment to safety. As we work through this safety review with the FAA, certain certifications will be delayed. As a result of this, we expect a small number of aircraft scheduled for delivery in the second quarter to be delayed. We expect this to have a minimal impact to our 2024 capacity plans. I am confident that we will be able to successfully look back on this review process, resulting in an even better airline for our customers, employees and shareholders. On the employee front, we reached a tentative agreement with the IBT for a four year extension to their existing contract. We expect to hear if it is ratified by their membership in the next few days. Taking a look at our operation. In the first quarter, we delivered top-tier service to our customers. We had our second best on-time departure performance in the first quarter in our history excluding pandemic years. This resulted in being second in the industry in on-time departures for the seventh month in a row. Additionally, our widebody operation had the company's best on-time performance since the pandemic. We accomplished all of this while having the price seat factor for any first quarter in our history. This is a great testament to the hard work of our team. In addition to strong operational performance, we also continue to make customer enhancements that have driven up our Net Promoter Scores. Some of these include continuing to retrofit our existing mainline fleet with signature interiors that feature larger overhead bins, in-flight entertainment and every seat back and Bluetooth connectivity. Signature interior aircraft were 9 points higher an on-time NPS compared to the rest of the narrow-body fleet. And we are on track for 50% of our North America fleet that have signature interiors by the end of the year. We were the first US airline to offer MileagePlus pooling, allowing customers to share and use miles with their friends and families. We've also partnered with the TSA to launch TSA PreCheck Touchless ID at O'Hare and LAX, which uses biometrics to enable customers to pass through the TSA line faster and without having to pull out their ID. Running a reliable operation and enhancing the customer experience continues to differentiate United. These encouraging operational results and improved Net Promoter Scores combined with our focus on safety by creating strong momentum for the rest of 2024. I will now turn it over to Andrew to talk about the revenue environment."
},
{
"speaker": "Andrew Nocella",
"content": "Thanks, Brett. United's revenue and financial performance will be top tier in Q1. And as Scott and Brett mentioned, we also had strong operational results. Without the ground into the MAX 9, we clearly would have produced a profit in the quarter. Looking back at 2023, we did have a great year, particularly in Q2 and Q3. However, United's relative financial performance in Q1 of 2023 did not meet our expectations. Improving United's absolute and relative Q1 margin is something we're very focused on to achieve our long term financial targets. Q1 has always been our most challenged quarter financially. Post pandemic Q1 seasonality worsened due to decreases in corporate business. For the first quarter of 2024, we took the lessons from 2023 and carefully refined our commercial plan with encouraging results. A few of our domestic capacity changes in Q1 included Florida capacity increased 20% with financial results well above our system average. Las Vegas capacity increased 7%, again, with strong financial results. Margins on off-peak early AM and late PM flights improved by 12 points year-over-year and margins on off-peak days improved by 11 points, driven by United changes and industry changes. In making these changes to how we deploy capacity in Q1, we sacrificed about 1 point of narrowbody utilization year-over-year. But in exchange, we offered a schedule that was more attractive to passengers with better departure and arrival times and more profitable for United, lower utilization also enhanced our reliability. We believe our Q1 2024 results set United up for producing profitable first quarters in the upcoming years and show our agility on adjusting our plan to meet new challenges. Turning to our overall revenue performance in the first quarter. Revenue increased 9.7% on 9.1% more capacity. Consolidated TRASM was up 0.6% and PRASM was up 1%. Domestic PRASM increased 6.1%, which we expect to be industry leading year-over-year while international PRASM was down 4.2%. Domestic revenue results were also well above our expectations on strong demand and did help offset lower RASM year-over-year from global flying and Latin America. United's domestic RASM gains since 2019 lead the industry even with United having the largest increase in aircraft gauge of any US airline. United's domestic network has been starved of gauge historically. I think our domestic RASM results in Q1 yet again showed that not all industry capacity is created equally, considering the marginal RASM performance of growth ASMs at other airlines versus United. Cargo revenue decreased 1.8% year-over-year and we're hopeful that this is the last year-over-year decline we'll see in the near term. MileagePlus had another strong quarter with revenue up 15%. United's premier frequent flyer new members are more engaged than ever by flying and using one of our co-brand credit cards. Managed corporate travel in Q1 was up 14% year-over-year. Yields for managed travel will be faster than non-managed travel due to stronger close-in pricing and refined discounting guidelines. The strength of the business traffic rebound is a nice development for an airline like United. Latin American PRASM was down 12.7%. Weakness was felt in near Latin America markets for the most part versus South America. We are pleased with our capacity growth across Pacific where capacity was up 66% and PRASM was down 12.9%. However, we do plan to make capacity adjustments to a small number of underperforming routes later this year. Q1 performance for United's Atlantic line was up with strong PRASM 11% up. We saw a material rebound in London where Polaris revenues were up 8% on 11% less capacity. We saw weakness to Germany offset by strengths in Southern Europe and Africa where we increased capacity. United's efforts to build our brand in premium product choices while reducing customer friction is having a noticeable positive impact on our results as we gain share across the network for leisure and business travelers. For our road warrior or frequent flyer business customers, United elimination of change fees, the functionality of our app to manage their entire travel experience, improvements to MileagePlus and the steady increase in United Club facilities has resulted in improving share. However, we cannot understate the importance of the elimination of change fees, which is a game changer for how people feel about United. United's focus on premium products has matched well with increased consumer demand for our premium seat choices. We believe this focus has diversified and made our revenues less cyclical in the long run. Premium passenger revenue mix improved 1.9 points versus Q1 2023 and 3 points versus Q1 2019. In other words, we're seeing near-term acceleration. Premium revenues were up 14% year-over-year on 10% more capacity and we estimate that United's premium revenue streams lead the industry. While our largest focus is on growing premium revenues, we also believe our rollout of Basic Economy is a critical competitive tool and important to attracting customers of all types in our core geography. Basic Economy sales trends in Q1 were up 35% year-over-year. Basic has clearly changed our competitive stance versus the ULCCs. Larger narrowbody jets are also increasing United’s gates faster with more premium seats than any other US airline. We are absorbing this gauge increase well, which can be easily measured in our continued domestic RASM growth relative to others. We continue to plan for further gauge growth between 2025 and 2027 with our expanded MAX 9 and A321 fleet. Other product innovations are planned with the goal of increasing choice for customers, expanding premium revenue streams and segmenting demand. United’s gauge growth will also create further cost convergence. More importantly, gauge growth provides consumers a wide range of premium seat choices that they want and that we have proven we can monetize. For Q2, we continue to see strong domestic and Atlantic demand with positive RASM results tempered by the Pacific where we expect a negative result year-over-year. We also expect Latin America will have a materially negative PRASM result year-over-year in the quarter. As we think about the second half of 2024, we do like the macro setup, particularly for domestic capacity where we think we can continue RASM growth above industry average. We are focused on building connectivity in our core non-coastal hubs in 2024 with both new mainline jets and with enhanced RJ capabilities. With that, I want to congratulate the entire United team on a job well done and turn over the call to Mike to discuss our financial results and updated fleet plan. Mike?"
},
{
"speaker": "Mike Leskinen",
"content": "Thanks, Andrew. And thank you to the United team for the tremendous effort as we work through the grounding of the Boeing MAX 9 fleet and entered the peak spring break travel season. In the first quarter, we produced pretax loss of $79 million, a $187 million improvement over the first quarter of last year. Our loss per share of $0.15 was better than our guidance and well ahead of consensus expectations, driven by both strong revenue results and disciplined expense management. The grounding of the Boeing MAX 9 fleet negatively impacted our earnings by more than $200 million and without it, we would have had a profitable quarter. We also generated $1.5 billion in free cash flow and our adjusted net debt to EBITDAR of 2.7 times is back to pre-pandemic levels. These are strong results in what is our seasonally weakest quarter and they provide another proof point that our United. Next plan is working. Before I turn to the outlook, I'd like to address the changes we made with Boeing and Airbus, to optimize the delivery skyline. Boeing's repeated delivery delays had created an impractical bow wave of aircraft deliveries that both United to address, and we have. In 2024, we now expect to take delivery of 61 narrowbody aircraft and five widebody aircraft. This compares to our contractual deliveries of 183 narrowbody aircraft at year-end and the 101 aircraft we were planning for at the start of the year. Due to these fleet changes, we now expect full year 2024 total capital expenditures to be approximately $6.5 billion, down from $9 billion at the start of the year. We've also made changes to level out our fleet plan for 2025 through 2027. This modified fleet plan allows us to execute on our long-term goals while also smoothing out the pace of deliveries and our annual CapEx spend. We've converted a near term portion of our MAX 10 deliveries scheduled through 2027 into MAX 9s. Additionally, we have signed letters of intent to lease 35 new Airbus A321neos with CFM engines scheduled for delivery in 2026 and 2027. With these changes, we now anticipate taking delivery of approximately 100 narrowbody aircraft on average each year during this three-year period. This delivery schedule provides fleet renewal, steady growth and addresses the bow wave of aircraft delivery delays that had been building. These changes bring our total adjusted capital expenditures in 2025 through 2027 to the $7 billion to $9 billion range in each of those years. Balancing our United Next growth plan and managing the business towards positive free cash flow remain top priorities. And with the rebalanced skyline, we are targeting positive and growing free cash flow over the next three years. While we will provide an updated long-term earnings target later this year, we are confident we are on a path to higher earnings, better margins and materially stronger free cash conversion. Now turning to costs. Unit costs trended as expected during the quarter and were up 4.7% year-over-year on 9.1% capacity growth. As I mentioned, it was challenging to re-optimize our expenses with the uncertainty created by the MAX grounding and continued delays to our aircraft deliveries. While our underlying costs are consistent with our forecast at the beginning of the year, it's important to understand that the continued reduction in capacity from delivery delays will continue to temporarily pressure our CASM-ex for all of 2024. As we entered the year we built a business plan for a larger airline, and deliveries have fallen more than 40 aircraft short of our expectations. We continue to incur most of the expenses as we hired for that capacity despite flying fewer ASMs and it is driving almost a point of CASM-ex pressure. We are working diligently to reduce these costs as much as possible and our higher completion factor has helped offset some of it. For the second quarter, we expect CASM-ex to be similar on a year-over-year basis versus the first quarter. Given our expectation for costs and our current outlook for revenue and fuel, we expect second quarter earnings per share to be between $3.75 and $4.25. We have great momentum. Our United Next plan is working and the future for United and our industry has never looked brighter. Our margins are already near the top of the industry and we still have significant and unique network and gauge opportunities in front of us. United has never been in a stronger competitive position. We have developed a wide variety of products that are compelling to a wide variety of customers. And as a result, they are increasingly choosing to fly United. I remain excited about our future and believe we're firmly on track to deliver $9 to $11 in earnings per share this year. With that, I'll pass it over to Kristina to start the Q&A."
},
{
"speaker": "Kristina Edwards",
"content": "Thanks, Mike. We will now take questions from the analyst community. Please limit yourself to one question and if needed, one follow-up question. Krista, please describe the procedure to ask a question."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Your first question comes from the line of Andrew Didora from Bank of America."
},
{
"speaker": "Andrew Didora",
"content": "I guess first one is for Mike or Scott. I guess, with your new CapEx forecast that I'm sure are not yet set in stone given there are a lot of moving parts here. It certainly implies much more consistent free cash flow generation over the next few years. How are you thinking about maybe deploying that capital, where do you see the best fit for that going forward?"
},
{
"speaker": "Mike Leskinen",
"content": "I'll take that question. Andrew, as I said in my prepared remarks, our net leverage is currently 2.7 times -- our net leverage is 2.7 times, which puts us back in the range of pre-pandemic levels. In fact, in 2019, we were at 2.5 times, in 2018, we're at 3 times. As we look at the path forward, I expect to see continued deleveraging. We also have -- we also still have some high coupon debt outstanding. A piece of our MileagePlus debt, $1.8 billion becomes prepayable in July, that debt is still yielding over 10%. So that will be my near-term priority is to take care of that debt. After that, with the -- on our way to investment grade credit metrics, we're going to have a tremendous amount of flexibility and we'll revisit other uses of free cash at that time. But you're going to have to stay tuned."
},
{
"speaker": "Andrew Didora",
"content": "Just a follow-up question for Andrew. Just on the corporate commentary and the strong transatlantic, I know you cited Heathrow in your prepared remarks. Should we read into that, that corporate was a big driver of the results in 1Q on transatlantic, or any other call-outs that you would have just to get a sense for what's driving the outperformance there?"
},
{
"speaker": "Andrew Nocella",
"content": "As I said, I mean, corporate was strong across the board, not just in London Heathrow to be clear. We saw strength domestically and around the globe. So it's great to see. We saw, I think, nine of our top 10 corporate booking days this year in our history, which is also really strong. So really across the board. The strongest industries are professional services, tech and industrials, but every -- I think just about every sector was up in the numbers this year. And I just think it reflects on where that's going. And as I said in my earlier script, Q1 corporate is really important to us. And the fact that Q1 is gaining strength, corporate is really very good for our outlook for future Q1s."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Sheila Kahyaoglu from Jefferies."
},
{
"speaker": "Sheila Kahyaoglu",
"content": "I wanted to ask domestic PRASM up 6% year-over-year in Q1 was double that of one of your peers that have reported so far. Curious how you would attribute that to the strong performance across the Mid-Con restoration, corporate, share gains in either premium or basic? You've touched upon that a little bit. But then maybe as a follow-up as well, how are you thinking about that sustaining domestic unit revenues here with industry capacity?"
},
{
"speaker": "Scott Kirby",
"content": "I'm going to start it and then turn it to Andrew for the more tactical answer, but I'm going to take a bigger picture, I think, more strategic approach to the question. And I'd start by saying, we've been at least trying to tell you over the last several years, how we thought the industry was developing the strategy behind United Next, and since everything that we've said and that has worked, but it hasn't resonated. So I'm going to try a different approach today. And really what is happening and there's a couple of airlines that have what I'm describing. But what has happened is we have -- the industry has structurally changed and United and at least one other have essentially a moat around our business now that never uses it before. The moat, by the way, to be clear, is a moat that is based on having a better proposition for customers. We have a better product, we have a better network, we have a better loyalty program and they choose to fly us. And what makes it unique? Other airlines can have a piece of that, but what makes a couple of airlines unique is we have great products, we have great service, we have a global network, it's hard to replicate. We can get you to Singapore, two destinations in New Zealand, three in Australia, Cape Town, Marrakesh, [indiscernible] Paris and hundreds more. And we also have a great loyalty program, and the ability to go to the exciting aspirational destinations causes people to want to be a part of the program. And it's really sticky when you're doing it well and you are doing it right. But in the past, that moat was breached in two ways, two significant ways. One, there are a large segment of customers for whom change fees, trumps everything else, particularly small business travelers, what I call domestic road warriors. And when we had change fees and we had a large competitor that didn't they would choose that large competitor. Even though all of our advantages may have existed, the change fees trumpet. It turns out that segment of the traveling public appears to be even larger than I appreciated. And we're now winning them because our natural advantages win. So we've closed off that breach. The second breach that we had was for price sensitive customers who want a disaggregated price, and that took us time to repair that and to address that and to create a product for those customers. But there's two things that we had to do. One, we had to create a great Basic Economy product, which we've done. But secondly and maybe more importantly, we had to have higher gauge. We had to be able to sell those seats profitably and in meaningful numbers in order to make that product real and make that competitive and to seal up that breach. And we have now done those two things. That is a huge part of what United Next was about. And those are structural changes. The moat that I described where we have great service, we also have a great global network, which leads to a great loyalty program is structural and it is permanent. And to your point about is this temporary or is it going to go on for? This is the new normal. There's a couple of airlines that are in this category, we're the highest margin airlines now. That is going to be the case going forward, because this was a structural change, no longer theoretical, this has happened. Andrew?"
},
{
"speaker": "Andrew Nocella",
"content": "Well, it's hard to follow that. I mean, on the tactics, the one that I would bring up at a very high level would be, we went into the quarter not trying to maximize aircraft utilization, particularly in seasonally Q1, which is weaker. We went in trying to maximize our profitability and I think it works. And I'm really proud of the team for all the changes we made across the network because I think they're incredibly effective."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Conor Cunningham from Melius Research."
},
{
"speaker": "Conor Cunningham",
"content": "Just going back to the comment on you taking advantage of the number of opportunities in the US domestic market. Can you just maybe elaborate a little bit more on that? You talked a little bit about Florida and Las Vegas. Is there any learnings that you have that you go into peak season or is it more of just a shoulder comment as you kind of take advantage of some of the other issues that some of the other carriers are dealing with in general?"
},
{
"speaker": "Andrew Nocella",
"content": "Well, as Scott said, the United Next vision here goes across all quarters. But in Q1, we definitely did see a lot of opportunity to continue to take advantage of things that were in our control. And within our control is the ability to continue to pivot the airline to more sunshine type markets like Florida and the Caribbean, and we did so, I think, with great success. In Las Vegas, we put in that category as well that our capacity deployed there was incredibly effective. The other thing is we knew off-peak periods in Q1, it's not a time to max by utilization. And we took this opportunity to reschedule the airline to make sure that we were not offering unproductive capacity, and I think that worked very effectively. Below all that or above all that, how you look at it, was just the core building of connectivity across our hubs. It's working exactly as we intended to do. We still have ways to go on this front. It will be 2026 or 2027 before the connectivity reaches, I think, our desired levels. And so we're pretty bullish on our ability to continue to outpace domestic RASM growth offered up by or competitors."
},
{
"speaker": "Conor Cunningham",
"content": "Maybe actually sticking with that specifically. I get the fact that you and Delta have distanced yourself from some of your competitors, and that's pretty obvious at this point, I think. And just -- but your performance relative to Delta sticks out pretty meaningfully. And I was just -- maybe you could just elaborate a little bit more on what's uniquely United, because when I think about it, I think that you have a more -- a bigger opportunity on premium. You talk a lot about upgauging, but a lot of that has to do with fleet delivery. So I'm just trying to understand on how you kind of close the gap or continue to separate yourself, I should say, from the peers this year?"
},
{
"speaker": "Andrew Nocella",
"content": "We continue to drive the United Next strategy. And you're absolutely correct, the aircraft that we'll take delivery of come with a lot more premium seat options. Our premium mix this year is up 1.1 points year-over-year in terms of revenue, which is, I think, a very significant change in a very short period of time. And we are going to continue to push that, but we're also going to continue to push Basic Economy. So our premium mix is up, while our Basic Economy is up and that's exactly the kind of the recipe we're looking for in our diversified revenue streams. And briefly on the global network, it's second to none. It's number one across the Atlantic and number one across the Pacific. And the changes we've made have just been, I think, pretty productive and efficient and accretive, and there's actually quite a bit of more of that to come. So I don't know if that exactly answers your question. But the outlook, I think, is very bright. The premium revenue strategy is working incredibly effectively and we're going to continue to push it and we think there's more room to close that gap."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Jamie Baker from JPMorgan."
},
{
"speaker": "Jamie Baker",
"content": "First one, probably for Andrew. So I've been following this Polaris press for champagne topic on social media. And I'll admit, in all seriousness, as an analyst, I'm intrigued by the notion of potentially unbundling the forward cabin. The evolution in economy is well chronicled at this point, but we haven't seen much change upfront. You had the -- the passenger that books last pays the most, but has the same experience as the passenger of the books early and pay the least, the way it used to be in economy. Is this something I should even be thinking about or is it a waste of my time?"
},
{
"speaker": "Andrew Nocella",
"content": "I won't dictate how you use your time, Jamie. But…"
},
{
"speaker": "Scott Kirby",
"content": "I heard they delete TikTok…"
},
{
"speaker": "Jamie Baker",
"content": "Well, that wasn't the point…"
},
{
"speaker": "Andrew Nocella",
"content": "What I would say is we continue to believe that there's ways to further diversify our revenue streams and segment them. And we continue to believe that there is more opportunity for premium products that we don't have on board the aircraft today. And those incremental premium products, I'm not going to announce it today, but I can tell you, you have many teams of people work on how to further innovate and provide more and more choice and to monetize that choice on our behalf, obviously, in the future. So I think that headline was just a hint more to come and a lot of people working hard at United to make sure that we can differentiate ourselves not only from our US competitors, but many of our competitors around the globe."
},
{
"speaker": "Jamie Baker",
"content": "And then second, and whoever wants to take this, but when you initially introduced United Next and its growth plan, aircraft were being delivered on time, the discount model wasn't impaired domestically. So it was pretty easy for us to map out how your capacity share would ramp over time. Obviously, everything has changed since that. My question is on a relative basis to the US industry, so considering these constraints on capacity. Does the new fleet plan keep your relative position on track with the United Next plan? It actually seems to me like you might be somewhat ahead of the plan on market share, but there are quite a few OA assumptions that I have to make there."
},
{
"speaker": "Andrew Nocella",
"content": "There's a lot of moving pieces. So I'm not going to specifically answer the question. Our market share across every single one of our hubs is obviously improving and improving quicker than our capacity this year. This year, we're domestically, I think the next six months are growing less than our competitors, it's TBD on what our competitors are going to do. But we're focused on delivering the United Next plan we've created and all the value that's being generated from that. And our coastal hubs are the second to none as we've talked about a million times. But getting our core Mid-Continent hubs up to their critical connectivity levels is a big, big focus and it’s just paying back dividends left and right, and we think it will continue to do so. What exactly our competitors do, I just don't know. We will continue to face struggles on the delivery schemes from Boeing and Airbus. But hopefully, as Michael talked about, we've built in the appropriate insurance plans for all of that. So you can say better on plan…"
},
{
"speaker": "Jamie Baker",
"content": "But suffice to say, you haven't fallen behind on a relative basis to the industry?"
},
{
"speaker": "Andrew Nocella",
"content": "It depends on what you're measuring. If you're measuring market share in our hubs, absolutely not."
},
{
"speaker": "Mike Leskinen",
"content": "Jamie, I'd encourage you to measure profitability and our relative profitability, that's certainly what we're focused on here in United."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Ravi Shanker from Morgan Stanley."
},
{
"speaker": "Ravi Shanker",
"content": "So speaking of TikTok, Scott, your industry commentary is usually very insightful. So I'd love your thoughts on the current headline risk to the industry from the incidents that may be out there. Kind of is this just a social media [indiscernible] or is it a pandemic hangover thing, is the lack of new aircraft thing, is the labor thing? What's your view on how the industry is going to assure its customers that flying is as safe it’s going to be?"
},
{
"speaker": "Scott Kirby",
"content": "Well, safety is the number one priority at United, but I also know it is the number one priority at all of our US competitors. This is one of the places where we don't compete. And one of the actually reasons that aviation is not just the safest way to travel, it is by far, the orders of magnitude better than other forms of travel. And one of the reasons is because -- and in safety, we share data with each other, we share all the incidents and events that happen and we learn from each other and that's what makes us so strong. I also know at United, we have a great foundation, a leading foundation and we're proud of it, of our training, our systems, our process and our reporting culture. But it's also true that there was -- while they were unrelated, a cluster of several high-profile events that have happened at United and in the industry. And I think that is an opportunity for us to take what is already -- to step back and take what is already a very high standard of safety and find ways to make it even higher. That's why certainly at United, we're embracing this as an opportunity. There are already a lot of things we've done but there are going to be more that we do, embracing this as truly an opportunity to take the already high standards to an even higher level, and I'm confident that we will do that. We can do that while running a great airline for our customers, for our employees and for our shareholders. We can do all those things at the same time and we'll come out even better on the other side, not just at United but for the whole industry."
},
{
"speaker": "Ravi Shanker",
"content": "And maybe as a follow-up, the pooling miles is a very interesting idea. Can you just unpack that a little bit kind of what may be launched at this time, kind of what are some of the cost or revenue implications thereof? And what do you think some of the benefits might be to United and our customers as you roll that out?"
},
{
"speaker": "Andrew Nocella",
"content": "Well, we're always trying to make MileagePlus miles more useful for our members so they can enjoy the benefits. And there are a number of members that alone couldn't get that trip to Tahiti or wherever they're trying to go and the pooling option allows them a better chance of doing that. I think it comes at a minimal no cost to United but it definitely enhances the value of the program. It's, I think, pretty unique among the largest airlines and we look forward to seeing how it goes. So we urge you to pull your family members and see what you can do."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Duane Pfenningwerth from Evercore ISI."
},
{
"speaker": "Duane Pfenningwerth",
"content": "Just on the longer term CapEx, certainly appreciate you have to have a plan at a point in time based on the facts available. But how do you think about the path to a pickup in deliveries required to hit that 2025 and beyond, what are the dependencies in your mind? And I guess, what are the odds we enter 2025 the same way we did this year with that 100 or so more of a placeholder than a realistic target?"
},
{
"speaker": "Mike Leskinen",
"content": "And I do want to kick off the question by reiterating how important generating free cash over the long term is to us here at United and we understand too our shareholders. So that is something we are balancing. We gave you a range for CapEx of $7 billion to $9 billion. We gave you a range because it's an acknowledgment that there's some uncertainty around the OEM delivery schedules and production rates. We also are managing this business to maximize profitability. And so make no mistake, we'll manage our deliveries as well in a way that captures the macroeconomic environment at the time. In three years, a lot can happen in three years. As I think about uncertainty for '25 and '26 in a stable macro economy, 787 production rates can -- Boeing continue to increase rates, that's going to be really critical also for the 737 line, are they able to increase production rates. So we'll watch that closely. I want to be clear that what we are giving is our expectation. Our expectation builds in some hedge that production rates don't increase at the rate that Boeing hopes. There is -- so there's upside risk and downside risk to CapEx as a result. I think we're going to be managing that $7 billion to $9 billion range, and that's why we wanted to share that with all of you today."
},
{
"speaker": "Duane Pfenningwerth",
"content": "And then maybe just a quick one for Andrew. And I've asked this before, I'm sorry if it's a little waste of time. But on international inbound or maybe a different way to say it, ex-US point of sale, where does that stand today? And as you think about your entities or geographies, are any of those starting to pick back up in terms of ex-US point of sale, are you seeing any inflections?"
},
{
"speaker": "Andrew Nocella",
"content": "I would say, yes, we are seeing progress. The one place we look to the most is Germany and core Europe, and that's still trails. So hopefully, that will continue to move forward. But I think we're seeing really progress across the whole globe on rebalancing and being a little bit less dependent on the US consumer to drive the global network."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Savi Syth from Raymond James."
},
{
"speaker": "Savi Syth",
"content": "I was just wondering on that 100 narrowbody aircraft per year. Just what's the thought on the mix of growth versus replacement? And I guess, asked another way, I appreciate, Mike, you mentioned kind of taking into account macro realities. But what's the right level of kind of domestic growth as you kind of look over the next three to four years, assuming you can get the aircraft delivered?"
},
{
"speaker": "Mike Leskinen",
"content": "And for our growth rate in 2025, '26 and '27, you're going to have to wait for Investor Day later in the year. The 100 aircraft, we have the ability to fly some of our older aircraft longer. And given the delays from Boeing and Airbus, I would expect again, macro economy dependent that we would continue to fly our existing fleet until end of life when they're at heavy checks. But we always have the optionality. If yields are not strong to early retire some of those aircraft and it's an economic decision when an aircraft is late in its life to early retire some of those aircraft that are less fuel efficient and very heavy maintenance. So I think of that as flexibility we have in the event of a macro event. But if there is absent a macro event you should expect us to sweat our assets until end of life."
},
{
"speaker": "Savi Syth",
"content": "And just a follow-up, Mike, to a comment you made earlier on -- I appreciate the 2Q unit cost color. But as you think about the year just high level, I'm wondering what are the kind of the year-over-year headwinds that might kind of step down from now or maybe step up? I know your capacity is moderating a little bit from the levels in the first half. But just curious, given that you have more time, are you able to address more of the fixed cost as you get into the second half?"
},
{
"speaker": "Mike Leskinen",
"content": "I would say you need to think about labor costs and when we lap and annualize some of those labor costs. So that would be the number one factor you should put into your model around differences quarter-to-quarter. Number two, the CASM ex impact of flying 40 less aircraft than we planned for this calendar year, you should expect those costs to linger. As we get into the back half and particularly in the fourth quarter, some of those costs begin to moderate, but you should think about Q2 and Q3, those costs continuing to weigh us down. Again, we will offset with the great operation we're running as we see completion factors move up we’ll offset partially. But those costs don't go away overnight. And I'll use this as an opportunity to also to talk about some longer term cost initiatives that we've started since I've taken over in the CFO seat. Number one, tech ops, there are significant opportunities for us to drive efficiency in our tech ops driving efficiencies in our supply chain by optimizing the volume of parts we purchase and improving the rates we pay for those parts. So we're undergoing a significant initiative there. I think the run rate you'll see from that initiative is more like 2025. We're also undergoing a significant procurement bottoms-up evaluation. We're going to go through waves going through different vendors to make sure we have best pricing in the industry. I think this is going to be in the fullness of time, measured $100 million-plus and cost efficiencies. Again, that's more like '25 and '26. But when I talk about unique United opportunities, I would put this in that category. And then finally, I'll highlight that we've got significant opportunities within our technology organization to help drive efficiencies throughout the full airline. But one that I'll highlight is moving a lot of our mainframe computing into the cloud, that's something that you don't save the cost of moving to the cloud until you shut the mainframe down. So many cases, we've moved 70%, 80%, 90% to the cloud, but we still have to maintain that mainframe with 10% or 20% of the systems on that mainframe. So there's a little taste. We'll give a lot more fulsome answer at our upcoming Investor Day."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Scott Group from Wolfe Research."
},
{
"speaker": "Scott Group",
"content": "So that was sort of helpful color on back half CASM a little bit. Maybe just a similar thought on back half RASM, comps get easier. Is it fair to assume we see RASM accelerate in the back half of the year, is there any other puts and takes to be thinking about?"
},
{
"speaker": "Andrew Nocella",
"content": "Just at a really high level, I would say that the [cap is] up domestically, I think is rough as in probably Q2, but gets better in Q3 and particularly better in Q4 is our estimate based on what we look at. So I think that is a nice trajectory. Second, we added a considerable amount of Asia Pacific capacity middle to late last year. And so as we lap that capacity, so it's now fully spooled up, we expect the line to improve. And as we make capacity adjustments to unproductive capacity in that region, we also expect that's going to show some improvements. And that follows always through Q1 of next year. Latin America, the capacity picture has been particularly difficult for the first half of this year. As you all know, the second half looks, I think, very different. And so I'm optimistic that Latin is going to turn the quarter in Q3. Although Q2 is still a very -- [poor] results. And in Europe, I think we've really sharpened our pencil, we paused growth for the most part this year on purpose. And I'm particularly optimistic based on how we deploy capacity that Europe is going to look fine. So I'm not giving you the exact numbers, but that's how I look across the globe and see what's happening and think about positive or negative trajectory by region."
},
{
"speaker": "Scott Group",
"content": "And then, Mike, I appreciate all your sort of comments on free cash flow. And I'd love maybe, Scott, to get your perspective on this discussion as well and maybe your thoughts on CapEx. Like if we wake up in six months and Boeing can start delivering a lot more planes again, could that -- in your mind, Scott, does that $7 billion to $9 billion go up again? Or maybe alternatively, is there something in your control that says, hey, maybe that $7 billion to $9 billion could come down even more?"
},
{
"speaker": "Scott Kirby",
"content": "I think the $7 billion to $9 billion is probably a pretty good number. And I think of it as we've ordered a lot of airlines more than anyone in history has ever done. And when you combine that with the supply chain challenges, as Mike described, is kind of a ballot, you have 40 airplanes that are supposed to be delivered in 2023, they got pushed to 2024 and none of them got delivered and then yet another 20 in 2023 got pushed and so now you have 60 in 2025. That also -- that wasn't just hard on the planning for us, it may things like our flight training center, really hard to run effectively, because constantly changing capacity plan, those are -- you're thinking about upgrading pilots and things like 18 month out decisions. So one of the things we attempted to do was level out the capacity, the aircraft deliveries, which we've done at approximately 100 per year. And so we'll have a lot -- at least a lot less variance, the standard deviation will be a lot less than it's been in the past. It's also kind of split 60-40 Boeing, Airbus, so there's a little more diversity in that number going forward. I don't think we'll take it out, but -- well, I know we're not planning to take it up because taking it up, drives things at the flight training center, just drives a lot of other complexities, this is just not worth it. I think the other thing that we will -- I know that we're going to do now and going forward is build a little hedge into or build a bigger hedge into our schedule. And like if we think we're going to take 100 airplanes this year, we're going to only put 90% or some lower number into the schedule. And if everything is on time and on plan, then we'll have a few extra spares around for a couple of months. That will cost a little bit but it doesn't cost nearly as much as overstaffing by 40 airplanes. And so I think it will give us not just certainty on CapEx, it will give us a lot more operational certainty for running everything better and more efficiently."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Helane Becker from Cowen."
},
{
"speaker": "Helane Becker",
"content": "So I have two questions. I think, Andrew, you talked about the quality of your product and the network and the loyalty and so on in your answer to somebody's question. But when you think about some of your alliance partners, they don't have the same commitment to service and any of the things that you just talked about that you have. So as you think about alliances going forward, and maybe this is a question for Patrick. How do you think about getting everybody on board to the same standard that you're setting so that you don't distress your customers when they have to connect because you're not flying some place non-stop that they want to go aspirational or they let your customers down?"
},
{
"speaker": "Andrew Nocella",
"content": "I'll start off with that. I'm not sure I agree with the premise of your question. I think our core partners have the highest standards when I think about ANA and Air New Zealand, to name a few. And also think that Lufthansa has the higher standards, look, they've gone through a number of strikes recently, which has been think rough on Lufthansa, the team and the customers, but I think they're behind that now. And I think their commitment and all of our commitment to customer service is actually pretty consistent. And we're so proud to be in joint ventures with each of these airlines. And we sit around the tables, I'd like to say, without lawyers and we work through difficult problems, and we talk about how to make the level of customer service more and more seamless each quarter. That being said, we are from different countries and different cultures and we have different ways of approaching our business. And quite frankly, we think that some of those differences are really important. They reflect who each of these airlines are and their unique identity. So we don't -- we're not trying to harmonize across every single product detail on how we build alliances. But that being said, I do think we have a similar alignment of customer first and going forward. And we -- and I’ll also plug in, we have the best alliance partners with the best hubs around the globe, which is one of the reasons that we have the leading network, and I think we're more profitable in this global network relative to our primary competitors."
},
{
"speaker": "Helane Becker",
"content": "And then just for my follow-up question, maybe Mike, as we think about the earnings guidance for the second quarter. How should we think about like the percentage corporate, leisure, domestic, international, are you starting to skew more corporate international in the next six months than you have in the past, or how should we think about that breakdown?"
},
{
"speaker": "Mike Leskinen",
"content": "I would just say that all of the above, domestic leisure has been really strong. And despite that historically being an area where we were less than -- we had less of a exposure than some of our peers, we've done an incredible job. Now business demand is clearly continuing to come back and that's wind in our sales from a relative perspective. So I think as we've said, it's been the theme of the call, the current results at United are very strong but the future is even brighter. So feel great about business continuing to drive our relative results."
},
{
"speaker": "Andrew Nocella",
"content": "I'll add one incremental fact, Helane. The growth in Polaris load factors has been pretty significant year-over-year. And the growth in premium load factors across the board at United Airlines, our paid premium load factor was up 9 points year-over-year in the quarter, which is amazing. But as we revenue manage all of that, we kept all of the premium leisure passengers in their seats as we added more corporate into their seats. So we were able to do both. And that is one of the reasons for the great execution in the quarter is that we see corporate rebound in, but we see the desire for premium products by leisure customers continue to be strong."
},
{
"speaker": "Helane Becker",
"content": "So is the answer then you're putting more premium seats, because if you have corporate demand for the same seats, you're pricing up to lose some, right? Don't you have to price that to lose some of that demand?"
},
{
"speaker": "Andrew Nocella",
"content": "What happened in this [indiscernible] case is during the pandemic, we had very high free load factors in some of these premium cabins, and that number is coming down more towards…"
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Brandon Oglenski from Barclays."
},
{
"speaker": "Brandon Oglenski",
"content": "Mike, can you give us some insight on how you're planning for the cost structure in '25 through '27 just given the variability that you gave us on CapEx. And I know it's aspirational to get 100 deliveries every year, and Scott spoke to it as well, maybe you filter in some buffer here on spare aircraft. But how do you think about hiring, especially given that some of these training events might be an 18 month decision?"
},
{
"speaker": "Mike Leskinen",
"content": "I think by level loading, our aircraft delivery schedule and making skyline stable, we're going to be able to better match our flight attendant, we're going to be better match our pilot hiring. So that the inefficiencies that we're discussing right now around, again, the 40 less aircraft we have for this year, those inefficiencies will work themselves out. And so that's what's critical to this. But in addition to our overall cost structure, when we think about the inflationary world that we've been in, that pressure is going to -- the industry is going to continue to face that. But at United, we have the gauge benefit and that gauge benefit will be metered in a smooth way. So I feel very excited about that."
},
{
"speaker": "Brandon Oglenski",
"content": "And maybe just a quick one for you, Mike. I know you guys had wanted to do an analyst meeting soon here, and that's going to get pushed back. But any strategic teasers you want to give us on MileagePlus, because I know it's been a focus of yours and the team?"
},
{
"speaker": "Mike Leskinen",
"content": "I will repeat what I've said in the past. MileagePlus, it's a crown jewel in the assets we have here at United Airlines. It was a critical source of collateral during the pandemic. But the dream is that it is recognized the value of that asset, the value of that business, especially as we grow it, is recognized in our equity market cap. It's not there today. You're going to see us continue to give more and more disclosure, more and more transparency to that business. You're going to see us share more and more details on the growth plans we have for the data in that business. And eventually, if we get no value in our market cap, we'll take more aggressive actions. I've been a consistent message on that and you'll hear even more at our Investor Day."
},
{
"speaker": "Operator",
"content": "Thank you. We will now switch to the media portion of the call [Operator Instructions]. Our first question comes from the line of Mary Schlangenstein from Bloomberg."
},
{
"speaker": "Mary Schlangenstein",
"content": "So I wanted to see if you could give a little bit more detail on the aircraft that were delayed from second quarter to third quarter as part of the FAA review, whether you can tell us what -- how many aircraft, what types of aircraft and specifically how the FAA resulted in the delays?"
},
{
"speaker": "Scott Kirby",
"content": "I'll try. I don't think we know for sure yet. I think we've got three airplanes that are coming in the next few months. They're MAX aircraft MAX-9s, three aircraft that are coming in the next few months, and we'll continue to work with the FAA on -- I'm going to change that. What we're mostly focused on, though, that's not what we are focused on. We are focused on figuring out everything I said in this call, how to use this -- embracing this process as an opportunity to get a new higher standard for safety. And as we go through that process, there will be some point along the way where we'll start taking aircraft deliveries again, but that is absolutely not our focus nor should it be our focus."
},
{
"speaker": "Mary Schlangenstein",
"content": "They haven't -- the FAA hasn't prohibited any aircraft deliveries. Is that right? It's just the start of the use of some of those planes or is it actually the deliveries themselves?"
},
{
"speaker": "Scott Kirby",
"content": "It's putting -- it's not the delivery, it's putting them on the certificate."
},
{
"speaker": "Mary Schlangenstein",
"content": "And you said it's just three for right now. And my second question was you all talked a lot about the corporate rebound and how that's playing out. But is there anything different that you expect to see in summer travel this season? Like it sounds like there might have been some geographic shifts for some areas that were strong last summer won't be as strong this summer? And do you expect the domestic market to be particularly strong this summer?"
},
{
"speaker": "Andrew Nocella",
"content": "As we head into the summer season, we expect strength across the board and in the United network tilt in terms of our best seasonality towards Q2 and Q3 and particularly across the Atlantic, across specific and TransCon within the United States. So we expect all of those entities to perform really strongly this year. And everything we have in terms of data right now, I would say that's where we stand."
},
{
"speaker": "Mary Schlangenstein",
"content": "Do you expect to set another record for this summer for passenger numbers?"
},
{
"speaker": "Andrew Nocella",
"content": "Yes, I think we will, as an airline and as an industry."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Leslie Josephs from CNBC."
},
{
"speaker": "Leslie Josephs",
"content": "Can you [Technical Difficulty] exactly what the FAA review prohibits you from doing? And is the change to the fleet plan from this year because of the Boeing delays in production and deliveries or because of the FAA review? And then on -- just a question on the mechanical issues lately. Have you had to update kind of procedures or anything else for your technicians so that those things don't happen, maybe things that were getting overlooked or not part of checklist prior?"
},
{
"speaker": "Scott Kirby",
"content": "First, the delivery delays are 100% of the issue. And the main focus has been less about changing the policies and processes, but really making sure that everyone keeps safety as a top of mind awareness. And spending a lot more time with the leadership team out talking about it, really making sure that safety is top of mind awareness. Now we, of course, will go through with the FAA and go through a pretty rigorous process and we continuously look at ways to improve safety across the board, and that's continuing. It's at an elevated level right now of looking for ideas but that's not something unique or new that is -- we have hundreds of people whose full time jobs are doing that day in and day out."
},
{
"speaker": "Leslie Josephs",
"content": "And the review prevents you from putting new aircraft into service and then what else, is it captain upgrade, anything else?"
},
{
"speaker": "Scott Kirby",
"content": "No, that's not it. We can do captain upgrades."
},
{
"speaker": "Leslie Josephs",
"content": "So it's just putting new aircraft into service?"
},
{
"speaker": "Scott Kirby",
"content": "That's the primary thing."
},
{
"speaker": "Leslie Josephs",
"content": "When do you expect the review to conclude?"
},
{
"speaker": "Scott Kirby",
"content": "That's, again, the way we would think of this is about going through a process to make it better using this as an opportunity to create a new higher standard, and it will conclude when it concludes. We're not going to predict the time."
},
{
"speaker": "Operator",
"content": "Thank you. I will now turn the call back over to Kristina Edwards for closing remarks."
},
{
"speaker": "Kristina Edwards",
"content": "Thanks, Krista. And thanks for everyone joining our great call today. Please contact IR and Media Relations if you have any further questions, and we look forward to talking to you next quarter."
},
{
"speaker": "Operator",
"content": "Thank you. Ladies and gentlemen, this concludes today's conference, and you may now disconnect."
}
] |
uber | 2,024 | 4 | [
{
"speaker": "Operator",
"content": "After the speakers' remarks, there will be a question and answer session. And if you would like to ask a question during this time, please press I would now like to turn the conference over to Deepa Subramanian, Vice President, Investor Relations. You may begin. Thank you, operator."
},
{
"speaker": "Deepa Subramanian",
"content": "Thank you for joining us today, and welcome to Uber Technologies, Inc.'s fourth quarter and full year 2024 earnings presentation. On the call today, we have Uber Technologies, Inc. CEO, Dara Khosrowshahi, and CFO, Prashanth Mahendra-Rajah. During today's call, we will present both GAAP and non-GAAP financial measures. Additional disclosures regarding these non-GAAP measures, including a reconciliation of GAAP to non-GAAP measures, are included in the press release, supplemental slides, and our filings with the SEC, each of which is posted to investors.uber.com. Certain statements in this presentation and on this call are forward-looking statements. You should not place undue reliance on forward-looking statements. Actual results may differ materially from these forward-looking statements, and we do not undertake any obligation to update any forward-looking statements we make today, except as required by law. For more information about factors that may cause actual results to differ materially from forward-looking statements, please refer to the press release we issued today as well as the risks and uncertainties described in our most recent Form 10-Ks and in other filings made with the SEC. We published our quarterly earnings, press release, prepared remarks, and supplemental slides to our investor relations website earlier today, and we ask you to review those documents if you haven't already. We will open the call to questions following brief opening remarks from Dara. With that, let me hand it over to Dara."
},
{
"speaker": "Dara Khosrowshahi",
"content": "Thanks, Deepa. So the theme of this quarter is acceleration. We accelerated growth in audience, trips, and the top line. Gross bookings growth on a constant currency basis beat even our own expectations, coming in above the high end of our guidance. This performance was powered by strong product innovation across our platform, driving multi-product use to an all-time high of 37% of Uber Technologies, Inc. consumers. It was also a stellar few months for the Uber One membership program, where we added five million members in the quarter, bringing our total member base to 30 million, up nearly 60% year on year. We are now one year into the three-year outlook we presented to investors last February, and pleased to say that in 2024, we cleanly exceeded our commitments on all three components of that framework. Gross bookings, 21% versus our commitment to mid to high teens constant currency CAGR. Adjusted EBITDA grew 60% year on year versus the high thirties to forty percent CAGR. An annual free cash flow conversion as a percentage of EBITDA was 106% versus our indication of 90 plus percent. We are thrilled with this performance and have started 2025 with a lot of momentum. Despite FX headwinds, we expect continued strong growth in Q1, with 17% to 21% constant currency gross bookings growth and continued profit expansion. So lastly, on autonomous, I'd encourage everyone to read our prepared remarks in supplemental slides where we spend some more time this quarter sharing our perspective on the state of AVs. The key takeaway is that while AV technology is advancing, commercialization will take significantly longer. And we have conviction that Uber Technologies, Inc. will be the indispensable go-to-market partner for AV players. This is undoubtedly one of our top priorities, and we're investing a lot of technical, strategic, and management attention to this topic with lots more to come. Just today, we announced that Austin residents can sign up for an interest list right in their Uber app to increase their chances of matching with a Waymo AV when we launch next month. With that, operator, let's take your questions."
},
{
"speaker": "Operator",
"content": "Thank you. Your first question comes from Brian Nowak with Morgan Stanley. Your line is open."
},
{
"speaker": "Brian Nowak",
"content": "Thanks for taking my questions. I have two, one on autonomous and one on the core rides business. So the first one, Dara, is on autonomous. As you think about the portfolio of assets you have at the company, do you think philosophically about investing more in autonomous assets, be it first-party car fleet or other fleet management tools? Or where are you on sort of the portfolio of the current assets from an autonomous perspective? And then on the core business, talk to us a little bit about how to think about puts and takes on rides incremental margins, and sort of profitability in the first quarter and throughout 2025? Thanks."
},
{
"speaker": "Dara Khosrowshahi",
"content": "Absolutely. So, Brian, I think on autonomous, we think we are very, very well positioned. We're investing aggressively across all parts of the portfolio. I think the way that you can think about it is that every new product that we build, we first build by going out and investing in supply and building out kind of liquidity on the supply side. And you really need that kind of magical liquidity to be able to match kind of variable demand and provide the five to six-minute, consistent ETAs in order for the network effect that you see on a local basis for us to work. And in autonomous, it's the same thing. Like, we did it with taxi. We've done it with low cost. We've done it with high capacity vehicles. Did it for Uber Eats in the past. It's just an investment in building out the supply base to match variable demand, and then the magic happens in a particular city. You'll see that magic in work in Austin coming up in a month. As far as investments that we made, you know, we're absolutely investing in fleet supply. This is an investment that we made for over a long time. Fleets now represent about 15% of our inventory. So while we are very well positioned to have kind of fleets in market that can manage autonomous, we are looking at acquiring a ton of depots with electric required for charging the fleets, etcetera. And, obviously, we are going out with various autonomous players and building out technical partnerships and then talking with OEMs about securing supply as their manufacturing platforms are preparing to get the scale for the next generation of autonomous. So it's a broad investment. It's across a very, very low number of units, so you're not really gonna notice it in the P&L. But we do think that this investment is going to prepare us as autonomous starts to scale and as kind of the commercial economics start to be apparent. But even with these investments, which I would term as aggressive investments, you're unlikely to impact the three-year outlook that we've given you. We think we can. This is kind of the power of man, which is we can deliver and some of it through your outlook, and at the same time, we can be investing aggressively in AD supply in every way."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"content": "Brian, it's Prashanth. I'm gonna take the second part of that question, and I think your question was really around the mobility profitability trends and outlook. So maybe I'll start with just a reminder that we want folks to look at the business the same way we do, which is at a total company level. And we're making investment decisions across our segments based on where we see the strongest returns and growth potential. So we're gonna continue to invest in mobility consistent with the overall profitability framework that we gave you guys back in February. So I wouldn't read anything into sort of how mobility profitability was other than we're seeing a lot of opportunity to continue to invest and drive growth. In this quarter that just closed, our EBITDA margin was 7.8% of gross bookings, and that was up 30 basis points year over year. We see continued benefits from supply incentives, leverage on the operating cost, and partially offset some of that tailwind by higher insurance costs, which we've talked about before. But, overall, these investments are really helping us put up that strong mobility growth number, which was at a constant currency basis, 24% in Q4, and we saw acceleration in the US. So we're leaning into things like membership. I think, in the prepared remarks, we talked about 30 million members now that's up five million sequentially, and I think it's up 60% year over year. Teams is another great area. I think we've more than doubled the number of countries that Uber Teens is available in the fourth quarter. And the usual areas like finding the right balance in marketplace and continuing to open up new geographies and some products. So, again, it's part of our overall model that we gave you back in February of last year, which is to drive that mid to high teens GB growth and that high thirties to forty percent profitability, and we'll continue to make the trade-offs we think are necessary to hit those numbers and also ensure that once we leave that three-year framework, we're still driving a great top line. Thanks for the question."
},
{
"speaker": "Brian Nowak",
"content": "Great. Thank you both."
},
{
"speaker": "Operator",
"content": "The next question comes from Eric Sheridan with Goldman Sachs. Your line is open."
},
{
"speaker": "Eric Sheridan",
"content": "Thank you so much for taking the questions. Maybe building on Brian's question on supply and just widening it out a little bit in both businesses. You talked on prior earnings calls about sort of extending the network as a potential stimulant for rider growth and supply density. Can you talk a little bit about those efforts and how they continue to scale and how we should be thinking about them as a potential growth driver for 2025 and beyond as you continue to scale into more areas of mobility? And then on the delivery side, any update on user behavior, obviously, the array of supply that's available to a shopper inside Uber Eats today is very different than it was twelve, eighteen months ago. What is that doing to user behavior, frequency, basket size? How should we be thinking about supply impacting those dynamics in the delivery business? Thank you."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"content": "Great. Thank you for the question. So, first, just as a reminder for folks, the way we think of the business and we encourage everyone else to is our growth is a combination of audience, so the number of users who are hitting our platform every month, how often they are engaging with the platform, which we measure as frequency, and then you round it out with price to turn trips into GBs. So in the last couple of quarters, we've made some comments on how we're focusing on less dense or some of the sparser, which I think is where your question is coming from. So as a reminder, the growth framework through 2026 is for that core business to grow in the low to mid-teens and then the growth bets we're making to kind of help push us up into that higher teens. And the initiative that we're focusing on in those less dense sparse or geos is really around driving the penetration into those less dense areas so we can extend sort of a length of time that we can get that core business to continue growing at an attractive rate. One of the things we've observed is that in our more populated or dense areas versus where we were maybe two or three years ago, growth has started to come down a bit because those areas obviously are more penetrated. Now we can offset this by pushing out into less areas. This started initially as a US delivery initiative, and it's really expanded now into a global one. I would say that as we focused on the US delivery business, we realized that the same opportunity existed across mobility and really around the world. And we're finding real promise really on the mobility side both in the US and non-US as well as in non-US delivery. Where we're now creating some more programs in this space. We see much higher growth in these less sparser areas. I think we've talked about in the past that it's not uncommon for us to see one and a half or more times faster growth outside of more dense areas. And we do that a few ways. On the mobility side, it is supply. So it's really about where we are investing into supply such as creating incentives to bring new drivers into those areas, opening more cities and locations. For example, when you think of the UK, you often think of London, but for us now, Liverpool, Manchester, those become areas that we wanna continue to grow out in Europe. We've got our efforts to add taxis, which will help us in some of those more sparse or populated areas. So once we have the supply, then we can use incentives to make sure the pricing is right to spur demand and sort of get that flywheel going that is the magic of the Uber marketplace. And then on the product enhancements, I would say that the option that we give consumers who are in some of these less dense areas is they can pay with price or they can pay with time. If you wanna pay with price, you can use something like our reserve product, which will give you a very high accuracy if you'll know when your ride is gonna be there, and it allows us to use our marketplace tech to make sure that we find someone who's able to be at the location you want when you need them there, or if you're willing to pay with time, we extend the wait time, which allows us again, to use the marketplace algos to find drivers or couriers who are in the region, but may take a little bit more time to get there. And we're finding that in the suburbs, people are more open to longer wait times. And then I think on the delivery and the growth rates there, what we're doing, listen, the basics remain the same, which is it's all about selection, it's about price, and it's about quality. In terms of selection, we got over a million active merchants up about 16% year on year. These are big and small merchants. Our sales per merchant continue to increase on a year on year basis, but if you look at our total kind of penetration here, in our top ten markets, we have about a third of the merchants out on those markets. So we think there's a huge amount of runway as it relates to selection. Selection increases conversion, but also brings in new audience once eaters figure out that their great neighborhood audience is available on Uber Eats as well. Second for us is price, and the number of merchant-funded offers, so to speak, to lowering price is at an all-time high. This is a really important initiative in terms of merchants being able to promote on the network and getting boosted in terms of their sort order for that promotion. And then membership, which Prashanth talked about now, 30 million members up 60% year on year. That table membership essentially effectively is delivering discounts to our most loyal members. So price is actually something that we're very, very actively working on. And then, of course, quality, making sure that our defect rate or rate continues to go down in terms of making sure that every delivery is a perfect delivery. And then on the back end side, for example, as it relates to shoppers, for grocery, we're really focused on the quality of those shoppers. You know, it's a lot easier, for example, just to deliver, let's say, an online food delivery to a home shopping for twenty items, twenty-five items, and getting it perfectly right is much more a challenge. So we're really shifting our marketplace metrics from cost and efficiency to cost efficiency and quality as well. When you bring all that together, selection, price, quality, increased marketing campaigns, you hopefully, you'll see our Super Bowl campaign out there. You get a good combination of growth in merchants, growth in audience, growth in frequency, and it's all powered by our push into less dense areas and membership well. So we're very, very happy with the trends there. You saw delivery gross bookings accelerate quarter on quarter. And we think that's just more evidence that we got a long, long runway here. Alright. Next question."
},
{
"speaker": "Operator",
"content": "The next question comes from Justin Post with Bank of America. Your line is open."
},
{
"speaker": "Justin Post",
"content": "Great. Thanks. Appreciate it. Couple of questions on the prepared remarks. Dara, you mentioned nine different AV companies. And also, you know, OEMs in your prepared remarks. US-centric, you know, we're only really seeing two companies with really high visibility right now. Can you talk about how you think the market could evolve from here and why it might not be just two companies and what you're seeing globally? And then on the constant currency outlook, I think you did 21% in Q4. You're guiding 17% to 21% in Q1, but also there's prepared remarks about kind of being stable. So maybe talk about what would drive you down to 17, 18% constant currency or what would cause you to be more at the higher end of the 21% in Q1? Thank you."
},
{
"speaker": "Dara Khosrowshahi",
"content": "Sure. I think on AVs, first of all, the opportunity we think in the US and worldwide for AVs is enormous. We estimate that the US market alone is a trillion-dollar opportunity as you commercialize APS scale and bring the unit economics down. And while, you know, we're incredibly excited in terms of the development of the technology, you see Waymo in market, obviously, who's a terrific partner. And a number of players including Tesla trying to, you know, get to prime time, so to speak, we think that the commercialization of the technology is gonna take way, way longer. And by the time that the technology commercializes, all over the world and in the US, you're gonna see many, many more players get over the finish line as it relates to technology. Just stepping back for a second, and this applies for the US and applies all over the world. There are five factors that you need all of which need to come together for scale commercialization of the business. And scale commercialization is like, ten, twenty, thirty percent of our volumes on a US basis, let's say, of a global basis. First, you have to get regulations. You gotta enable regulations. There are national regulations, state regulations, city regulations. Pretty complicated. All the team regulators have to get comfortable with this new technology on the streets affecting our everyday. Second, you know, in order to get regulators comfortable, we think you need a superhuman safety record. Like, we don't think it's good enough for an autonomous driver to be better than a human. I think we have the chance to be multiple times better than the human. And I think the industry should take that kind of chance and insist on a superhuman safety record. You're seeing Waymo definitely get there and many, many other players kind of working to get their safety record up and demonstrate that safety record as well. Third, you need a cost-effective hardware platform. Like, the hardware platforms now, they cost hundreds of thousands of dollars. You've gotta get to the tens of thousands of dollars. There's a lot of work to be done to get there in many, many years. To build out these scale hardware platforms. Fourth, you need, like, first-rate on-the-ground operations. This is what I was talking about before in terms of fleets and recharging and cleaning and, you know, finding lost items, millions of lost items we do every year. And then fifth, you need a high utilization network that can manage the variable demand every day on a seasonal basis. With flexible supply as well, which we think our hybrid network is kind of the best solution there. You need all five to come together, and we think the only way that all five could come together is Uber Technologies, Inc. partnered up with the AD ecosystem. And we think we're kind of an indispensable part of, again, achieving all five and moving from a really, really cool, amazing technology to a really terrific scale business. Now I think that you're gonna see lots of experimentation and a b players, you know, going direct, working with us, etcetera. But especially, we're looking forward to our launches in Austin, Atlanta, where I think we're gonna demonstrate, you know, AV provider like Waymo pretty clearly that a combination of a great and Uber Technologies, Inc. is the best combination out there. And I think this is gonna apply in the US, it's gonna apply all over the world. So today, when you're in the tech development phase, yeah, the US, you don't see too many players, but by the time all five of these entities come together, regulatory, etcetera, which is gonna be years from now, I think you're gonna have a number of players getting to prime time both in the US and internationally. I think that's great for the ecosystem. We think competition is great for the industry. Kinda you're seeing, you know, with deep seat coming in and generative AI, like, how exciting that competition is. And we think the same thing that's happening in generative AI is happening in AV as well. You'll see it definitely in the US, and you're gonna see it all over the world."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"content": "Justin, I'll take the second part of that question, which I think was on putting our Q1 guide in perspective. So let's maybe start with a recap of Q4. 21% GB growth at constant currency year over year, and now we have delivered 21% or four out of the last five quarters, and that growth continues to be led by audience, which is an impressive number when you think that we're adding roughly 20 million, a little over 20 million actives even at the scale we have today. It's a great indicator of how the product continues to drive or get acceptance across the globe. Gonna be relatively similar to Q4 on an underlying basis. So that is 17% to 21% on FX neutral GB growth and great leverage on that with up 33% at the midpoint for EBITDA. So I'll break down some elements of that GB growth to help put it in context. First, our guidance for the first quarter includes us overcoming some notable headwinds. First, we are lapping a leap year quarter from last year. And in the Q1 guide, we've already incorporated the impact from the devastating fires in Los Angeles as well as some unusual weather patterns, particularly in the south where there was some crazy snow that came through there, which did shut down a number of cities. So just making those adjustments there, you can easily get to another one to two points of GB growth if you were to normalize for that. Second, we've got the growth in Q1 again, going to be led by audience similar to what we saw in Q4. So we probably see a little bit of a rinse and repeat in terms of the breakdown between audience and frequency in Q1 versus in comparison to Q4. And third, where I'll spend a little more time just to help people understand is how to think about foreign exchange within the context of Uber Technologies, Inc. So we are expecting FX to be a larger top-line headwind in Q1. Think five and a half percentage points of headwind, and that compares to closer to three points in Q4. And about half of our GBs come from outside the US. And then of those that are outside the US, Latin America, which is a sizable region, represents about a quarter of our international GVs. So now focusing specifically on Latin America, we had a number of countries that saw significant currency depreciation against the US dollar. Notably Argentina, Mexico, and Brazil. And these are top twenty countries for us, so we certainly feel the impact of them on the top line. What is helpful for folks to remember with regards to Uber Technologies, Inc. is while we price our trips or our orders in local currency, we also pay our drivers and merchants in local currency, so that creates a natural hedge. Meaning that our profit exposure from those foreign currency fluctuations tends to be driven by those US dollar denominated expenses, which will be some of our tech organization, our G&A, and other US build cost structure. So the way we try to operate the company is that we will take FX on the top line, but as a management team, we do our best to absorb those impacts in the profit line, whether they be favorable or headwinds to us, to kind of continue to drive the consistent margin expansion story that you've seen over the last couple of years."
},
{
"speaker": "Dara Khosrowshahi",
"content": "And, Justin, I just one comment from me. Listen, I think a lot of investors ask how long can Uber Technologies, Inc. keep growing at the scale as fast as it does and sometimes on planning time, we do as well. I'll just remind you that our gross bookings growth rate this year actually accelerated over last year. So this is a business that continues to surprise us pleasantly in terms of the runway ahead."
},
{
"speaker": "Justin Post",
"content": "Great. Thanks for your time and attention."
},
{
"speaker": "Dara Khosrowshahi",
"content": "Great. Next question."
},
{
"speaker": "Operator",
"content": "The next question is from Doug Anmuth with JPMorgan. Your line is open."
},
{
"speaker": "Doug Anmuth",
"content": "Great. Thanks for taking questions. I have two. Dara, first, just following up on the AV commercialization challenges, I'm curious if there's anything additional you can share on your experience with Waymo in Phoenix and just how you're helping drive utilization and demand there in particular. And then for Prashanth, just given the healthier pricing backdrop in rides that we're seeing through 2025, can you just talk about how you're thinking about the sustainability of insurance costs and those slower insurance price increases through the year? Thank you."
},
{
"speaker": "Dara Khosrowshahi",
"content": "Absolutely. So, Doug, in terms of AV, the first thing I've said I would caution is that the scale of these AV deployments both for us in Phoenix with Waymo generally, are really, really small right now. For perspective, like, our growth in San Francisco, Phoenix, and LA in Q4 accelerated versus Q3. So just the numbers are really small, and it's very difficult to, you know, get patterning based on these smaller numbers. Our very, very early experience in Phoenix suggests that and some of the other deployments that we've got suggest that the Uber Technologies, Inc. network is able to drive significantly higher utilization versus any kind of first-party network could just because of the scale and the variability in terms of supply and demand in a particular market. And, you know, the other pattern that we see is customers love the product. So the opt-in rate for customers the second time that they're offered an AV is significantly higher than the opt-in rate the first time. So it's a great product, and you see that in terms of pricing. You can actually price the product at a premium too, which is terrific. So those are very, you know, it's a great product. Doesn't really have an effect on an overall business. We're able to drive really strong utilization. We are now preparing for some pretty big launches in the tens going to the hundreds of vehicles later this year in Austin and Atlanta. And we will have much, much more to tell you about the results there, and you know, we're quite optimistic that the results are gonna be quite strong."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"content": "Great. That second question's I got insurance. Let me maybe I'll start with the reminder that the US mobility business is required to carry insurance with a liability coverage that is often, usually, much higher than what is required for other modes of passenger transportation. And in some cases, it can be up to fifty times more coverage than what is required in a personal vehicle. So it is a benefit that we provide to our drivers as part of being a contractor for Uber Technologies, Inc. So at a macro level, we're pleased to see that the insurance pressure is easing. The consumer price index motor vehicle insurance is now only growing at 11% year over year in December, which is still a big number, but it's down more than 50% from what we saw in April where it peaked in the low twenties. So with the external headwinds peaking, we are also starting to see the benefits of all the internal initiatives that we've been driving such as the tech innovation and policy work coming through. So our outlook now, and we might have signaled this last quarter, and I think we have more confidence today than we did even in Q4, that the US mobility's insurance cost is likely to be high single digits on a per trip basis in 2025, and that's meaningfully lower than we've seen for the last two years. It's coming from a couple of elements that we've talked about before. We've talked about tech, risk management, and regulatory. So let me just double click on a couple of those. On the tech side, last year, we were piloting and we are now expanding to almost all of our US markets. A driver insights dashboard, and this allows drivers to see more about their driving behavior. And we're pulling data from their phone and the telemetrics on things like speeding, harsh braking, or acceleration, etcetera. And it shows drivers how they can drive more safely to improve their driving score. What we're hearing from drivers is just the ability for them to see that information, which where they were not aware of before, is improving their behavior. But to sort of encourage that improvement, we are also expanding the use of our advantage mode for drivers. And this is where you can actually get higher earnings and better route matching opportunities if you have, among other things, a better driver safety score. So yeah, encouraging giving them visibility to the score and then sort of encouraging the behavior we want through economics is gonna continue to play out through the use of our tech. On the risk management side, we've essentially finalized terms with all of our carriers on the insurance side, and market pricing is stable. So we've got a much better view as we look into 2025 of where that is, and clearly having a captive insurance company and being able to offer to self-insure when we don't get the pricing we want continues to give us great leverage in those negotiations. And then lastly, a little bit longer cycle, but it's the regulatory work that we're going on. And you probably see us out in the news and in respective markets where we are. We're creating a bit more attention on the need for insurance reform on a state-by-state basis. We are starting to get progress in areas like Georgia, California, New Jersey with more to come."
},
{
"speaker": "Dara Khosrowshahi",
"content": "And just to clarify one of my earlier comments, the growth in San Francisco, Phoenix, and LA comment that I made was for all of mobility. That mobility growth in Q4 over Q3 in those markets actually accelerated our overall mobility business, not just safety."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"content": "K. Alright. Done. We'll go to the next question. Thank you."
},
{
"speaker": "Operator",
"content": "The next question is from Michael Morton with MoffettNathanson. Your line is open."
},
{
"speaker": "Michael Morton",
"content": "Hi. Thank you for the question and appreciate the new remarks on AVs. I could follow-up on a question on a comment Dara made earlier. And just general business models with AV. When you talk about securing supply from OEM, speaking about Uber Technologies, Inc. buying cars directly? And then you're thinking over the long term about potential business models with AVs, could you talk about an agency model versus a merchant model of renting AVs for the day. And then a question we get from investors is how much of your global mobility business do you see being addressable by autonomous vehicles due to different driver costs in certain markets compared to the AV cost. Thank you so much."
},
{
"speaker": "Dara Khosrowshahi",
"content": "Yeah. Absolutely, Michael. So in terms of the business model, I think there are gonna be there's gonna be a ton of experimentation around the business models. I think early on, you know, we've got a big balance sheet and we can buy cars. I think eventually it's gonna turn into the fleet partners that we have essentially buying cars and getting financing from third parties. That you see right now with electric vehicles. A lot of our fleet partners actually are able to finance these EVs, etcetera. In the early days, you're not gonna have kind of a financing construct in place, and clarity regarding what residual values are for these cars. So I think that, you know, we'll put up some balance sheet risk. Our fleet partners will put up some balance sheet risk over a period of time. I think that most of the ownership will be a combination of fleet partners. You might see some financial players, you know, kind of infrastructure players just like there are entities, REACH, that own hotels. You will have kind of fleet entities as well. And then, hopefully, there'll be some kind of individual ownership as well of people, small businesses putting up these cars and these fleets and taking care of the car, so sort of small business fleets. But, again, we see around the world for ourselves operating an SMB fleet model as well. So there's gonna be a ton of experimentation. But early on, you know, we will take some balance sheet risk in order to get catalyzed the industry, so to speak. But, ultimately, we think all of it is gonna be financialized. In terms of AV, I think a couple of things in terms of the addressable market. First of all, I think early on, right now, the cost of AV is building that comes close to the cost of drivers. So I think the first markets that are going to be penetrated are gonna depend on regulation, first of all. And, again, the regulatory environment is pretty complicated. And second is kind of the revenue per mile in the markets. This would tend to be US markets or European markets where the revenue per mile is higher and will tend to be in the center of cities. You know, the operation domain for many of these AV deployments is very, very limited and over a period of time is going to expand. So I think in the next five years, the addressable market's gonna be probably, you know, in the order of ten to fifteen percent of the overall marketplace. And then gradually is going to expand over a period of time over the next fifteen years or so."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"content": "Great. Thank you, Michael. Sarah, we have time for one more question."
},
{
"speaker": "Operator",
"content": "Thank you. Your final question will come from the line of Nikhil Devnani with Bernstein. Your line is open."
},
{
"speaker": "Nikhil Devnani",
"content": "Hi. Thank you for taking the question. Dara, last time you talked about price elasticity and today the letter talks about affordability. And the Q1 EBITDA guide suggests it's starting to moderate that profit growth. First, how much of this EBITDA guide is impacted by FX? And then bigger picture, I guess, the skeptical take would be that pricing was a tailwind for the business for several years. We're now hitting that ceiling. And as you push more on affordability, gonna be a headwind to margins going forward. So in your view, why is that not the right take? How do you eventually get a good return on these lower-cost rides and drive operating leverage in the mobility business if you're leaning into that value proposition for consumers? Thank you."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"content": "Yeah. Nikhil, why don't I just take the first part of it and let Dara take the longer part of it there. I've mentioned, I went through a little bit on the FX side. And our philosophy on FX. Clearly, the impact of foreign exchange and the profits that we collect in those foreign jurisdictions when they come back to the US are worth less. And with more than half of our business outside the US, there is an impact there. We have chosen not to pass that volatility on to investors. We find ways to manage that, whether it be good news or bad news, within the company using the levers that we have and sort of that's been the philosophy of the company. We talked about that in the prepared remarks. So it is not a zero impact. It certainly weighs on the business, but for your modeling purposes, you should think of FX as a top-line impact and leave it to the management team in both good days and bad days to do what we can to show steady margin improvement regardless of FX."
},
{
"speaker": "Dara Khosrowshahi",
"content": "Yeah. Nikhil, I would say in terms of pricing, whether it's a tailwind or a headwind, I just say that the vast majority of pricing that we have taken in the market has been in the US. And the vast majority of that price increase has been hassle on cost insurance. So it shows up in gross bookings. It shows up in cost. And that part of the price increase is ultimately economically neutral. We've always believed in kind of a model where we build out premium products. So this is our U4B product, which is a highly premium reserve product well for U4B. We introduced business block as well and using the higher margin of the premium products to fund the lower-cost products like UberX share and shuttle, etcetera. Taxi, two-wheelers, three-wheelers. I think we've been able to consistently demonstrate in the past the ability to balance top-line growth and bottom-line growth, and that's our expectation going forward. And I would tell you that today, you know, when we talked about that three-year guidance in terms of mid to high teens top line and then a bottom line of in the thirties to forty percent growth, we are more confident than ever that we can meet that guideline in almost any pricing environment but kind of the way that we run the company is to run it for both top and bottom line. And I think you'll see us continue to deliver on both of those going forward."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"content": "Thanks, Nikhil. So before we wrap up here, I wanted to share some news. After nearly six action-packed years, Deepa has decided to leave Uber Technologies, Inc. Today is gonna be her last day with us, and so on behalf of Dara, the leadership team, and the global finance org, I do wanna thank Deepa for her many contributions to Uber Technologies, Inc. and wish her all the best in her next challenge. Oji Krishnamurthy, who many of you know well, is gonna step in to lead IR in addition to his existing role managing the strategic finance team. So Bologie will be joining you for the Q4 callbacks this morning along with Alex and the IR team. This quarter, we are going to be in New York, Chicago, San Francisco, Orlando, and Boston. So please reach out to Alex or the IR team if you're looking to see us in any of those cities. And then just to close, I wanna thank the Uber Technologies, Inc. team for all their great work in 2024, and thank you for joining us this morning."
},
{
"speaker": "Operator",
"content": "This concludes today's conference call. Thank you for joining. You may now disconnect."
}
] |
uber | 2,024 | 3 | [
{
"speaker": "Operator",
"content": "Hello, and welcome to the Uber Third Quarter 2024 Earnings Conference Call. [Operator Instructions] I would now like to turn the call over to Deepa Subramanian, Vice President, Investor Relations. You may begin."
},
{
"speaker": "Deepa Subramanian",
"content": "Thank you, operator. Thank you for joining us today, and welcome to Uber's Third Quarter 2024 Earnings Presentation. On the call today, we have Uber CEO, Dara Khosrowshahi; and CFO, Prashanth Mahendra-Rajah. During today's call, we will present both GAAP and non-GAAP financial measures. Additional disclosures regarding these non-GAAP measures, including a reconciliation of GAAP to non-GAAP measures are included in the press release, supplemental slides and our filings with the SEC, each of which is posted to investor.uber.com. Certain statements in this presentation and on this call are forward-looking statements. You should not place undue reliance on forward-looking statements. Actual results may differ materially from these forward-looking statements, and we do not undertake any obligation to update any forward-looking statements we make today, except as required by law. For more information about factors that may cause actual results to differ materially from the forward-looking statements, please refer to the press release we issued today as well as the risks and uncertainties section described in our most recent Form 10-K and in other filings made with the SEC. We published our quarterly earnings press release and prepared remarks, supplemental slides to our Investor Relations website earlier today, and we ask you review those documents if you haven't already. We will open the call to questions following beef opening remarks from Dara and Prashanth. With that, let me hand it over to Dara."
},
{
"speaker": "Dara Khosrowshahi",
"content": "Thanks, Deepa. Uber delivered yet another strong quarter, a record quarter of profitable growth with gross bookings up 20% year-on-year in constant currency. We also generated an all-time high GAAP operating profits of more than $1 billion. This performance was powered by new records in audience and frequency as more people and more places are using Uber more often. Our underlying platform continues to strengthen, more than 7.8 million people now drive, deliver shop with Uber, earning more than $18 billion during the quarter. More than 25 million people are now Uber One members, up 70% year-on-year. Our advertising business grew nearly 80% year-on-year, and our autonomous strategy is working as our 14 AV partners are clearly understanding the significant value Uber can bring to their deployment plans. Thanks to the team for another great quarter. And before we go to Q&A, I'd like to hand it over to Parashanth to briefly reiterate our capital allocation approach."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"content": "Thank you, Dara. Let me add my welcome to our third quarter earnings call. I wanted to jump in quickly with an update on our share repurchase program as well as a reminder of the capital allocation framework that we presented at the investor update back in February. Our capital allocation priorities remain unchanged, responsibly investing in future growth and returning capital to shareholders. On the growth front, we believe we still have a huge amount of organic opportunity in front of us, including our fast-growing portfolio of new products, which are now cooking at $20 billion of annual GB, with geographic expansion, especially into less densely populated markets, and lastly, with increasing user frequency, including through our membership efforts. On capital returns, we plan to steadily increase our share repo in the coming quarters. Specifically, we intend to work our way towards a durable share count reduction in 2025. Now to quickly touch on M&A, we remain extraordinary disciplined, and I want to emphasize that all opportunities are reviewed with a rigorous value creation mindset and Uber's bar for M&A has never been higher. As Dara has said, the best deal is not having to do a deal at all, and we are in that enviable position today. So we are excited to continue on our exceptional path of organic growth while sticking to our firm commitment to you, our shareholder, of capital returns. So with that, let me hand it back to Deepa to open the call for questions."
},
{
"speaker": "Deepa Subramanian",
"content": "Sarah, can we have the first question, please?"
},
{
"speaker": "Operator",
"content": "Your first question comes from the line of Eric Sheridan with Goldman Sachs."
},
{
"speaker": "Eric Sheridan",
"content": "The commentary, especially around the capital allocation policy. I want to come back to the concept you introduced in the letter around less dense markets. Could you go a little bit deeper in both the opportunity set, but also some of the operational dynamics of building supply as well as stimulating demand in less dense markets? And how we should be thinking about that scaling in the years ahead?"
},
{
"speaker": "Dara Khosrowshahi",
"content": "Yes, Eric. We think it’s a terrific opportunity. And frankly, sometimes we take ourselves for not recognizing it properly earlier. Uber started as a company in the middle of big cities, and our biggest cities, Sao Paulo, New York, et cetera. Continue to be the largest source of demand. But continuously, we’ve seen that growth outside of the core in the boroughs of New York now extending into the suburbs or in secondary and tertiary cities has been higher than the core itself almost accidentally, and this is true for Mobility and Delivery as well. And really for us, the start of our focus on less dense areas started with Delivery. In the U.S., especially if you look at noncore cities, et cetera, it’s 60%, 70% of the market, so the majority of the market there. Generally, it’s growing faster than city centers as well. So we’ve really started focusing on improving selection in those areas. And then like you said, then building out the liquidity that's necessary in terms of both demand and supply, couriers and making sure that those couriers are busy. And that kind of cycle, that positive cycle of investing in supply and demand together, increasing liquidity, getting better ETAs, getting better service levels starts to accelerate and add to itself. And we’re starting to see that now in Delivery, but not just in the U.S. We’ve extended this focus in the U.K., Australia, really all over the world. We’re looking at the density by quartile of all of the areas that we deliver to or all the areas that we are giving mobility services to people to, and we are actively investing in those less dense areas. And we think the opportunity set there is very, very significant, both in Mobility and Delivery. So we think it’s early days and – but it is a focus of both Mobility and Delivery. And I think it will be a tailwind to our core business in terms of growth over the next 2 to 3 years and hopefully even more than that."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Brian Nowak with Morgan Stanley."
},
{
"speaker": "Brian Nowak",
"content": "I have two. First of all, I wanted to sort of drill in a little bit more to the U.S. mobility bookings trends. Dara, you sort of look at how the business has trended since your investor update. Are there any areas where you're sort of exceeded or come in a little shy versus where you thought the U.S. rides business would be growing? And has anything changed in sort of your outlook for U.S. rides contribution to growth over the tenure of the outlook that you gave at the investor update? That's the first 1 on U.S. rides. And the second one, just on Phoenix and sort of Arizona around Vaymo. Anything you can share on sort of early signs of incremental volume to Uber from the Vaymo partnership in that market?"
},
{
"speaker": "Dara Khosrowshahi",
"content": "Sure. Absolutely. So in terms of our U.S. mobility growth, the U.S. generally has been kind of the gift that keeps on giving. It’s our largest market, a little less than 50% of our GBs, but more than 50% of our profitability. So the business continues to grow and thrive. We are seeing in the U.S. a couple of trends. One is that we’ve been very public in terms of the increase – the substantial increase in commercial insurance costs really that have happened over the past 2 years. And as we have passed on those increases in cost, especially in states where insurance costs are very, very high, like New Jersey or California. As we pass on those costs, we’ve seen the – kind of the typical elasticity from consumers, which is as GBs, as price goes up, the transaction growth slows down a bit. And that elasticity is usually one for one. It’s no different than what we’ve seen. And actually, we’ve seen our competitor do the same as well. We are seeing weekday growth stronger than weekend growth as well. So people are definitely getting back to back work. I think like the weekend party hours, maybe consumers are a little more price sensitive in terms of whether they choose to go out or not, but weekday is very strong, and Uber For Business especially is very, very strong. Overall, it’s up over 50%. I’m not sure what the U.S. number is, but it’s really strong, both in terms of selling to enterprises, selling to health, selling to transit systems as well. That is definitely a bright spot for our business as well. And then we’re not really seeing any signs of consumers trading down. Like our share product is growing very quickly as match rates continue to increase. We’re investing in newer products like Uber Teens to kind of bring in this new demographic into our system and then shuttles into our system as well. So overall, we’re quite optimistic in terms of how the U.S. market is developing, but those insurance cost increases are definitely resulting in the kinds of slowdowns in transactions that we expected based on elasticity experimentation that we’ve done in the past. I think the good news is that while the insurance cost will continue to go up, we expect them to go up at a lower rate, so to speak, both because the market is normalizing and because we’re taking a lot of action in terms of safer routes, safer drivers, encouraging drivers to drive more safely to try to get those insurance costs down, but that’s kind of a slow-moving target, so to speak. So pretty optimistic in general in terms of the U.S. markets overall going forward. And then to your second question in terms of autonomous and incrementality, in Arizona and Phoenix, at this point, Brian, it’s really too soon to tell. We have relatively modest number of vehicles out there. We know that the experience with Vaymo is absolutely terrific. It’s a delightful experience. Riders are rating their Vaymo driver at very, very high levels. And so we love the experience that it is bringing forth. I think the real test is going to be the expansion of our partnership, and it’s a significant expansion with Vaymo in Austin and Atlanta. We’re starting next year, you’re going to get Vaymos in the hundreds in those markets. And I think then we will see whether there’s incrementality as it relates to autonomous or not. But we’re pretty optimistic where we sit. And I will remind you, too, that we’ve got 14 different AV partnerships and not only are we expanding with Vaymo that we’re really happy about, but you will see expansions with many of our other autonomous partners in domestic and international markets on the AV side."
},
{
"speaker": "Operator",
"content": "Your next question comes from Doug Anmuth with JPMorgan."
},
{
"speaker": "Doug Anmuth",
"content": "I'm going to stick with AV. Dara, can you just talk more about your goals here in doing fleet ups in AV world and some of the ways that you'll be able to drive some greater efficiencies for AV tech providers? And then maybe you could just talk about San Francisco a little bit, perhaps any impact that you're seeing in that market from Vaymo? And is there anything notable to call out on volume, frequency or loyalty in San Francisco?"
},
{
"speaker": "Dara Khosrowshahi",
"content": "Yes, definitely. So generally, in terms of fleet ops, the background of ops is we have been partnering and working with fleets and building up our fleet operations kind of practices for years and years. Typically, we have about 15% of our global mobility supply hours come from fleets. And this is a supply that’s dedicated to us. So they tend to work longer hours. They were kind of multiple shifts in terms of drivers and the supply is dedicated to us, which is terrific. And we work with these fleets in many countries in the U.S. and Europe as well in Spain, for example, and many other countries as well. So fleet operations is something that we built, for example, we have special tools for fleets to be able to manage our fleet to be able to drive high utilization of their cars based on demand, et cetera. And so we’re really extending this practice to the AV space. Housing, charging, cleaning cars can be expensive, and we think just like their advantages to a platform, a global platform being demand to drive the utilization of these AV fleets, we think there’s also an advantage to a global player establishing fleet operations to take care of kind of the local complex logistics that happens in a more efficient way and we think more cost-effective way for our partners as well. So it’s just another way in which we want to be kind of the best demand and operational local operation platform for AV out there. And we’re really excited to get started with Vaymo, and hopefully, we can expand from there. In terms of San Francisco, we see that Vaymo is on the streets here all the time. And in the areas where Vaymo operates, we do see them have category position in the high single digits or low double digits. We aren’t seeing any effect in terms of our consumers one or the other. The price is generally at a bit of a premium to X. It’s more of a, call it, a comfort electric type of a price out there. And it’s a great product, and we’ve been competing with Lyft. And – in San Frisco [indiscernible], we compete with Waymo as well. But we’re very happy to kind of extend our partnership with them and really start to build together in cities like Atlanta and Austin. And hopefully, that will be the dominant way forward for that partnership going forward."
},
{
"speaker": "Operator",
"content": "Next question is from Justin Post with Bank of America Merrill Lynch."
},
{
"speaker": "Justin Post",
"content": "I guess just go to mobility bookings decelerated 3 points to 24%. I know it's a tougher comp. But anything unusual or anything that surprised you in the quarter? And then the incremental take rates and margins were quite strong in Mobility. How do you think about where you are on those and the drivers of growth there as we go forward?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"content": "Yes. Justin, I’ll take the first part of that. So maybe let’s start with sort of the recap of how we did for Q3. So gross bookings at 20% on constant currency. And remember, that’s our fourth quarter now of clocking at least 20% growth. That came from audience and frequency as it has for the last several quarters, audience really driving the majority of that at 13% frequency at fourth. And then with the leverage that we’ve been able to drive the financial leverage, we are able to get EBITDA growing at almost 3x the rate of gross bookings growth. Your comment on sort of where is Mobility headed. Really the – we speak about the trips at the Q4 level, I think, in the prepared remarks, to be similar to what we saw in Q3 with a little bit of deceleration driven by less year-over-year pricing impact is sort of what we’re seeing down the LOB lines as well. So again, you should expect trip activity for Q4 to be sort of in line with what we saw in Q3 with a little bit less benefit from pricing, both you don’t see as much year-on-year increase from insurance in Q4 as well as on the delivery side, you don’t – you see the – some of the benefits of the efforts we’re making to drive affordability impacting basket size. So overall, we still feel kind of this is a large business that continues to grow at a very good rate. And I would say that think of Mobility growing sort of in the low 20% range on a constant currency basis in Q4 and then EBITDA margin probably flattish sequentially."
},
{
"speaker": "Operator",
"content": "Your next question is from Mark Mahaney with Evercore."
},
{
"speaker": "Mark Mahaney",
"content": "Okay. I'll just double-click two things on the insurance costs. So Dara, just talk about, are those -- where are those in international markets? Is that primarily a U.S. market problem and specific state problem? Or is there -- is that a global challenge, rising insurance costs? And then then let's talk about advertising a little bit too. So that growth is pretty robust. The sustainability -- that's very high growth rate that you're doing 70%, 80%. The sustainability of that? Or as you think about the opportunities and -- particularly on the delivery side, where do you think you are? Are there lead markets where you've got you're at several percentage points of bookings and most of the markets you're well under 1%. Just talk about that path of adoption."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"content": "Thank you, Mark. This is Prashant. I'm going to take insurance and Dara is going to take ads. So insurance is primarily a U.S. phenomenon for us that -- where we provide insurance to our drivers when they are on their way for -- to pick up a rider and then again when the rider is on trip. The -- we talked about this in prior quarters that we've seen pretty steady increase in insurance. And this last quarter was no different. The CPI for motor vehicle insurance in the U.S. was up 16% year-over-year in September, but that is starting to moderate. I think Dara mentioned that earlier on in one of the questions. Remember, it peaked sort of in the low 20s back in the spring. So as we look forward to 2025, I'd say we expect the insurance cost to continue to increase, but at a pretty significantly modulated rate compared to what we've seen over the last 2 years. And as we've said many times, there's a lot of effort that we have to help drive that insurance cost down and really bend the curve that includes the deployment of safety technologies that we're putting in the risk management program we have, which includes sort of the relationships we have with our [indiscernible] driving some of those initiatives where we've actually been able to see success in insurance in a couple of states, Georgia, Texas, for 2 -- as 2 examples. And our our principle has been unchanged on this. We pass along insurance cost increases, and we pass along insurance cost decreases. So as we make progress on insurance, you'll see us continue to pass those benefits on to our riders. Let me pass off to Dara to take your question on advertising."
},
{
"speaker": "Dara Khosrowshahi",
"content": "Yes, absolutely. So advertising, we’re obviously very, very pleased with the growth of our advertising business. We’ve always said that in Delivery, it can get to 2% plus of gross bookings were in the mid-1%. So we’re right in between 1% and 2% at this point. So we’re making good progress there. And if I were to generally split our advertising business into kind of 4 different categories: one is the CPC kind of bidding for placement for small businesses. That business continues to progress really, really well. We’re able to increase the number of monetizable impressions per user session, so kind of increasing the ad load a little bit with little or no penalty to the user experience because the ads are really targeted. We’re showing high-quality restaurant and high-quality choices to users as well. So our kind of SMB, small medium business, CPC business continues to grow at very, very high rates. Our penetration with enterprise is generally a little bit lower than SMB advertisers, but that is growing quickly as well. And some of the larger enterprises, they’re looking to target different consumers, they’re looking to target different segments of the day, for example, that might be breakfast, that might be lunch, that might be thinner or they’re looking for consumers that are net new or incremental. So kind of the tools that we’re building for enterprises are a bit more sophisticated in terms of tracking, targeting, et cetera. And we’re making really good progress there with our ads team. And then we’re really focused on our sponsored listing product. This is for groceries. And these are CPGs, et cetera, the Cokes and Pepsis of the world who can advertise on our grocery product in order to increase their share in our marketplace. And we’re very, very early in the development of that product. We’re launching about 8 different markets now, again, looking to mature tool set for the enterprise advertisers. And then at the same time, we just have to keep building our grocery business to be bigger and to become an absolutely necessary buy for the big brands out there, the big global brands out there. And based on the growth rates that we see in our grocery business and the number of partners that we’re bringing in, we’re quite optimistic that we are getting there. And then the other area that we’re pretty excited about is our mobility advertising. These are our journey ads. We are really kind of restricting that space to very, very high-quality advertisers. Click-through rates are 2x to 3x that of industry averages. So the advertising is getting the attention of the riders. We’re very careful there not to hurt the rider experience, which is – which kind of is as a result of our focus on ad quality. We are – we recently announced a partnership with T-Mobile Advertising Solutions to bring our Journey TV offerings to about 50,000 vehicles across the U.S. So we think that will be another jump start to our mobility advertising solutions as well that we’re quite optimistic about. Ultimately, we think mobility advertising is an opportunity for us to increase margins, but also increase the ability for drivers to earn more with these tablets, for example, in their cars to the extent that it improves driver earnings and their quality of life, we think that’s a terrific thing as well. So very pleased with how the ad team and tech teams are delivering, and we think we are midway along this journey and have plenty of room for growth ahead of us in all 3 areas, whether it’s CPC or sponsor listings or mobility solutions."
},
{
"speaker": "Operator",
"content": "Next question is from Ron Josey with Citi."
},
{
"speaker": "Ron Josey",
"content": "Maybe, Dara, I wanted to stick on the delivery side a little bit here and understand just what's driving the map season frequencies? I think we said in the letter [indiscernible] exceeded $50 million in the quarter, frequency reached all-time highs. And so I just want to understand on the delivery. Can you talk about just how are new maps coming on for restaurants? Or has that evolved a little bit more to newer verticals, just given the investments and awareness around grocery and pretty much everything that Uber has to offer. I guess that's question number one. And then question number two on frequency overall. 25 million Uber One members globally, teen trips up 40%. We'd just love to hear your thoughts on just other initiatives on driving greater frequency across the platform. So 1 is on delivery, two is on overall frequency."
},
{
"speaker": "Dara Khosrowshahi",
"content": "Yes, absolutely. So on delivery, listen, we’re pleased with the results. It’s another quarter of 17% growth in terms of gross bookings. And listen, on the [indiscernible] side in terms of audience, first of all, delivery is – it’s a big category. I think the growth in the category continues to surprise many, maybe including ourselves. And it is the main line Uber Eats business that is bringing on the new audience, I would say, significantly assisted by mobility as well. We have the unique differentiator in our marketplaces, which is we have our mobility business with an Eats tab right on top of it and also actively cross-promoting users between Mobility And delivery, and increasingly now from Delivery to Mobility as well. So about 1/3 of our new audience comes from a Mobility business, and it’s a lower-cost audience and obviously very much engaged with the platform. But we are continuing to invest in increasing advertising and increasing brand spend all around the world and the message that’s landing with Uber Eats is obviously a message that is resonating, we gain category position as a result of kind of that increasing audience and Delivery in 10 – of our top 10 markets. So more people are hearing about us and it is resulting in category position gains that we’re very happy about. And then for us, in terms of frequency, number 1 is just the quality of service, increasing selection, making sure that on-time rates continue to increase, making sure that unfulfilled or errors in terms of deliveries, not getting what you wanted continues to decrease. So we are continuing to kind of grind if you want to call it that, in terms of customer experience. The better you are, the more people stay with you, and you want to avoid those situations where something happens, something unexpected happens or a poor experience happens, which can cause that consumer to look for alternatives. And then once we have that core experience improved, then the focus is on membership. Members spend 3x more than nonmembers. Retention rates are higher for members as well. And with 25 million members, up 70% year-on-year, you can see the momentum as it relates to that part of our business as well. So I think it’s all coming together very well. And you can see it in the – both the top line results and our margins continue to increase, and in terms of our category position improving versus our competitors as well."
},
{
"speaker": "Operator",
"content": "Your next question comes from Nikhil Devnani with Bernstein."
},
{
"speaker": "Nikhil Devnani",
"content": "Thanks for the commentary on capital allocation. It seems like in other areas of the business, whether it's dark stores and delivery or autonomous vehicles, you've opted for more of a partnership approach to say, capital efficient. So I guess, could you just remind us how you think about partnering versus buying your way into a new vertical or a new market? What makes an acquisition a better path in your mind? And where does further expansion and diversification of the Uber platform to adjacent opportunities fit in your priority set right now considering the transition that is happening around the core business with autonomous vehicles?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"content": "Thanks, Nikhil. We're going to do this in 2 parts. I'm just going to do a refresher on how we are thinking about capital allocation to give everyone the opportunity to make sure then I'll let Dara kind of talk about how we do those trade-offs between when partnership makes sense. So just as a reminder to everyone, and I said this at the start of the call, our #1 priority is responsible organic investments aligned with the growth strategy, focused on what's going to drive free cash flow. We've got plenty of opportunity ahead of us. We've talked about on the mobility side, things like [indiscernible] on Delivery. We have our groceries and our direct business. And then we have the terrific [indiscernible] platform, which sort of spans both products. Back in February, we also said liquidity was important to us, and we had a goal of getting to investment grade. We actually got there much faster than we were expecting. In Q3 of this year, we hit IG, which is a great accomplishment for us. And now it really allows us to focus on really the return of that excess capital to shareholders. So we will continue to selectively evaluate M&A, but it's a really high bar, and it's going to have to be both strategic value and financially accretive. I think Foodpanda is a terrific example of how we think about that, where it was a clear win both strategically where Taiwan is such a great market for Uber Eats given its high frequency and great membership coverage. And then financially, the deal is very accretive with the likelihood that we'll get an incremental $150 million in EBITDA pretty shortly after we close. So beyond that, get our capital back to shareholders. And again, I made this point in the opening, but I want to restate it. The repo program is the primary vehicle on that. And now we feel pretty good that we're going to be at a share count reduction in 2025. So having said that, I'll pass back to Dara now to get into when do partnerships make sense."
},
{
"speaker": "Dara Khosrowshahi",
"content": "Yes. So generally, when we look at partner versus acquisitions, et cetera, or whether we want to actively get into an area, really, we ask ourselves: one is, can we really get into an area with a proper focus? Is it substantially related to the core? And then second is like can we add value? And the example of [indiscernible], for example, we just concluded when we looked at that segment, there are millions of retailers out there. It is all they do. And we, as a tech-first company, couldn’t add a bunch of value to what these retailers are doing, and we’d rather partner with them to extend their reach and then to complement their services in certain segments, for example, fulfilling for them, our direct business that allows some of these retailers to fulfill whatever product that they’re serving like a Walmart or an Apple. So if we can’t uniquely add value, if it can’t be a core focus of the company we’ll look to partner [indiscernible] for example of autonomous, we were in that business, but it wasn’t [indiscernible] of the world where autonomous is all we do, and we can bring them the complement, which is our demand and our operations, local operations, which allows them to monetize the substantial investments that they are making. In terms of adjacencies and how we look at them, we will typically – because of the power of the platform, we will typically experiment with different adjacencies. We’ve – on delivery, obviously, we started with food. We’ve gone into grocery. You’re going to see us getting deeper into any and all kinds of local retail as well. And with mobility, we started with cars, and we’re going on 2-wheelers and 3-wheelers and buses and trains, et cetera, and we’ll continue to kind of test out some of these adjacencies. Typically, we look for behaviors that are frequent, meaning you can get multiple interactions per month, and also can benefit from our expertise in terms of real-time local logistics as well. Our ability to match and price based on inventory on a given day that can change substantially from 9 a.m. to noon to 8 p.m. when we’re pricing out our service, unlike many like traditional retailers, we don’t even know what our inventory is. So we have to kind of do a scan of our real-time inventory in every market that we operate. It makes it a very, very challenging, but really interesting technical problem to be able to scan that inventory quick enough and then price that both on the demand side and the supply side. So where there are circumstances where we can bring value to them and where the customer interaction tends to be highly frequent or can take advantage of our local logistics and pricing and matching capability, that’s where we’ll look to act. And first, typically, we like to build things organically. We’ve built a ton of businesses. Eats was built organically here. So building organically as part of the DNA of this company. And then if we see something really interesting, we will look at acquisitions. But again, like Prashanth said, we will be very disciplined in terms of those acquisitions because the bar for return on investment is quite high at our shop right now."
},
{
"speaker": "Operator",
"content": "The next question is from Ross Sandler with Barclays."
},
{
"speaker": "Ross Sandler",
"content": "Just going back to the autonomous questions. So I guess on the Vaymo partnership, why only 2 cities? Why not something much broader? Is that an option in the future? And then you guys are an investor in Wave. Could you talk about how you see the second tier of the Robotaxi market behind Vaymo and Tesla evolving? When do you see that next wave of companies and fleets conceivably being on the road and on Uber specifically?"
},
{
"speaker": "Dara Khosrowshahi",
"content": "Yes, Ross, in terms of the two cities, really what you want to get is the proper liquidity in a city anytime that you launch. And with Vaymo as well and many other AV players, there's a need to kind of map different cities and map both originations and destinations. So there's an investment that goes into launching these cities. So it doesn't make sense to getting into 20 or 30 cities in kind of a thin. Way you want to go into a city with the proper investment in your depots, in your infrastructure, in your mapping, et cetera, so that you start getting a return on capital. And Vaymo and ourselves thought that these 2 cities are very attractive cities to launch it. And hopefully, we can go from there. But really, the focus right now is to make sure that Austin and Atlanta work the way that we believe that they will. In terms of other players out there, it's really hard to generalize. I think that Vaymo is clearly the leader in the industry. but there are many other players who are developing this technology. And these cars are live in many cities around the world, certainly in China as well. And so you will see deployments of other autonomous partners on the Uber network, so to speak, outside the U.S. coming up in '25. And I think that the autonomous kind of ecosystem will continue to expand across many different partners because the potential of the market, both in terms of saving a bunch of lives with safer drivers out there, but the potential in terms of extending mobility and making available to many, many more people and -- at a reasonable price is just so significant that many players are going to go after that opportunity. And I think we've shown with all of our partnerships that we are by far the best partner in terms of driving utilization and working locally with some of these partners. So stay tuned, you're going to see more launches coming up."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"content": "Sara, we’ll take our final question now."
},
{
"speaker": "Operator",
"content": "Your final question comes from the line of Benjamin Black with Deutsche Bank."
},
{
"speaker": "Benjamin Black",
"content": "Can you just talk a little bit about the broader consumer landscape, how favorable is the state of the macro environment for you in some of your larger markets? What proof points or KPIs do you guys track that give you confidence that it's not deteriorating. And then the second one is on Uber Direct. Do you need to supplement that business with some incremental investments to drive deeper penetration? And in terms of your Darden deal, it's exclusive? Is that sort of the right way to think about the direction of travel for the structure of future partnerships?"
},
{
"speaker": "Dara Khosrowshahi",
"content": "Yes. So I think generally, consumer demand continues to be strong. especially on services. Spend on services still isn't where [indiscernible]. So I think all service players travel, for example, Booking.com, I think reported last night, pretty strong results. So all kind of services providers are enjoying this. And if you look for us, in our audience is an all-time pie, frequency is at an all-time high, our consumer retention is up globally year-on-year in both Mobility and Delivery similar to the past couple of quarters as well. We're not seeing any signs of trade down in Delivery. It's something that we look at. So eaters are ordering more from kind of the $2 bucket versus the the $1 bucket in terms of our own ratings and in all top markets. So it looks like the consumer is strong. And when you look at U.S. and Mobility, gross bookings in the U.S., for example, they grew 17%, which is a very solid number. And then International actually grew faster than that. So international markets continue to be very, very strong, which is something that we are quite happy about. And then we continue to see very strong spend on the corporate side as well. U4B growth rates are very strong. 50% constant currency growth as we continue to penetrate into new accounts, but actually existing accounts continue to grow as well, and about 50% of our U4B business is premium, which is kind of black and comfort, et cetera. We're not seeing any signs of trade down there. So for now, the consumer -- all the consumer signs are strong, and we're certainly hoping that they stay that way. And then in terms of Direct, we continue to invest aggressively in Direct actually. You see the partners -- the partnerships with Darden. And some of the partnerships that we have are exclusive and some are not exclusive. It really depends. It's hard to generalize. There are some players who want multiple partners. I think one of the benefits that we bring in the direct business that we are global in nature. So one partner, especially global brands, can partner with us and we can integrate into their tech ecosystem and we can deliver for them in New York, and we can deliver for them in any international -- in Tokyo as well. And there are very few -- there's no one else who really has the global scope that we do. But as it relates to Direct, we're actively increasing our engineering headcount there and continuing to sign up more partnerships and also deepen our capabilities in terms of the services that we offer our partnerships. It's one of the fastest-growing parts of our business. And we think the extension of direct beyond just same-day delivery into kind of more fundamental parts of the fulfillment ecosystem as a real potential opportunity for us going forward. So I think that's it. Thank you, everyone, for joining. A huge thank you to the Uber team for all of the efforts that undergird kind of what Prashant and I and Deepa report to the Street. Another good quarter, and we're looking forward to closing out 2024 with a strong Q4. And I think for short, we're going to be talking on some of the investors in a couple"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"content": "Yes. Thank you, Dara. We're going to be in Toronto, Miami, Boston and San Francisco over the next couple of weeks. So if that corresponds with anyone's interest, please reach out to depot. We'd love to see you."
},
{
"speaker": "Dara Khosrowshahi",
"content": "All right. Thanks, everyone."
},
{
"speaker": "Operator",
"content": "This concludes today's conference call. Thank you for joining. You may now disconnect."
}
] |
uber | 2,024 | 2 | [
{
"speaker": "Operator",
"content": "Thank you and welcome to the Uber Q2 2024 earnings conference call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks, there will be a question and answer session. If you would like to ask a question during this time, please press star, one on your telephone keypad. I would now like to turn the conference over to Deepa Subramanian, Vice President, Investor Relations and Corporate Finance. Please go ahead."
},
{
"speaker": "Deepa Subramanian",
"content": "Thank you Operator. Thank you for joining us today, and welcome to Uber’s second quarter 2024 earnings presentation. On the call today, we have Uber CEO, Dara Khosrowshahi, and CFO Prashanth Mahendra-Rajah. During today’s call, we will present both GAAP and non-GAAP financial measures. Additional disclosures regarding these non-GAAP measures, including a reconciliation of GAAP to non-GAAP measures are included in the press release, supplemental slides, and our filings with the SEC, each of which is posted to investor.uber.com. Certain statements in this presentation and on this call are forward-looking statements. You should not place undue reliance on forward-looking statements. Actual results may differ materially from these forward-looking statements and we do not undertake any obligation to update any forward-looking statements we make today, except as required by law. For more information about factors that may cause actual results to differ materially from forward-looking statements, please refer to the press release we issued today, as well as the risks and uncertainties described in our most recent Form 10-K and in other filings made with the SEC. We published a quarterly earnings press release, prepared remarks, and supplemental slides to our Investor Relations website earlier today and we ask you to review those documents, if you haven’t already. We will open the call to questions following brief opening remarks from Dara. With that, let me hand it over to Dara."
},
{
"speaker": "Dara Khosrowshahi",
"content": "Thanks Deepa. Q2 was another record quarter for Uber and further demonstrated our ability to deliver profitable growth at scale. Gross bookings grew 21% on a constant currency basis, consistent with trip growth. Our audience expanded 14% while frequency grew 6%, supported by 7.4 million drivers and couriers globally. At the same time, adjusted EBITDA grew 71% year-on-year and we generated record quarterly GAAP operating income. These are super strong results that we’re proud of, but I also understand there are two big questions out there that I want to address before we head into Q&A. First, the strength of the consumer and how Uber will perform in a recession. Based on what we’re seeing today, the Uber consumer is in great shape. Our audience is bigger than ever and using our services more frequently than ever. While our consumers tend to be higher income, we’re not seeing any softness or trading down across any income cohort. Were the current macroeconomic fears to materialize, we’re confident that Uber can perform well because of the countercyclical nature of our platform. On the mobility side, more driver supply brings down prices for riders and improves reliability, and on the delivery side, merchants are investing in performance channels like ours for growth, improving selection and affordability for consumers. In fact, in Q2 the number of first-time consumers on Uber Eats in the U.S. was higher than at any point over the past five quarters. It’s clear that delivery is much more habitual than many assumed, made even more so by our Uber One membership, which now covers 50% of delivery gross bookings. We’ll continue to drive consistent top line growth while expanding GAAP operating income. Our track record of making and then exceeding our commitments should give investors confidence that we’ve built the capital discipline and operational muscle to perform well in any scenario. Second, autonomous - put simply, Uber is uniquely positioned to offer tremendous value for AV players looking to deploy their technology at scale. While the operation of a ride hail network may seem simple, our technology obscures a huge amount of complexity. We support roughly one million trips per hour and our average ETA globally is approximately four minutes. That’s possible because of marketplace tech that makes over 10 million predictions per second, and more mundanely, we handled more than 25 million lost items in just last year alone. We also know that a key factor in AV commercialization will be asset utilization. AV players will need to ensure that their expensive assets are being used as close to 24 hours a day as possible while also managing the daily and weekly peaks and valleys of ride hail activity. Uber can provide enormous demand without AV players needing to invest capital towards acquiring customers or building the marketplace tech that delivers reliability at the standard that consumers have come to expect. That’s all to say that Uber will be an indispensable partner for AV players of all sorts. We’re in late stage discussions with additional global AV players to join our platform and will have more announcements in the coming weeks and months. Thanks to the Uber team for another great quarter. With that, Operator, let’s open the call for questions."
},
{
"speaker": "Operator",
"content": "Thank you. [Operator instructions] Your first question comes from the line of Brian Nowak with Morgan Stanley. Your line is open."
},
{
"speaker": "Brian Nowak",
"content": "Thanks for taking my questions. I have two, the first one is on AV. Dara, I appreciate the color, and even the extra color in the press release. My question is, is there any more detail on what you’re seeing in Arizona around incrementality of rides from the partnership? How do we think about sort of the relative unit economics, and philosophically, what is your strategy of reinvesting dollars to sort of drive more AV growth versus delivering profitability? Then the second one on mobility specifically, can you talk to us just a little bit on what you’re seeing on mobility MAPC versus frequency growth drivers, just [indiscernible] or break apart what’s driving that growth in the quarter for mobility? Thanks."
},
{
"speaker": "Dara Khosrowshahi",
"content": "Sure, absolutely Brian, thanks for the question. I don’t want to speak specifically to Arizona because obviously we have Waymo as a partner there, and I want to hold confidentiality, etc. as any partner should. But when we look more broadly at our operations with the various AV players that we see, what we do see is that the utilization that these AV players are able to develop on our network is significantly higher than the utilization we believe that they’re able to run out without [indiscernible] basis, so 3P utilization is significantly higher than 1P utilization. If you think about the role of the marketplace, the role of the marketplace is to drive utilization of fixed assets. I mean, in the end, it’s why a McDonald’s or a Starbucks or even Dominos now works with us - they have direct channels to consumers, but they also work through the marketplace to bring more demand to their stores, so to speak, and we think the same will be true of AV players, which is as long as we’re able to drive higher utilization and the utilization that we drive, the incrementality we think significantly exceeds the take rate that we will charge on average for mobility. Not including insurance costs, our global take rate is around 20%, so you’d have to drive 25% increasing utilization. We believe that those utilization numbers are possible and we think that we can exceed those kinds of utilization numbers. Right now, the economics and the math are definitely working. I think the additional benefit that we bring to these players is we have a dynamic dispatch model that can determine what are the pick-ups and drop-offs that an autonomous player can effectively play with - you know, the pick-up point is easy, it’s within a block, same thing with the drop-off points, and then what are the circumstances when we should dispatch a human for a particular pick-up or a drop-off, if the route is complex or the pick-up or drop-off has some special circumstances. We’re able to essentially allow autonomous players to dispatch in situations where we know that they will succeed, so all in all the early data is quite encouraging, and as I said, we’ve had lots of discussions with other players out there. We don’t think this will be a win or take all market, and we think that we will continue to have the most liquid and largest marketplace that will be--that will have humans and AV players as part of it during this pretty long hybrid period, as autonomous is development and regulators are trying to figure out exactly how to regulate it. Prashanth, do you want to take the second one?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"content": "I will, thanks Dara. I think, Brian, your question was on mobility growth, so maybe I’ll start with just restating how we did for Q2 and our outlook for Q3. For Q2, the results that we printed, if you do it at a constant currency, very strong at 27% year-over-year growth. For Q3, we’re looking for sort of a repeat in that mid-20s range, again on a constant currency basis. But when you dig into why do we have such confidence in the mobility business, I would take you back to the framework we talked about in February, that mobility over the three years that we gave you should be growing at the mid-teens or better, and that’s coming from a couple items. On the user side, we still believe that we have a pretty massive TAM that we can go after. We’re continuing to drive product innovation, and we talked about a couple of those at Go Get earlier this year, and we’re continuing to find new demographics in areas to continue to expand in. Maybe one data point on TAM that I think is helpful for folks is our monthly penetration of consumers, and we define that as folks who are over 18 years, is less than 20% across our top 10 countries, so a lot of room to run there. Another key driver will be frequency, which I think folks understand to be how our monthly active--how many times our monthly actives engage with the platform. We are launching new products, continuing to improve reliability so that when you call for an Uber, we’re able to get you one at a time that you’re looking for, and of course the benefits of membership. Only about half of our riders take one to two trips per month, so again plenty of upside there to continue to drive this as a more frequent daily use case."
},
{
"speaker": "Dara Khosrowshahi",
"content": "Then Brian, I think you had asked about our strategy to reinvest to drive, let’s say, AV growth versus profits. Generally we are able to lean into our newer products, so for example if you look at moto, which are two wheelers in Latin America and a number of developing countries, if you look at our shared product, UberX Share, where we get more than one passenger in a vehicle, or even taxis, those newer products are growing faster than the base business and their margins are substantially lower than the base business, but we’re able to-- as we scale, we’re able to leverage our cost base, our technology improvements in terms of targeting, in terms of CPT all allow us to have a profit envelope to be able to be reinvest into our newer products - AV is one of those new products, while overall increasing profit margins. This is something that we’ve been doing for years, and we think AV will be part of the same equation. I don’t--you know, AV is not something that we’re going to look to make substantial profits from over the next five to 10 years, and that’s just fine because we’ll be able to build a lot of liquidity in the marketplace to continue on the path that we have been operating in over the past five years."
},
{
"speaker": "Brian Nowak",
"content": "Great, thank you both."
},
{
"speaker": "Dara Khosrowshahi",
"content": "You’re welcome. Next question?"
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Doug Anmuth with JP Morgan. Your line is open."
},
{
"speaker": "Doug Anmuth",
"content": "Thanks so much for taking the questions. Dara, can you just talk more about the importance of the BYD partnership as you bring new EVs into global markets, and then perhaps how that can tie into AV over time? Then Prashanth, just if you could talk more about the drivers of delivery profitability - good upside there in the quarter, and what gives you the confidence on the clear path to EBITDA profit in grocery and retail as well? Thank you."
},
{
"speaker": "Dara Khosrowshahi",
"content": "Yes, absolutely Doug. I’ll start with BYD. The electrification of our fleet is an incredibly important initiative for us. We are--if you look at Uber, Uber drivers are switching over to electric at five times the speed that normal drivers are, and if there’s any driver that you want to switch over to EVs, it’s an Uber driver because Uber drivers also drive around five times the miles of a regular driver as well, so it’s a very targeted segment that we’re going after and we’re hoping that governments can help us go after as well. The number one reason why some drivers hesitate to move over to EVs is affordability, and the fact is that BYD, when you look at cost and quality, BYD is really second to none in terms of any manufacturer out there. We’re very, very excited with the partnership. We are--we believe we’re going to bring over 100,000 new BYD EVs onto the Uber platform across some of our most important global markets out there, and we’ve always talked about climate being a team sport, we are going to be leaders in terms of climate change, and having BYD as a partner is just terrific to see. More recently, BYD has committed to very, very significant investments in the AV space, and judging from what they have accomplished in the EV space, I would not--I would make a bet on them in AV as well. But the investment that they’re making in AV is in the billions and we’re very much looking forward to partnering with them on both EVs and AVs. Prashanth?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"content": "Yes, so I think your question was on delivery profitability. Although we don’t--we don’t want to draw attention to incremental margins, we did have a pretty terrific quarter for incremental margins in delivery - 10% for the second quarter, so putting a little context around that. We are clearly seeing the benefits of scale as it runs through the delivery business and we still have many levers that we’re continuing to tune to drive that profitability in delivery. That includes some incredible tech that the team has built that continues to drive down the cost per transaction--cost per trip in terms of operational improvements. We’ve got great improvements in advertising - I think we mentioned in the prepared remarks that’s now running in excess of a billion dollars on a run rate basis, and continuing to find ways, both operationally and with tech, to reduce some of our other costs like refunds and appeasements, which are still a bit of a drag on the delivery segment. You know, the fact that we were able to grow delivery profitability while continuing to have very strong growth in grocery really is a good indicator of how much strong growth we’re seeing in that profitability. I think delivery EBITDA was up by 25 basis points sequentially, and that is despite grocery growing at a substantially faster rate than delivery. In grocery profitability, it’s what we’ve talked about in the past - you know, using the power of the platform, we can bring down the customer acquisition cost and drive those cost efficiencies. We’ve got 15% of our Eats customers are now using grocery - that’s up about 200 basis points year-over-year as of middle of the year, and we’re seeing retention on grocery also improving. I mentioned the ads revenue, and then also starting--given that our selection’s improving, we’re also driving down consumer promotions and continuing to add more and more merchants onto the platform - we mentioned Costco, and I think in the press release or prepared remarks, we also mentioned a couple other grocers. All in all, things are on track to where we gave you in our three-year model, and grocery is continuing to be a strong story for our delivery business."
},
{
"speaker": "Dara Khosrowshahi",
"content": "Just one very encouraging trend on grocery and retail is that ad spend on grocery and retail has more than tripled on a year-on-year basis - obviously that’s very high margin product, and we are continuing to expand our CPG product now into a bunch of new countries, so the momentum there is terrific to see."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Eric Sheridan with Goldman Sachs. Your line is open."
},
{
"speaker": "Eric Sheridan",
"content": "Thanks so much for taking the questions. Maybe two, if I could, coming back to the delivery business. Building on the last set of comments, how do you think about the potential longer term for increased utility, increased frequency as you layer more supply into the delivery network, and what you continue to learn about the relationship of evolving the experience for consumers and what it means for platform growth over a longer period of time? Then also on the delivery side, we’ve seen a lot of market consolidation and market rationalization in some of the countries around the globe. How do you think about the asset portfolio on delivery and your current marketing positioning against some of those industry dynamics you’re seeing on the capital side? Thanks so much."
},
{
"speaker": "Dara Khosrowshahi",
"content": "Yes Eric, so what we’re seeing in terms of delivery is the long term growth is incredibly promising, and especially our ability to expand into the adjacent category of grocery and retail. The grocery and retail TAM is actually bigger than the online food delivery TAM, so not only do we believe we’ve got a long runway in online food delivery but we’re just getting started as it relates to grocery and retail. We now have 1.1 million merchants on the platform - that’s up 13%. Our merchant penetration in most countries still is very low, well under 50%, and every time we add a merchant, because we have more diversity of choice, average conversion tends to improve for consumers who are kind of searching for their favorite restaurant or favorite dessert place, and each merchant gives us actually another item to market against as it relates to search engine optimization or search engine marketing in third party channels as well. So new merchants add conversion, choice, and actually are another item to market against, and we’re a very, very long way in terms of full merchant penetration in the marketplace. It all results in either retention being up globally in every single mega region just in June on a year-on-year basis, so right now we believe there’s a very, very long runway for growth. The more consumers use our products in a multi-product way, whether it’s a mobility user using delivery or a delivery user buying from grocery and retail, the more they transact on the platform, multi-product consumers spend three times more than single product consumers, and for us, the more products we add to the marketplace, the more this benefit adds onto it, and then on top of that, you add our membership product as well, which is now over 50% of bookings. The volumes are strong, we are not having to buy our way into strong volumes, we’re kind of earning our way into strong volumes, and I think the fundamentals are going to be there for some time to come. In terms of our portfolio, we had made the strategic decision a few years ago, probably three or four years ago to exit markets that we didn’t think we could either be the number one or number two, and if we’re the number two, the ability to move to a number one position. We’ve gained category position in delivery in every one of our top 10 markets on a year-on-year basis. It’s a function of the great execution of our operations team, the technology that we’re shipping, and then the power of the platform. There’s no other global player who operates both in mobility and delivery or has as broad a platform as we do, so we’re very happy with our portfolio, so to speak, and I think the results speak for themselves."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"content": "Eric, as someone who’s been in the business coming up now on my one-year anniversary soon, I’m surprised--I was surprised to learn how sticky the food delivery business is. It is very habitual, and we’ve got great data that shows that stickiness is improving. I think I looked back at five, six quarters of data, and it gets better every quarter in terms of either retention, so there’s clearly the trajectory to follow what we’re seeing in mobility."
},
{
"speaker": "Eric Sheridan",
"content": "Appreciate it, thank you."
},
{
"speaker": "Dara Khosrowshahi",
"content": "You’re welcome. Next question?"
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Justin Post with Bank of America. Your line is open."
},
{
"speaker": "Justin Post",
"content": "Thank you. I wonder if you could revisit the consumer downturn scenario. What would you expect to happen for mobility if we do have a recession or a bigger downturn as far as maybe trade down or looking for lower priced rides, the impact on bookings and profitability? Then Prashanth, maybe you could talk about--it looks like you’ve turned the corner on independent contract deals in Massachusetts and other areas. What happens to your cost when you sign those deals, and can you cover it with higher fees? What are the business model impacts of signing those deals? Thank you."
},
{
"speaker": "Dara Khosrowshahi",
"content": "Yes Justin, in terms of a consumer downturn scenario on mobility, we see these circumstances in a number of markets - LatAm has been through a bunch of cyclical trends, etc., and usually a downturn, the leading indicator of a downturn is a weak job market. We might be seeing it in some of the western markets, we might not - it’s very difficult to tell, but when there is a weaker job market, typically our driver supply on the mobility side significantly improves. We’re a very, very flexible work platform, average earnings per utilized hour for drivers in the U.S., for example, is $33 per utilized hour, so it’s highly flexible and the earnings per utilized hour are strong. Typically what we see is improvement in driver supply. As driver supply improves, surge comes down, ETAs improve, the service itself becomes more compelling, and as a result volumes typically turn out to be quite sticky. In addition to those trends, we are actively investing in affordability, right - the membership program essentially brings prices down for both mobility and delivery, and we’re investing in products such as two-wheelers and three-wheelers and UberX Share, all of whom provide discounts of, let’s say, 25% to 50% of, let’s say, the price of an UberX as well. We think that we can thrive in upturns and downturns, and I think that the team has proven that they have execution capability to be able to perform in any kind of market. Listen - we’re watching trends very, very closely and I do believe we’ll be able to adjust as needed. Prashanth, do you want to talk about Massachusetts?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"content": "Yes, I will. Justin, maybe I’ll also just start by reminding folks that we have three different broad models on how we go to market in our operating framework for folks. We have the traditional independent contractor, which is how most people think of Uber, and that is the model that the company was largely built on. Then over time, we’ve adapted to now the IC-plus model, which is what you referred to for Massachusetts, and that’s where we enter into agreements to provide some level of benefits, and then there are still some countries that we use a fleet model, where an independent company sort of handles the actual execution on the ground, and we serve as feeding them the global--or the in-country demand or the in-city demand. Specifically in Massachusetts, we reached a deal with the Attorney General that settled on a set of standards for earners that includes how we measure or how we define time on the platform, certain healthcare, family and medical leave benefits as well. As a consequence for that, the Attorney General dropped their action against Uber and we’re no longer in pursuit of a ballot issue in Massachusetts, like we had very successfully done in California. The consequence of that is we will factor that into our operating model in Massachusetts, but as we’ve said back in February at our investor day, we still have plenty of runway to focus on operational costs, so while this will be built into the cost structure that we push to the market, we continue to believe that there is plenty of runway ahead for us to continue to drive down our operating costs through the support costs and payments and a variety of other measures, that we continue to sort of grind out those basis points that will continue to make Uber an affordable option for all."
},
{
"speaker": "Justin Post",
"content": "Great, thank you."
},
{
"speaker": "Dara Khosrowshahi",
"content": "You’re welcome. Next question, Operator?"
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Nikhil Devnani with Bernstein. Your line is open."
},
{
"speaker": "Nikhil Devnani",
"content": "Hi, thanks for taking my question. Dara, I wanted to ask a two-parter on autonomous vehicles. First, can you help us understand how much of the ride share demand takes place during peak hours, in mornings and evenings? I would imagine that utilization math around the peak is really at the core of your value prop to partners. Then second, the partnership model makes a lot of sense to us for both sides, but there is a world where providers choose not to partner, they choose to compete more directly, so my second question is around, I guess, what the Plan B is for Uber in the event the leading players choose not to extend partnerships or engage in partnerships? How do you navigate that scenario? Thank you."
},
{
"speaker": "Dara Khosrowshahi",
"content": "Yes, absolutely. In terms of peak and trough, while we haven’t disclosed the numbers, there are very, very significant peaks during rush hour both ways, obviously in the mornings and going home, during after-hours drinks, etc. We are able to shape demand and supply--actually, demand through surge when we need to, and supply, obviously positioning our drivers through incentives either on a temporal basis or on a geographic basis, if there’s a concert going on, etc. The good news there is that through our incentive structure, essentially those are variable costs for us. We will pay more during those peak periods and then when we don’t need supply, we can take incentives out, so we have a model where essentially we’re able to shape supply to match demand in a variable basis. I think that in an AV world, the car is there at all times, so you kind of have to pay the overhead for the car and the amortization of the car during all periods, so we think kind of hybrid network that can--that consists of both humans and robots can handle the peaks and valleys much more effectively than a pure play network. In terms of AV partnerships, etc., I would tell you, Nikhil, that based on the conversations that we’re having, we are highly, highly confident of being able to acquire AV content, if you want to call it that, on a global basis. The fact is this is not turning out to be a winner take all market - originally, I think that was the concept why Uber wanted to develop the technology itself, but every single OEM is investing in some L2 or L3 technology. If you look at some of the newer tech coming in terms of imitation learning technologies that have taken the imagination of folks through LOMs, that same technology, we believe can potentially introduce a new wave of AV through imitation learning at substantially lower capital costs that was necessary historically, so we think there are going to be many, many AV providers. If there are many, many AV providers, the marketplace--and our marketplace is by far the largest marketplace, global marketplace both for mobility, delivery, and then freight as well, the marketplace will have a very, very strong position. At this point, we don’t see any signal that a Plan B will be necessary. Also, take note that we have investments, strategic investments in a number of AV players - Aurora, we’re working with Waymo, for example, and there are other investments that we have in AV players to make sure that Plan A is the right plan going forward. So far, I’d say so good, and as I mentioned in my remarks, we will have more partnerships to announce in the next weeks and months, and I think the market will see--you’ll see that Plan B isn’t necessary."
},
{
"speaker": "Nikhil Devnani",
"content": "Thanks Dara."
},
{
"speaker": "Dara Khosrowshahi",
"content": "You’re very welcome. Next question, Operator?"
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of John Colatuoni with Jefferies. Your line is open."
},
{
"speaker": "John Colatuoni",
"content": "Great, thanks for taking my questions. Given the continued progress on mobility frequency, I was curious if we could go back to some disclosure you provided about a year ago, showing pre-COVID cohorts in the U.S. and Canada had lower frequency than more recent cohorts. How has mobility usage progressed across cohorts over the past year, and what does that progression tell you about the opportunity to keep driving frequency higher through multi-product adoption? Second, the $1 billion in advertising run rate suggests over 50% growth, which is really strong but a bit of a deceleration from more like 80% exiting last year. Talk about how restaurants are balancing investments in sponsored listings versus merchant-funded offerings, which you mentioned grew over 70% year-on-year in the quarter. Thanks."
},
{
"speaker": "Dara Khosrowshahi",
"content": "John, in terms of mobility frequency, while we’re not going to disclose specifically what frequency looks like, I would say that when we look at lower cost products, when you look at UberX Share, hailables, two-wheelers, three-wheelers, the frequency of some of the newer products is significantly higher than the frequency of, call it the X product, etc. When you look at the overall frequency numbers for both mobility and delivery, they’re up on a year-on-year basis. It is absolutely helped by multi-product usage, it is absolutely helped by membership as well, so whether you look at cohorts, whether you look at new customers, high income, low income, the frequency numbers for us in both mobility and delivery are very, very constructive. You want to talk about ads, Prashanth?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"content": "Sure. I think the question--your question, John, again was on merchant-funded offers, or offers in general, how are we seeing that have an impact for the business. I would tell you to think about it in two elements. First, as we’re able to drive, and we see very strong cooperation from merchants in using merchant-funded offers to drive their demand, it is actually being a very helpful way for them to address their need, to attack the affordability question that folks are asking, so that can come through a variety of different things that they’re putting onto the platform - it could be a buy one, get one, it could be if you spend a certain amount, you get a certain percentage off. We’re seeing extremely strong growth in the use of merchant-funded offers and the tech that we have is allowing them to be quite creative in how they want to apply that and when. I think that’s something that’s quite unique to us, and as a result of that, we are seeing very good support of their business growth. In a time when I think there is more macro concerns around what’s happening with some of the large enterprise customers, we are seeing our SMBs really lean in more and are seeing strong growth in this. I’d also say that when we look at the category levels that folks are shopping at on the merchant side, we’re continuing to see folks shopping at what we would have categorized as a more expensive or, I think it’s a two dollar sign category versus the single dollar sign, so we’re again seeing folks not trading down at SMBs because some of that is being supported by the RFO or the restaurant-funded offers that we are enabling them to support."
},
{
"speaker": "Dara Khosrowshahi",
"content": "Then just on the sponsored listings part of the business, the growth continues pretty significantly. We’re a bit over 1% of delivery gross bookings through advertising, we had a target of 2%-plus. We think that target is certainly achievable, and actually for grocery and retail, we think that the number can be well over 2% based on what we see in terms of competitors, what we see in terms of what Amazon is doing. The focus for us with sponsored listings right now is increasing the number of monetizable impressions per user session through introducing new ad formats and placements, and really increasing the monetization of search in a smart way that doesn’t hurt the core consumer experience, so we have holdout to make sure that advertising is a complement to our eater experience and at the same time is a targeted way for merchants to reach their audience. If you think about sponsored listings, sponsored listings tend to improve audience for a particular merchant, and then merchant-funded offers, because of the price nature of those offers, tends to improve conversion as well. For Uber profitability, the sponsored listings business is more profitable for Uber but we think merchant-funded offers are a very important strategic part of our drive to improve the affordability of the overall marketplace, and increasingly we’re working with merchants to be able to move money from sponsored listings to merchant-funded offers in a back and forth and a targeted way to achieve what their goals are. The team is doing a great job. We continue to invest in our sales team, and the technical teams continue to ship some pretty impressive product out there."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"content": "Let me give you one metric we haven’t shared before, and that is globally, restaurant-funded offers or merchant-funded offers have grown 70% year-over-year."
},
{
"speaker": "John Colatuoni",
"content": "Thank you both."
},
{
"speaker": "Dara Khosrowshahi",
"content": "All right, can we get the next question? Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Ross Sandler with Barclays. Your line is open."
},
{
"speaker": "Ross Sandler",
"content": "Hey guys, one more follow-up on ads. With talk about getting to 1.6% of gross bookings for ride hail ads, so I know we talk about delivery ads quite a bit, but what’s the status of your ride hail side advertising business of late? Then the letter mentioned the Instacart initial read. Can you provide a little bit more color on what you’re seeing thus far from the Instacart partnership? Thank you."
},
{
"speaker": "Dara Khosrowshahi",
"content": "Yes, absolutely. For mobility ads, we haven’t introduced a target in terms of the percentage of gross bookings. We are very, very sensitive to the fact that people come to Uber looking for a ride first, and to the extent that we introduce them to some of the premium brands that are advertising with us, we want to make sure that that experience is an excellent experience for the rider and also an excellent experience for the advertiser. It’s resulting in some very strong ad engagement from riders - click-through rates are over 2.5% compared to industry averages that are less than 1%, so I think for us, the focus is more on quality versus quantity, and I think that we’ll continue that focus going forward. The contribution of advertising is very, very positive in terms of newer ad formats that we are introducing, improving targeting capabilities, and then also investments in measurement and attribution for our ad partners, so we’re very, very happy with the progress here, but I don’t want to put a percent target because the experience of the rider comes first. In terms of Instacart and the trends there, we’re very encouraged by the trends there. We talked about Instacart baskets being 20% higher than our base basket sizes, and we’re seeing the demand come from a lot of suburban markets - you know, it kind of matches the Instacart geographic penetration, so we do think that the incrementality of the volume from Instacart is quite strong, and I’d say so far the partnership has been an excellent one."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"content": "Maybe just a reminder to folks, we only went live in the second quarter of ’24, where Uber Eats is live on the Instacart app, so it’s still early days. All right, can we take our final question?"
},
{
"speaker": "Dara Khosrowshahi",
"content": "Yes, let’s do it."
},
{
"speaker": "Operator",
"content": "Your final question comes from the line of Mark Mahaney with Evercore. Your line is open."
},
{
"speaker": "Mark Mahaney",
"content": "Okay, thanks. Two questions please. On the TAM comment, Prashanth, that you made earlier, I think you said in your top 10 markets, less than 20% penetration. My recall is that about a year ago, you’d said it was a little under 10%, so you’ve had nice growth there. Are there particular markets where you could--like, what are you lead markets, like how high have you seen that penetration go? I assume that you’re going to be able to go higher than 20%, but any clues you’ve seen in the markets that you’ve been in, that tell you how high that could go would be helpful. Then could you also talk overall about subsidies and incentives for drivers and consumers and where those are now, and is this something that’s kind of a flat line expense going forward? Is there more leverage as a percentage of bookings, or even in absolute dollars, how do you think about those incentives and subsidies going forward? Thanks a lot."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"content": "Yes, thanks for the question. I think a good frame of reference, or an example to help you with that TAM, if the United States was to move to the TAM penetration that we are seeing in the U.K., that’s worth another $13 billion in gross bookings, so call it 8% or so of our current run rate, just by moving the U.S. to the U.K. We know the opportunity is there. Brazil, I think is another great example where we’re seeing really explosive growth. The frequency in Brazil is a really impressive number that also I think is a great metric for how we have confidence as we continue to feed more markets and continue to expand our mobility products’ availability, reliability into more geographies. That’s going to continue to provide runway, and that sort of links into your second question, which is as we think about balancing supply and demand, I would say the overall sentiment at a global level today is that supply is in a better position than it has historically been. That may not be true in all markets, but at a global level, it is. What that allows us to do is to pivot those incentive dollars into driving demand, and one of the challenges, I think as the leadership team at Uber faces is we have so many areas that we could pivot those dollars into, and they greatly exceed our ability to fund within our financial framework that we gave you, so much of the time is spent on capital allocation to ensure that we are both making decisions that are right for the near term in terms of continuing to make sure the market is liquid, but also providing the right incentives that we need to continue to fund future growth products. I think our Teams product, as an example, which is one that we’ve launched, and I may ask Deepa to help me here with the metric, I think Teams’ user base is up--was it up 100% Deepa, am I remembering the number right? Yes, up 100%, and that’s a relatively new product that we’ve launched but that takes some investment to increase awareness about the product, but once you’ve done that--sorry, it’s trips, trips that were up, so those are the trade-offs, I think that we continue to make a decision on. This quarter, we opened up Hungary--sorry, we opened up Luxembourg, and last quarter we opened up Hungary, so we’re continuing to find new geographies as well as expanding in existing countries into new areas. Look for us to continue to make that balance while trying to stay within that great operating framework we gave you of driving mid to high teens GB growth with higher 30% to 40% EBITDA over the next three years."
},
{
"speaker": "Mark Mahaney",
"content": "Thank you Prashanth."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"content": "I think with that, we’re going to wrap the call and we’ll turn it back to you, Dara."
},
{
"speaker": "Dara Khosrowshahi",
"content": "Yes, thank you very much everyone for joining the call, and a huge thank you to the team at Uber. Prashanth and I and Deepa get to talk to investors about all the accomplishments and the consistent execution of the team, but it’s actually the teams on the ground, the technical teams who deliver in good markets, bad markets, uncertain markets, and we certainly wouldn’t have the kind of execution that we’ve had without everyone at Team Uber contributing, so big thank you to Team Uber."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"content": "And just a reminder, we’re going to be on the west coast, in Chicago, in New York, and in Europe in the coming quarters, so we’re very accessible for folks. Reach out to Deepa if you want to see us."
},
{
"speaker": "Dara Khosrowshahi",
"content": "Awesome. We’ll talk to you next quarter. Thank you again."
},
{
"speaker": "Operator",
"content": "This concludes today’s conference call. We thank you for joining. You may now disconnect."
}
] |
uber | 2,024 | 1 | [
{
"speaker": "Operator",
"content": "Thank you for standing by. My name is Sarah, and I will be your conference operator today. At this time, I would like to welcome everyone to the Uber Q1 2024 Earnings Conference Call."
},
{
"speaker": "",
"content": "[Operator Instructions] I would now like to turn the conference over to Deepa Subramanian, VP of Investor Relations and Corporate Finance. You may begin."
},
{
"speaker": "Deepa Subramanian",
"content": "Thank you, operator. Good morning, and thank you for joining us today, and welcome to Uber's First Quarter 2024 Earnings Presentation. On the call today, we have Uber's CEO, Dara Khosrowshahi; and CFO, Prashanth Mahendra-Rajah."
},
{
"speaker": "",
"content": "During today's call, we will present both GAAP and non-GAAP financial measures. Additional disclosures regarding these non-GAAP measures, including a reconciliation of GAAP to non-GAAP measures, are included in the press release, supplemental slides and our filings with the SEC, each of which is posted to investor.uber.com."
},
{
"speaker": "",
"content": "Certain statements in this presentation and on this call are forward-looking statements. You should not place undue reliance on forward-looking statements. Actual risks may differ materially from these forward-looking statements, and we do not undertake any obligation to update any forward-looking statements we make today, except as required by law. For more information about factors that may cause actual results to differ materially from forward-looking statements, please refer to the press release we issued today as well as the risks and uncertainties described in our most recent Form 10-K and in other filings made with the SEC."
},
{
"speaker": "",
"content": "We published our quarterly earnings press release, prepared remarks and supplemental slides to our Investor Relations website earlier today and we ask you to review those documents, if you haven't already. We will open the call to questions following brief opening remarks from Dara. With that, let me hand it over to Dara."
},
{
"speaker": "Dara Khosrowshahi",
"content": "Thanks, Deepa. Our results this quarter once again demonstrate our ability to deliver consistent, profitable growth at scale. Uber is off to a solid start in 2024 with trips up 21% year-on-year, consistent with our gross bookings growth rate on a constant currency basis. Our audience expanded by 15%, while frequency grew 6%, underpinned by 7.1 million drivers and couriers on our platform. At the same time, record adjusted EBITDA of $1.4 billion grew 82% year-over-year, and we generated $4.2 billion of free cash flow over the last trailing -- over the trailing 12 months."
},
{
"speaker": "",
"content": "We're making good progress on many of the initiatives we laid out for 2024 in our last earnings call. Demand for Uber remains strong. And just last week, we hit another best week ever for gross bookings, and we expect to deliver another quarter of over 20% year-on-year growth on a constant currency basis in Q2."
},
{
"speaker": "",
"content": "With that, operator, can you open up for questions?"
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Your question comes from the line of Justin Post with Bank of America."
},
{
"speaker": "Justin Post",
"content": "I guess, Dara, a lot of press on Tesla and robotaxi efforts lately. How are you thinking about AV impact on Uber and potential for new competition?"
},
{
"speaker": "",
"content": "And then maybe, Prashanth, it looks like stable bookings growth outlook in the low 20s in the second quarter, excluding FX. Anything to call out on headwinds or tailwinds? And any changes to your outlook, mid- to high teens growth, as you think about bookings in the second quarter?"
},
{
"speaker": "Dara Khosrowshahi",
"content": "Prashanth, you want to talk to the second question first..."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"content": "Yes, why don't I -- let me get that one out of the way, Justin, and thank you for the question. So just a recap for how we'd like folks to think about our gross bookings. Remember, the growth algorithm is audience, which is a measure of how many users of the product; frequency, how often are they using the product; and then, of course, pricing. Dara just mentioned that for the first quarter, we had very strong audience growth, up 15%. Great growth in frequency as well, up 6%. And pricing relatively flattish."
},
{
"speaker": "",
"content": "So we see similar trends expected for the second quarter, and that's what's implied in the guide in terms of the composition of that growth algorithm. Demand for the products remains strong. I think we're expecting another quarter of pretty consistent scaled top line growth of over 20%. Actually, if you think of the guide that we gave for Q2, it's almost identical, both at the midpoint and at the range to what you gave -- what we gave for Q1. So very consistent performance, and we're exactly where we want to be with respect to the 3-year CAGR outlook that we gave you in February."
},
{
"speaker": "",
"content": "Maybe just a little bit of color on the Q2 guide. We included in the press release some notes on FX headwinds. So we want -- I did want to call that out. We've got about 5 percentage points of headwind to Mobility's year-over-year gross booking growth, primarily coming from the Argentine peso. So said another way, we still expect Mobility to grow in the mid-20s range at a constant currency basis."
},
{
"speaker": "",
"content": "I'll also highlight that in the prepared remarks, I made a comment about this, we expect Mobility's adjusted EBITDA margins to be down slightly quarter-over-quarter given that we did hold back some investments in Q1 and we would not do the same here for Q2. So with that, let me pass to Dara, and he can take the AV question."
},
{
"speaker": "Dara Khosrowshahi",
"content": "Justin, in terms of AVs and our strategy, it really remains the same. First thing I would say is that we think that the AV technology at maturity is going to be very good for the industry. It will be great for Uber. It holds a promise of safer rides. It holds a promise of expanding the marketplace by lowering prices and making mobility, delivery available for a wider swath of the population. And usually, when we see kind of lower prices for any service, you see higher adoption for a service, and that really is the promise of AV."
},
{
"speaker": "",
"content": "At the same time, we think that the technology is going to take a lot of time to develop. Obviously, there has to be a regulatory framework to put in place. And as the technology develops, we think that actually you're not going to make a jump from one tech -- human drivers fully to AV. There's going to be a relatively long period, a transition period that happens. Where for example, on Uber, you see it now, you have a combination of human drivers during -- human drivers fulfilling certain rides or deliveries or even loads on the trucking side along with AVs as well. And over period of time, you'll see kind of the penetration of AVs increase. I think it's very difficult to predict that period of time."
},
{
"speaker": "",
"content": "But really, what we bring is the systems that we put in place, the pricing, matching, routing algorithms, the payments systems that we have on a global basis as well as the demand that we bring that enables us to partner with these AV providers to really drive utilization of their assets, this is very expensive tech that's been developed over a long time. And if you're an AV fleet owner or you are an individual owner of a car, whether that's a Tesla or another kind of car, you're just going to make more money and make a higher kind of return on your investment if you plug in your AVs into the Uber ecosystem and into Uber demand."
},
{
"speaker": "",
"content": "So we think we bring lots to the table. We're looking to partner with the AV industry. I do think that there's a good amount of excitement over some of the newer technologies and kind of the imitation models that we see in terms of AV. And you see that promise with Tesla's FSD. It looks like a great product. And also, you see that same promise in a lot of smaller players, whether that's a Wayve in the U.K. who got funded for $1 billion, a Waabi that, for example, we have investments in, these imitation learning models have a lot of promise over kind of the more classic heuristic-based development that you saw with AV."
},
{
"speaker": "",
"content": "And we think it's going to allow more players into the marketplace. We think it's going to reduce the amount of capital required to develop these systems over a long period of time. And we're looking to partner with big players and small players. And again, as this technology develops, we think we will be a big partner in it, and we think, ultimately, it will benefit AV players and it will benefit ourselves and riders and eaters as well."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Brian Nowak with Morgan Stanley."
},
{
"speaker": "Brian Nowak",
"content": "I have 2. The first one, Prashanth, I want to go back to that -- the comment in the prepared remarks that you just referenced about intentionally holding back some investments with lower ROI. Can you just sort of help us unpack it a little bit? What areas of investments did you hold back on? And sort of how do we think about the driver-versus-rider incentives or investment strategies as you go throughout the course of the year to drive durable growth?"
},
{
"speaker": "",
"content": "Then the second one, sort of wanted to hone in a little bit on Latin America. There's been some comments from one of your competitors in Latin America about potentially pulling back investment there. One, I'd be curious to hear about your -- what you're seeing in Latin America. And just remind us, what was the base case outlook for Latin America in the Analyst Day guidance that we got in February?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"content": "Thanks, Brian. Let me start then. So maybe as a reminder, when we think about investments on a quarterly basis across the market, we think about investments as what do we need to do to encourage drivers and couriers to come on to the platform, what can we do to be helpful to bring merchants to the platform. And then lastly, what can we do to encourage consumers. So we rotate among those 3 on a quarterly basis based on what we are trying to drive in the different markets in which we operate."
},
{
"speaker": "",
"content": "For the first quarter in Mobility, because of the seasonality trends in the first quarter, the return we get on some of those investment dollars tends to be lower than we see later in the quarter just because of seasonal patterns. And because that ROI is lower, it didn't make sense for us put as much into the first quarter as we would in other quarters. So you'll see us ramp that back up in 2Q. We called it out purely to keep folks from running too far ahead with enthusiasm on Mobility margin improvement. We are very confident that Mobility is still on a great trend for continuous margin improvement. But just from a timing standpoint, we didn't want to -- we wanted to acknowledge some of the lumpiness that you are likely to see."
},
{
"speaker": "Dara Khosrowshahi",
"content": "Yes. And I think in terms of Latin America and the competitive environment there, first thing I'd say, I'm assuming you're asking about Mobility, we're seeing very healthy Mobility volume growth in Latin America, in mid-20s. So we like the market, and we certainly like the volumes that we're seeing there. I would say that while -- I think you're referring to DiDi, they signaled a bit more capital discipline, we're not seeing that as of yet. We see DiDi being highly competitive in the marketplace and spending into the marketplace quite aggressively. Listen, it could be temporary. It might be driven by their desire to show international growth as the China markets have slowed down a bit as the prep for the IPO, but it's difficult for us to speculate on that."
},
{
"speaker": "",
"content": "And I'd say, we've seen this behavior before, Brian. And we have a very strong record of effectively responding to defend our category position when our competitors spend up and we do the same thing, and typically, we're much more efficient than our competition in terms of financial efficiency, network efficiency, et cetera. But at this point, we see DiDi leaning in, certainly not leaning out. And we are leaning in as a response, just like we do with other competitors all around the world. The good news for us is we have a very strong P&L, you see our margins continue to increase, so we have lots of pockets of investments to reach into, but we are going to be aggressive."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"content": "Brian, just to shout out for the note last week, I thought that was nice. And we're very much aligned with the more public participants in this market, the better it is for everyone."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Doug Anmuth with JPMorgan."
},
{
"speaker": "Douglas Anmuth",
"content": "I just wanted to go back to the decel that you saw in monthly trips for MAPC in 1Q. Just hoping you could unpack that a little bit in terms of LatAm and some of the holiday impact there and what that means in 2Q."
},
{
"speaker": "",
"content": "And then, Dara, can you just talk more about your Delivery strategy in the suburbs, the key levers to success there? And then how you think the Instacart partnership fits in as well?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"content": "Yes. Let me take the first part of that. So again, the Mobility gross bookings growth for the first quarter was -- on a constant currency basis was 26%. Included in that 26% is about 1 point, whether you look at it sequentially or on a year-over-year basis, that came from us deconsolidating the non-ridesharing portion of our Careem business in December. Remember that used to be included in Mobility's results. And when we split that out, you have it in the compares, but you don't have it in Q1. So that's roughly about 1 point."
},
{
"speaker": "",
"content": "And then from a more seasonal impact, we'd call out 2 items. First, in Latin America, last year, we saw stronger demand in Brazil around Carnival that we did not see recur in Q1 of this year. And then from a timing standpoint, both Easter and Ramadan shifted on us between the quarters. So again, on a comp basis, that creates some lumpiness. But overall, I would say that we are very much -- remain confident on the growth of the Mobility business. Again, mid-20s year-over-year at constant currency for Q2. Sort of very consistent with what was done in Q1. And the -- as we mentioned in Dara's opening remarks, audience and frequency are both strong at the overall Uber level and remain very strong at the individual LOB levels."
},
{
"speaker": "Dara Khosrowshahi",
"content": "Yes. And Doug, in terms of our suburban strategy for Eats, it's very similar to our general strategy for our Delivery business on a global basis. We're very happy about our growth rates here, 17% constant currency growth rates for the second quarter in a row. Our U.S. growth rates are higher than that -- our U.S. and Canada growth rates are actually higher than that, which we're quite happy about. And generally, we are growing faster in the suburbs than we are in urban destinations, where we have higher penetration."
},
{
"speaker": "",
"content": "And it's about getting the basics right. Building an audience and a brand, increasing selection, making sure we've got pricing right and making sure the quality of the service continues to be high. And really with the Instacart deal that we have, represents the addition of a very high-quality and highly targeted audience, suburban audience, to the Uber Eats ecosystems and to our merchants. And we think that additional demand from this high-end consumer is going to be welcomed by our merchants. And at the same time, we continue to increase, for example, penetration with Domino's and a bunch of other merchants in the suburbs."
},
{
"speaker": "",
"content": "So we think that we're well positioned to continue to grow into the suburbs, and we definitely think that the Instacart deal puts us in a better position for growth going forward in the suburbs."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Eric Sheridan with Goldman Sachs."
},
{
"speaker": "Eric Sheridan",
"content": "Maybe a 2-parter on Uber One. Would love to learn anything that you've sort of continued to evolve and develop with respect to Uber One internationally as some of those markets have rolled out and they've begun to scale the longer Uber One has been available in some of the more overseas markets?"
},
{
"speaker": "",
"content": "And second, you have the call out in the prepared remarks around the subscription revenue run rate, what do you see as some of the biggest white spaces to drive more subscription revenue, but also continue to add more value and depth to Uber One at the subscription layer in terms of incentivizing adoption?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"content": "Before Dara jumps into that, I just want to remind everyone on what the -- is being referred to. We announced in the prepared remarks that our Uber One membership fees are now in excess of $1 billion. So that's a -- that's the first time we've called that out, but it's a big waypoint for us on our way to continue driving that."
},
{
"speaker": "Dara Khosrowshahi",
"content": "Yes, Eric, in terms of our strategy for Uber One internationally, it's largely the same as our strategy domestically and globally. It's a global product. We see penetration of Uber One consistently increasing in the U.S., Canada and internationally. Members are now generating 32% of Mobility and Delivery gross bookings, which are nicely up year-over-year. It's over 45% in Delivery gross bookings, where generally kind of were -- more highly penetrated. And I'll remind folks that members spend 3.4x as much as nonmembers per month. So it is a great vehicle for us to drive adoption and drive really attachment with our various services as well."
},
{
"speaker": "",
"content": "We are kind of working on a bunch of pretty exciting new initiatives. One that I would call out is continuing to optimize on the use of Uber Cash on the Mobility side. On Delivery, you get a discount on -- you don't have a delivery fee, you get a discount on your food often. With Mobility, you get back Uber Cash. And actually, 25% of Uber Cash earned on Mobility in the U.S., for example, is being redeemed on Delivery, and that's up from the mid-teens when we originally rolled out the benefit. Business riders also get Uber Cash, which is pretty cool. And we're seeing over 60% of the Uber Cash that's earned on Mobility actually redeemed on Delivery as well."
},
{
"speaker": "",
"content": "So we think that membership is a powerful lever in terms of general penetration into our marketplace and the frequency growth that we're seeing, but it's also a great lever in terms of using Uber Cash and introducing more of our users to the Delivery benefit as well. In terms of Mobility, we do think that we can penetrate more deeply into Mobility and like we're now introducing cash-back accelerators, where you can increase the cash-back amount for any product to the extent that we're trying to drive a product or quest that encourage users to use more premium products as well but carry higher margins for us."
},
{
"speaker": "",
"content": "You will see more member exclusives coming up where members have exclusive access to events and experiences, which will kind of surprise and delight our members. And then lastly, I would say that we are now moving more of our members on a global basis to annual pass. Annual pass actually results in significantly higher retention rates. So we'll cut the -- our members are able to save money, so to speak, and we see it in the retention benefits. And that has resulted in retention increasing nearly 200 basis points on a year-on-year basis in March, for example."
},
{
"speaker": "",
"content": "So there's a lot going on. We think we are -- there's a ton of white space as it relates to our membership product. We're very pleased with $1 billion in revenue, but we think that there's a lot more growth there in membership generally and in terms of membership revenue."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Nikhil Devnani with Bernstein."
},
{
"speaker": "Nikhil Devnani",
"content": "Dara, I wanted to ask about U.S. rideshare growth. First, is it keeping pace with your mid-20s growth overall for the business? And then second, can you talk a bit more about where the growth is coming from? Obviously, the service is not new anymore. So it feels like it's more frequency led but is there still a healthy supply -- or healthy funnel, sorry, of new customer acquisition that you're still finding maybe it's suburbs or smaller cities or new demos, however you want to frame it. But just your overall thoughts on how this growth sustains would be very helpful."
},
{
"speaker": "Dara Khosrowshahi",
"content": "Yes. See, in terms of U.S. Mobility growth, we don't disclose U.S. versus non-U.S. But obviously, by the overall numbers that you see in terms of our Mobility growth, 26% on a year-on-year basis compared to 28% last quarter and 100 basis points of kind of slowdown was because of Careem on a comparable basis. These are very, very high growth rates, and the U.S. is our largest market in terms of gross bookings. So we wouldn't be able to grow at these rates, so to speak, without the U.S. growth being very, very healthy."
},
{
"speaker": "",
"content": "In terms of where Mobility growth is coming from, I'd say the significant -- the most significant part of growth is coming from audience. Our MAPC growth in Mobility was up 17% on a year-on-year basis, overall, 15%. So the audience growth for Mobility is actually growing faster. And one particular area of growth that we're seeing is our new products. When you look at our Hailables product, U4B, our new Health business, Reserve, UberX Share, all of these products, kind of our new growth bets, are growing 80% year-on-year. But at the same time, over 20% of our new customers are coming from this new product category as well. So it's a good business. It's growing very, very quickly, but it's also introducing a whole new audience into our marketplace."
},
{
"speaker": "",
"content": "Last thing that I would add is that with the pandemic, I think a lot of people who were kind of commuting to work, et cetera, stopped commuting. We have lost some of our most frequent customers. We see the weekday commute use case being particularly strong as people are coming back to work. Some folks may not like that, but we love it here at Uber, people getting back to work and getting back to the office. So there is an audience who kind of stopped using us as frequently as they used to. We were kind of a daily habit. And hopefully, we will see that audience come back, and we're seeing evidence of that in terms of the weekday volumes being super strong."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Ross Sandler with Barclays."
},
{
"speaker": "Ross Sandler",
"content": "Great. The prepared remarks flagged a bunch of new features in the advertising business, enterprise features. So can you guys give us an update on where we are with the non-restaurant advertising as a percentage of just the total advertising ARR?"
},
{
"speaker": "",
"content": "And then somewhat related, with the new Instacart partnership, can we sell advertising against that engagement? And I guess just how does the Instacart partnership change your own -- your kind of O&O efforts in U.S. grocery? And how are the unit economics going to work in this partnership?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"content": "Ross, it's Prashanth. Let me start just with a couple of data points and then hand off to Dara. First, as a reminder to everyone, we hit a $900 million run rate for advertising in Q4 of 2023. We do not break that down between Delivery and Mobility."
},
{
"speaker": "",
"content": "And then on the Instacart arrangement, as Dara had mentioned and we discussed yesterday, when folks click through Instacart and they come to the Uber Eats WebView app, that was -- our ads and those are our -- that's our space to use and monetize. So with that, let me pass off to Dara to make some more comments."
},
{
"speaker": "Dara Khosrowshahi",
"content": "Yes. In terms of the non-restaurant advertising, listen, it's still really in nascent stages. So we talked about restaurant advertising getting to 2% of gross bookings. We actually think that our sponsored items, product, for example, grocery, can get the higher percentages of that. Instacart, for example, we think, is in the mid-2s in terms of advertising as a percentage of gross bookings. And we fully launched out our sponsored items in the U.S. and Canada, and now we're scaling it in 8 additional priority markets in 2024."
},
{
"speaker": "",
"content": "So I'd say like sponsored items is where we were in sponsored listings for restaurants 3 years ago. We gave you a very clear growth map to $1 billion in terms of revenue, and we're going to beat that this year. And we're quite confident we can start moving in a similar direction as it relates to nonrestaurant-sponsored items in the grocery space. We're already active with about 500 top CPG brands, and we're seeing very strong retention as we expand. And really, it's going to be about the growth of the underlying grocery platform."
},
{
"speaker": "",
"content": "As we increase grocery audience -- this last quarter about 15% of our monthly actives on Eats bought from grocery. That's up nicely on a year-on-year basis. As that audience increases, we think we can monetize that audience with the base business. But with advertising just as we've done with restaurants, and we think it's -- it can be an enormous opportunity, and it can be a high-margin opportunity as well."
},
{
"speaker": "",
"content": "I would also point out that we're quite bullish on a rider ads. We're seeing very strong engagement from riders, a click-through rate of about 2.5%, more than 2.5% compared to an industry average of less than 1%. So video ads and tablets continue to be a very promising growth area for us, and we're quite happy to see the progress there."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Mark Mahaney with Evercore."
},
{
"speaker": "Mark Stephen Mahaney",
"content": "Two questions, please. I think in the prepared remarks, you talked about delivery, MAPC growth accelerating in markets like the U.S. Can you go into the -- why MAPC growth accelerated for you? And then secondly, in Delivery, grocery and retail delivery, can you talk about what impact that's having on segment margins or what the unit economics are there -- are like there? Or yes, how much of a drag or when do you see a path to profitability? And maybe it's already there for those 2 segments, but just talk about the impact of those 2 segments on the Delivery's overall profitability."
},
{
"speaker": "Dara Khosrowshahi",
"content": "Yes, Mark. So in terms of delivery growth and audience growth, this has been pretty consistent, right? We've accelerated the growth rate of our Delivery business. It was growing closer to 10% early last year. It's now growing in the teens. And we think the nature of that growth is improving as well, which is most of the growth last year was on price. Now actually, price is a relatively small portion of the growth, and audience and frequency are the largest portion of the growth in Delivery. And it is about just getting the basics right. It's about having a great service, having a significant selection, or selections. Active merchants is up 12% on a year-on-year basis."
},
{
"speaker": "",
"content": "It's about improving pricing. So for example, merchant-funded promos, these are -- merchants put in promos, pricing promos into the marketplace in order to drive volumes. Those are up 100 basis points on a year-on-year basis. Again, lowering effective price to the consumer. And then it's about quality. We continue to improve our defect rates. All that adds up to higher frequency, higher retention of audience. And we continue to spend aggressively in terms of marketing our brand. We think the Uber Eats brand is a top brand out there. And then on top of that, of course, we've got the unique platform benefits of our Mobility business that continues to grow audience, throwing over some of that audience to our Delivery business."
},
{
"speaker": "",
"content": "So this is all part of the formula that we have in this journey that we've been on over the past couple of years. We're able to do so while we're increasing margins because of the efficiency that we are getting in our marketplace, because of the efficiency, the kind of structural benefits that the platform brings, and we see no signs of that slowing down. Prashanth, do you want to talk about grocery, retail?"
},
{
"speaker": "Prashanth Mahendra-Rajah",
"content": "Yes. I'll take the last part of that. So we remain very positive on grocery and retail. The business growth remains quite strong. GBs are up about 40% on a constant currency basis. Once again, 40%, so very strong top line there. And despite that very strong growth, we were still able to expand our Delivery EBITDA margins by about 20% sequentially, and that was partly contributed to by improvement in the profitability of the grocery business. So it is still not where we want it to be. It's still not at a positive EBITDA margin, but it is improving both year-over-year and sequentially, and we feel very good about the path we have to getting to profitability on grocery."
},
{
"speaker": "",
"content": "It's going to come from a couple of items. First, the power of the platform, which we refer to quite frequently here. About 15% of our Delivery users are ordering on -- are ordering groceries, and that's up set from where we left Q4. Continuing to see opportunities on ads, which are great margin accretive for us as we bring those CPG players into the platform for grocery advertising. Being able to lower some of the consumer promotions we have. So overall, a number of different drivers. And we think that grocery will eventually be a very strong part of the overall portfolio."
},
{
"speaker": "",
"content": "With that, I think we have time for our final question, operator. So if we could go to that."
},
{
"speaker": "Operator",
"content": "Your final question comes from the line of James Lee with Mizuho."
},
{
"speaker": "James Lee",
"content": "Two here on Delivery. Can you guys give us an update on maybe the European gig economy regulation, maybe what policy we should pay attention to, and how should we think about implication of labor costs? And maybe on the U.S. side, can we get a sense of the impact of minimum wage in Seattle and New York on GB and EBITDA? And how do you guys plan to mitigate impact going forward?"
},
{
"speaker": "Dara Khosrowshahi",
"content": "Yes. As far as the EU platform work directive, EU lawmakers essentially voted to maintain a status quo there, with platform worker status continuing to be decided on a country-by-country basis. Member states have until mid-2026 to implement that. And we think that the deal is really unlikely to bring major changes to the current situation in the vast majority of EU countries. And for us, our view remains the same, which is we believe that we should bring kind of the flexibility that gig works brings to couriers, to drivers in the marketplace, along with certain protections that we kind of talk to and have discussions with on a local basis. So we really don't see any changes coming in terms of the EU."
},
{
"speaker": "",
"content": "In terms of the -- Seattle and New York, I think some of the regulation that we've seen has actually been very unpopular with couriers, restaurants and customers. So for example, we saw in Seattle, which is a relatively small market for us, Delivery order volumes decreasing by 45%, which has resulted in courier wait time actually increasing 50% on a year-on-year basis. So couriers may be making more per order, but they're getting a lot less orders, which has resulted in 30% of active couriers actually leaving the platform, which I think is certainly not what the City Council had in mind."
},
{
"speaker": "",
"content": "So we're actually seeing the City Council in Seattle, for example, bring forward a reform in Seattle to make the standard lower and much more viable for the platforms. We're not there yet. But there's a vote coming up in -- I think it's actually tomorrow, and we think we'll have a positive outcome there. And it's important that it's a positive outcome for couriers and restaurants and customers, because certainly, the Seattle -- the regulation that has been in place in Seattle has clearly been poor regulation that has hurt the people that they're supposed to protect."
},
{
"speaker": "",
"content": "We'll see what happens in New York City. Unfortunately, again, in New York City, we have had to essentially slot couriers, and we've got a waitlist of over 20,000 couriers who want to be on the platform. But because of that regulation, we've had to reduce the number of couriers on the platform by close to 25% since the standard went in place. So less people get to earn in New York, we don't think that's a good thing."
},
{
"speaker": "",
"content": "Now again, we have been able to absorb the financial hit of all these different regulations in our platform. You've seen in our profitability, which is up over 80% in Uber Eats on a year-on-year basis. So we're a big company. We have a lot of markets. We're quite diversified. Our technology continues to drive a more effective marketplace that allows us to absorb these regulations. But I think couriers in New York City who want to work, couriers in Seattle who want to work, they're getting hit hard by these regulations, and we're hoping that kind of regulators see the right path going forward because, so far, regulation has definitely hurt the people that it's supposed to protect."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"content": "Okay. Before Dara wraps it up, I wanted to remind everyone next week is our annual Uber GO-GET. This is our event which showcases new products and features across both the Mobility and Delivery. Obviously, we're not going to get ahead of the announcements, but our theme is togetherness. And in addition to the product piece, we've got a great fireside chat with Dara and Maria Shriver. This will be in New York. So if any of you are looking to get out of the office, please reach out to Deepa and we can see what space we have."
},
{
"speaker": "",
"content": "If you do join us, my only request is you travel by Uber. And with that, let me have Dara wrap it up."
},
{
"speaker": "Dara Khosrowshahi",
"content": "I like it. My CFO is upselling. And thank you, everyone, for joining us on the call, and a huge thank you for the Uber teams. There's a ton of work that goes into all of the new products that we're launching, into the products that we'll be talking about in GO-GET, and into delivering the kind of growth and profitability that we've seen from Uber over the past couple of years. So a big thank you for the team for continuing to deliver this quarter."
},
{
"speaker": "Prashanth Mahendra-Rajah",
"content": "Thanks, everyone. Talk to you next quarter."
},
{
"speaker": "Operator",
"content": "This concludes today's conference call. Thank you for joining. You may now disconnect your lines."
}
] |
udr | 2,024 | 4 | [
{
"speaker": "Operator",
"content": "Greetings, and welcome to UDR's Fourth Quarter 2024 Earnings Call. [Operator Instructions]. As a reminder, this conference call is being recorded. It is now my pleasure to introduce your host, Vice President of Investor Relations, Trent Trujillo. Thank you, Mr. Trujillo, you may begin."
},
{
"speaker": "Trent Trujillo",
"content": "Thank you, and welcome to UDR's quarterly financial results conference call. Our press release, supplemental disclosure package and related investor presentation were distributed yesterday afternoon and posted to the Investor Relations section of our website, ir.udr.com. In the supplement, we have reconciled all non-GAAP financial measures to the most directly comparable GAAP measure in accordance with Reg G requirements. Statements made during this call, which are not historical, may constitute forward-looking statements. Although we believe the expectations reflected in any forward-looking statement are based on reasonable assumptions, we can give no assurance that our expectations will be met. A discussion of risks and risk factors are detailed in our press release and included in our filings with the SEC. We do not undertake a duty to update any forward-looking statements. When we get to the question-and-answer portion, we ask that you be respectful of everyone's time and limit your questions to one plus a follow-up. Management will be available after the call for your questions that did not get answered during the Q&A session today. I will now turn the call over to UDR's Chairman and CEO, Tom Toomey."
},
{
"speaker": "Tom Toomey",
"content": "Thank you, Trent, and welcome to UDR's Fourth Quarter 2024 Conference Call. Presenting on the call with me today are President, Chief Financial Officer and Chief Investment Officer, Joe Fisher; and Chief Operating Officer, Mike Lacey. Senior Officer, Andrew Cantor, will also be available during the Q&A portion of the call. First, I'd like to congratulate Mike on his well-deserved promotion to Chief Operating Officer; and Joe for his appointment as Chief Investment Officer. Both Mike and Joe have been exceptional leaders, driven value creation and have positively influenced UDR's culture. As Joe transitions from his role as CFO, we have commenced an executive search process to fill this critical role. We are early in process and we'll update you as progress is made. Moving on, in conjunction with our earnings release, we published a presentation that highlights our outlook for 2025, completed with what we see as the drivers of potential outcomes. Our prepared remarks align with the presentation, and those on our webcast can see the slides on your screen. We will resume our usual format for the balance of earnings calls in 2025. Next, turning to Slide 4. Key takeaways from our release and 2025 outlook are: one, fourth quarter and full year 2024 FFOA per share results, net guidance expectations, while same-store results exceeded our guidance midpoints. Two, based on consensus estimates, we expect economic growth and apartment demand will remain resilient in 2025. This growth profile should be enhanced by supply pressures abating in the back half of the year from the historically high levels experienced in 2024. Three, ongoing investments in innovation, including advancing our customer experience project should continue to drive incremental NOI growth in excess of the broader market in 2025. Fourth, despite and elevated cost of capital, we are positioned to take advantage of external growth opportunities when appropriate. We will continue to utilize various sources of capital, including existing joint ventures and operating partnership unit deals to accretively grow the company while heating cost of capital signals. Fifth and final, our balance sheet is well positioned to fully fund our capital needs in 2025 and beyond. With that, I'll turn the call over to Joe."
},
{
"speaker": "Joseph Fisher",
"content": "Thank you, Tom. Topics I will cover today include our fourth quarter and full year 2024 results, including recent transactions, the 2025 macro outlook that drives our full year guidance, and the building blocks of our 2025 guidance. First, beginning with Slide 5. Our fourth quarter and full year FFO as adjusted per share of $0.63 and $2.48 achieved the midpoint of our previously provided guidance. Additionally, our same-store results meet expectations with NOI growth that was above the high end of our guidance range. During the quarter, we shifted to an occupancy-focused strategy similar to the fourth quarter last year and built occupancy going into 2025. Occupancy trended sequentially higher for each month during the fourth quarter, resulting in a 50 basis point sequential improvement versus the third quarter. As anticipated, this occupancy trend resulted in slightly lower blended lease rate growth versus original fourth quarter expectations but the right decision to maximize NOI in 2024 and place our portfolio in a position of strength as we enter our traditional leasing season. Thus far in 2025, we have maintained occupancy above 97% which is approximately 30 basis points higher than our fourth quarter average. Underlying market rent growth has turned positive sequentially and is following normal seasonal patterns. New lease rate growth has largely bottomed across our regions and renewal lease rate growth remains healthy in the mid-4% range. We are encouraged by these results. Turning to Slide 6 and our macro outlook. As in years past, we utilized top-down and bottom-up approaches to set our 2025 macro and fundamental forecast. Our 2025 rental forecast of 2% and was informed by third-party forecast and consensus expectations for a variety of economic factors that drive rent growth and our internal forecasting models. Among the positive factors are favorable GDP, job and wage growth, a continued decline in home ownership rate due to elevated mortgage rates and lower total housing supply. We combined this top-down forecast with a bottom-up growth estimate built by our regional teams as they best understand local supply and demand dynamics in their markets. Our 2% rent growth forecast for 2025 and is slightly conservative when compared to prominent third-party forecasters estimates in the mid-2% range. In short, our outlook is driven by stable demand set against declining multifamily supply while factoring in macro uncertainties such as immigration reform and regulatory risk. Turning to Slide 7. We remain encouraged by a variety of key supply and demand metrics that are supportive of positive near to intermediate term fundamentals for the apartment industry. First, at the top left, our residents' financial health remains resilient with rent-to-income ratios below the long-term average. Second, at the top right, relative affordability versus alternative housing options remains decidedly in our favor at roughly 60% less expensive to [ rent to own ], a 25% improvement from pre-COVID. This supports a stable to declining homeownership rate and absent a major correction in home prices or a significantly more accommodative long-term interest rate environment, we do not expect this dynamic to change. Third, at the bottom left, the latest census statistics indicates that the largest U.S. age cohorts remain in their prime renter years. This should provide continued support for long-term rental demand. And fourth, at the bottom right, while multifamily deliveries are expected to remain above historical average levels at the beginning of 2025, development start activity has significantly retreated and is down approximately 65% from recent highs and is now well below historical averages. This should benefit rent growth in late 2025 and beyond. Moving on to Slide 8. Third-party data providers are forecasting full year 2025 multifamily deliveries in the U.S. and in our markets to be similar to the historical averages. Based on development completion data, peak deliveries occurred in the middle of 2024 and should trend downwards below long-term historical averages in the second half of 2025. We are cognizant that there will be supply slippage as we move through the year, and that lease-up concessions could remain prevalent for a period of time after the pace of new deliveries abates. Where concessions move throughout 2025, will be a key driver to our ability to capitalize on our rent growth forecast. On Slide 9, we provide more context on which regions expected to feel the greatest impact from 2025 supply. The Sunbelt is forecast to face new supply deliveries to the tune of approximately 4% of existing inventory, which is twice as much as coastal markets. Positively, Sunbelt Supply is down by nearly 1/3 compared to 2024 completions, while new supply across our coastal markets is on average similar to 2024. Mixing this all together, we arrived at our 2025 guidance, which is sized on Slide 10. Primary expectations include full year FFOA per share guidance of $2.45 to $2.55 and same-store revenue and expense growth expectations that translate to NOI growth of 1.75% at the midpoint, which is 25 basis points better than full year 2024 results. Slide 11 shows the building block for our full year 2025 FFOA per share guidance at the [ $2.50 ] midpoint, which represents a 1% year-over-year increase. Drivers include a $0.10 increase from same-store revenue and lease-up income from recently developed communities, offset by a $0.05 decrease from same-store expenses. A $0.01 increase from interest expense due to a lower average debt balance, which mitigates the impact from the midyear expiration of certain hedges, a $0.01 decrease from G&A and property management expenses reflective of inflationary wage growth and a $0.03 decrease from joint venture and debt and preferred equity activities due to a combination of the following 2 items: First, a $0.02 decrease attributable to moving to nonaccrual status for our debt and preferred equity investment in 1,300 Fairmount located in Philadelphia, which we previously disclosed. And second, a $0.01 decrease attributable to the pending sale of the company affiliated with a one-off technology investment. Should the transaction occur, UDR's $43 million of notes receivable that earn 12% interest would be converted into equity of the acquiring company. We are excited that the company we chose to support and help build is expected to be acquired by an industry leader and exchanging our notes for equity is the prudent long-term economic decision. We have received various inquiries pertaining to the risk in our debt and preferred equity book. So here are important considerations to help provide transparency. 1,300 Fairmount was our largest investment risk. And by moving that investment to nonaccrual status and taking a reserve, we believe we have largely derisked this book of business. There remain 2 investments on our watchlist, totaling approximately $40 million, which would represent $0.01 or less than 0.5% of FFOA per share in the event of nonaccrual. However, for these investments, we have been encouraged by their recent operating trajectories and the senior loans for each do not mature until mid-2026. Moving on to Slide 12. And specific to the first quarter, our FFOA per share guidance range is $0.60 to $0.62 or an approximately 3% sequential decrease at the $0.61 midpoint. This is driven by a $0.01 decrease from same-store NOI, primarily due to higher expenses attributable to normal seasonal trends and a $0.01 decrease from a lower debt and preferred equity investment balance due to recent pay downs and the aforementioned tech investment. Last, on Slide 13, we provide our debt maturity schedule and liquidity. Only 10% of our total consolidated debt matures through 2026, and thereby reducing future refinancing risk. Combined with more than $1 billion of liquidity, the $211 million of proceeds from our recently completed first quarter property dispositions, minimal committed capital and strong free cash flow, our balance sheet sits in an excellent position. In all, our balance sheet and liquidity remain in excellent shape. We remain opportunistic in our capital deployment, and we continue to utilize a variety of capital allocation competitive advantages to drive long-term accretion. With that, I will turn the call over to Mike."
},
{
"speaker": "Michael Lacy",
"content": "Thanks, Joe. Today, I'll cover the following topics. How our 2024 results and other drivers factored into the building blocks of our full year 2025 same-store revenue growth guidance. an update on our various innovation initiatives, expectations for operating trends across our regions and our 2025 outlook for same-store expense growth. Turning to Slide 14. The primary building block of our 2025 same-store revenue growth guidance include our embedded earn-in from 2024 lease rate growth. Our blended lease rate growth expectations for full year 2025 and contributions from our innovation and other operating initiatives. Starting with our 2025 earn-in of 60 basis points, which is about half of our historical average and in line with our earn-in from a year ago. The 50 basis point sequential increase in average occupancy we achieved during the fourth quarter of 2024, led to slightly lower blended rate growth and resulted in earning towards the lower end of the range that I spoke to on our third quarter earnings call. We believe this was a prudent operating strategy that will position us well as 2025 progresses. Next, portfolio blended lease rate growth is forecast to be approximately 2.5% in 2025. This is 100 basis points higher than what we achieved in 2024 which matches our expectations for year-over-year rent growth improvement. We expect blends will be lighter through the first half of 2025 before improving during the second half of the year as supply pressures lessen. This dynamic, if accurate, means that blended rate growth should contribute approximately 90 basis points to our full year 2025 same-store revenue growth and have a positive flow-through impact on 2026 earn-in. Underlying our blended rate growth forecast are assumptions of approximately 4% rate growth in 2025 and approximately 1% new lease rate growth on average. Moving on innovation and other operating initiatives are expected to add approximately 65 basis points to our 2025 same-store revenue growth, which equates to $10 million to $15 million or approximately 7% growth for this line item. The bulk of this growth should come from the continued rollout of property-wide Wi-Fi, other property enhancements such as further penetration on package lockers, improved retention and less fraud. For retention, our guidance assumes that our 2025 resident turnover will be 100 basis points below that of 2024. Equating to approximately $3.5 million of higher cash flow. This improvement should be driven by our proprietary customer experience project, which helps us improve our residents' experience throughout their time with UDR. Thereby increasing their probability of renewal. Today, our efforts have resulted in higher resident retention on a year-over-year basis for 21 consecutive months. We continue to enhance how we measure, map and orchestrate the customer experience, which we believe will drive further year-over-year improvement in turnover and margin expansion in the years ahead. Last, we expect the combination of higher occupancy and reduced bad debt to provide a modest positive contribution to same-store revenue growth in 2025. Regarding fraud, recall that in mid-2024, we implemented a variety of AI-based detection measures, process improvements and credit threshold reviews to enhance our upfront resident screening. We have seen the benefits of these efforts in recent bad debt trends, resulting in more favorable results in recent quarters. Rolling all this up, our 2025 same-store revenue guidance ranges from 1.25% to 3.25%, with a midpoint of 2.25%. The 3.25% high end of our same-store revenue growth range is achievable through improved year-over-year occupancy, additional accretion from innovation and blended lease rate growth that occurs more ratably throughout the year or at a higher level than our initial forecast. Conversely, the low end of 1.25% reflects the inverse scenario, with full year blended lease rate growth closer to flat, some level of occupancy loss and delayed income recognition from our innovation initiatives. Turning to Slide 15 and our regional revenue growth expectations, we expect the coast will continue to perform better than the Sunbelt in 2025, led by the East Coast. The East Coast, which comprises approximately 40% of our NOI is forecast to grow same-store revenue by 2% to 4%. We expect New York and Washington, D.C. to be our leading markets in the region, continuing 2024's trends. We are slightly more cautious on Boston due to peak supply deliveries that are expected to occur midyear, which could result in some pricing pressure. The West Coast which comprises approximately 35% of our NOI is forecast to grow same-store revenue by 1.25% to 3.25%. San Francisco, Seattle and Orange County are expected to produce upper tier growth, while Monterey Peninsula is forecast to be softer, some of which is due to recently enacted rent control. Last, our Sunbelt markets, which comprise roughly 25% of our NOI, our forecast to have same-store revenue growth of flat to positive 2%. Austin and Nashville will continue to face elevated new supply in 2025, which should limit our pricing power for the third consecutive year. On a relative basis, we expect Tampa and Orlando to be leaders among our -- some markets. Moving on. As shown on Slide 16, we expect 2025 same-store expense growth of 3.5% at the midpoint. This is primarily driven by growth in real estate taxes, personnel and administrative and marketing costs. While only 5% of total expenses, insurance expense growth of negative 4.5% to negative 6.5% reflects the benefit of the pricing we negotiated on our policy renewal in December and our deployment of targeted CapEx. To conclude, as summarized on Slide 17, we delivered strong fourth quarter and full year 2024 results. Same-store revenue, expense and NOI growth were all better than the midpoint of our guidance and same-store NOI growth exceeded the high end of our range. The near-term operating environment presents some challenges, but we have successfully navigated through historically high levels of new supply and fundamentals suggest an attractive growth outlook with 2025 same-store NOI growth expected to accelerate compared to our 2024 results. We continue to innovate with the intention of increasing the growth, improving resident retention and further extending our operating margin over time. I thank our teams for their collaboration, which drives innovation and superior results. We are positioned to take advantage of external growth opportunities when appropriate. We will continue to utilize various sources of capital, including existing joint ventures and operating partnership unit deals to accretively grow the company while heating cost of capital signals. And our unique approach to portfolio strategy, operating excellence and continued innovation has created a company that is a full cycle investment and one that we believe maximizes value creation for our stakeholders, regardless of the economic environment. Finally, I give special thanks to our teams in Southern California for their efforts during the recent wildfires that resulted in no damage to our properties and our teams across the country for their actions during the most recent polar vortex that brought brutally cold weather and even snow to southern states from Texas to Florida. I'm proud of the preparations you took to ensure the safety of our residents and fellow associates. And the difference you have made to the cities, communities and families affected by these events. With that, I will open it up for Q&A. Operator?"
},
{
"speaker": "Operator",
"content": "[Operator Instructions]. And our first question today is from the line of Nick Yulico with Scotiabank."
},
{
"speaker": "Nicholas Yulico",
"content": "First question is just in terms of the guidance, helpful all the details on markets and on same-store revenue. Can you just give us a feel, though, in terms of blended rate growth how that could trend through the year for the different markets, particularly as you think about sort of Sunbelt versus the rest of the portfolio? Is there more of a kind of convergence on blended rent growth on the regions as you get into the back half of the year?"
},
{
"speaker": "Michael Lacy",
"content": "Nick, it's Mike. I'll take that. I think, first and foremost, maybe starting high level with a total company just as it relates to that 2.5%. I think, first of all, it starts with our strategy. Obviously, you've heard us talk about this over the last 6 to 9 months really driving our occupancy up during a period of time where expirations are low. And given the fact that we've had historically low turnover, that allowed us to drive occupancy to about [ 96.8 ] during the quarter. Happy to report today, it's closer to [ 97 to 97.2 ] and so that's giving us a lot of tailwinds to be able to drive our rents as we move forward. But as you think about that 2.5%, it's important to think about the cadence of it. And so in the first half of the year, our expectations as we continue to deal with elevated supply it's around 1.4% to 1.8% growth. And then when we get into the back half of the year, closer to about [ 2.8% ] to 3.2%. So again, first half of the year, call it, [ 1.6% ] at the midpoint. That is right where we landed for 2024 in the first half. In the second half of the year, that 3%. It's still about 70 to 90 basis points lower than the pre-COVID average. And so we do have seasonality built into that number. We expect 3Q would be higher than 4Q, but again, it is lower than most pre-COVID norms. Specific to the regions, I think it's probably good to start on Page 15, where we were able to go through just some of the expectations around the different regions. For us, what we expect is obviously a higher earn-in for places like the Coast, East Coast being higher than the West Coast. Right now, we think earn-in is 1.3 for the East. about 80 bps for the West Coast and then we were negative 1 for the Sunbelt. Specific to the blends though, Coast is looking very similar to what we achieved in 2024. Our expectations are blends will be roughly around 2.5% to 3% on the East. It's going to be about a 1 to 1.2 contribution to our total revenue in that region. On the West Coast, probably closer to plus or minus 2.5% blends this year. And again, that contribution is pretty close to 1% as it relates to total revenue. And then as you get into the Sunbelt, blends this, we're thinking probably closer to 60 to 90 basis points this year and a relatively small contribution, only around 30 or 40 bps on the difference is where other income comes in. And so for us, we had about 8% growth in 2024. expectations are another year where we're expecting around 7%. And I've seen a lot more growth in places like the Sunbelt. So similar to 2024, expectations are, we could see anywhere from 10% to 12% growth in the Sunbelt versus closer to, call it, 5% growth on the coast."
},
{
"speaker": "Nicholas Yulico",
"content": "Very, very helpful. Second is just on investments. And Tom, I think you said the balance sheet set up pretty well for you to get to -- decide to do more investments. I guess the guidance is for you to be a net seller this year. So how should we think about sort of where the focus is going to be on investments? And is there actually some sort of capital built into the plan that if you were to do acquisitions, you don't necessarily need to raise new capital and there could be some benefit if acquisitions actually pick up?"
},
{
"speaker": "Joseph Fisher",
"content": "Nick, this is Joe. Maybe 2 things on that one. I'd say number one in that seller component, that's really a byproduct of a couple of sales that we have teed up last year that happened to slip into early January. So those are really related to neutral funding for last year. So I wouldn't read too much into us looking like a net seller. That's more just a '24 issue and timing issue. As it relates to capital and deployment, I think you're going to see us remain fairly opportunistic on that front. We've continued to advance discussions with our joint venture partner, LaSalle and their capital stores, which after being on the sidelines for kind of 12 months as they went through a global mandate review, happy to report, we had meetings with them earlier this week, and we are back in action and looking to deploy capital with that partner. On the DPE front, as we've said in the prepared remarks and previously disclosed, we think we've really kind of cleared the deck on that front from a risk perspective. And so now we're back into normal course business and we had a couple of really good payoffs there in the fourth quarter as well as some effective payoffs this year. So we're focused on redeploying capital on that front. When you get into the development side, we don't have much of a pipeline today. But as we continue to get more optimistic on where rent growth goes in '26 and '27, we do expect to see maybe 2 to 3 starts coming out of the development side this year, included one possible here in the next quarter -- and then you got the redevelopment portfolio. The redevelopment team continues to hum and continues to collaborate really well with the operations team. And so continue to invest on the redevelopment side. And then I think lastly, while we haven't had anything announced recently, the OP unit transactions that you've seen us do in the past, we do have a number of discussions ongoing on that front. And so we'll continue to see what plays out on those, but we are definitely looking to be active and opportunistic here with capital allocation."
},
{
"speaker": "Operator",
"content": "Our next question is from the line of Eric Wolfe with Citi."
},
{
"speaker": "Eric Wolfe",
"content": "You mentioned that were concessions trend in your markets will be a key factor in achieving your outlook. So could you just talk about where concessions are today and sort of where you think they might go as we progress through the year?"
},
{
"speaker": "Michael Lacy",
"content": "Eric, I'd tell you, first, it goes back to kind of finishing up on a strong note. So coming off a very strong 4Q. This positioned us obviously with high occupancy and our turnover continues to trend down. And so right now, what we're seeing in January, further momentum, again, occupancy above 97% today. Turnover in January was down another 500 bps on a year-over-year basis. And our rents and other income are tracking with our expectations for the first half of the year. And so we are getting more active as we try to drive our market rents up, and we're driving our concessions down. We're right around a week in January, and we're starting to push that down to sub-1 week as we move further into the first quarter. Concessions are coming down a little bit right now. And again, I think that's part of our strategy to drive occupancy now put our focus on driving our rents out."
},
{
"speaker": "Nicholas Joseph",
"content": "That's helpful. And then I guess as far as the new CIO role, can you maybe just talk about the rationale for the change there from CFO? And then Joe, if there's anything that you're expecting to do differently in this role is the company's capital allocation strategy is going to change at all? Or if it's more about processes, just anything that's going to be different now versus before?"
},
{
"speaker": "Tom Toomey",
"content": "Eric, I think I'm always striving and the room is striving to get better. And so I'd start off with first as my prepared remarks, congratulations to Mike and Joe for promotions and assuming additional responsibility. As part of my role and the Board as well as the executive team is to push ourselves to get better and deeper talented bench. And I think this opens up opportunities under both of them to advance people's careers and their skills and ability to generate shareholder value. And with respect to the CFO, Joe has been an exceptional CFO for the company for 8 years. I don't want to say you get stale in the job, but you become a key part of our success. But I'm looking to say, \"Gosh, how can we get better as a team?\" And it opens up a slot. And I think with Harry retiring and Joe stepping in the CIO, working with Andrew and the team there. He brings a fresh perspective. I would expect us to continue to have a lot of success in the investment area and we'll commence a search for a CFO. I think it's a very attractive position and a very stable capable quality and team member for our future. So that's how I've been thinking about it, and the group has been always along in this conversation about how do we get better as a group, how do we get better as a company. And I think it prepares us that way. And again, growing talent is a critical element of our long-term success."
},
{
"speaker": "Operator",
"content": "Next question is from the line of Jamie Feldman with Wells Fargo."
},
{
"speaker": "James Feldman",
"content": "Mike, I was hoping you could walk through the line of sight on other income a little bit same-store revenue growth contribution year-over-year from that bucket in the guidance. We're just trying to figure out if this number goes down as Wi-Fi rollouts move through the system? Or if this could say even or reaccelerate in the out years?"
},
{
"speaker": "Michael Lacy",
"content": "Sure. Appreciate the question, Jamie. First and foremost, just as it relates to other income, we have a culture and history of driving incremental -- in fact, we've been at this for more 10 years where we're not only increasing our -- do every year, but also driving those margins as well. So as we look at it, we've got about $60 million in max potential NOI to choose from right now through a whole list of different initiatives. We're looking at them. We're prioritizing them. We're trying to assess which ones we pull the lever on. And I'm happy to report, again, last year, we had 8% growth in other income it's going to be another strong year this year. I think for us, when I look at it, we've got about 11.5% of our revenue that comes from other income. It's approximately $180 million on our $1.5 billion and same-store revenue. And it looks pretty promising. I look at the Wi-Fi rollout, the package lockers, the -- amenity areas, things like that, that are really driving a lot of this line item. We look at it at about 60% of that 7% growth in 2025 is already baked. And when I say that, we've done a lot of the heavy lifting with the Wi-Fi rollout. We still have about 10,000 to 12,000 units we're installing throughout this year. But a lot of that income is coming from all the work that we've done over the last 12 to 18 months. So we feel pretty good about our other income line item at this time."
},
{
"speaker": "Joseph Fisher",
"content": "Jamie, maybe just to add on to that, too, because we do focus a lot on other income as a company and obviously, within the investor space. But you've heard us talk somewhat ad nauseam on customer experience in the past. And you're seeing the results of that, of course, with turnover -- incoming down both absolute and relative. But that initiative is across all line items. So as we continue to do better and better on customer experience, keep driving down that turnover. It's going to enhance pricing power, enhance other income, enhance occupancy, drive down turnover costs, both capitalized and expensed. And so I do think you'll continue to see a benefit there as we really lead into that initiative, which may not show up in other income necessarily, but will show up throughout the enterprise. So just be cognizant of that."
},
{
"speaker": "James Feldman",
"content": "Okay. That's very helpful. But do you think as we look ahead in the next few years, like at some point, does it become a headwind to the growth rate? There's enough still that you can keep it going for a while in terms of your growth rate?"
},
{
"speaker": "Tom Toomey",
"content": "This is Tommy. I think like a lot of things in life. It's a flywheel. And customer experience projects going to spawn off many more new ideas about other income aspects and our relationship with our customer because they're going to be with us for a longer period of time. So I think it's premature to kind of highlight some of those. Why? Because they're in early stages of experimenting and finding out what customers respond to and don't. But it is the cornerstone of how we can build out a deeper pipeline of those opportunities in the future to backfill it. Clearly, I'm with you, if you don't keep innovating, you eventually run up against your own success. I think the case here is continue to innovate, use data, use that aspect of it to convert to cash flow, if you will. And we'll find out where that margin keeps growing, if you will. But that's essence the long view of that customer experience project."
},
{
"speaker": "James Feldman",
"content": "Okay. And then as we -- I'm looking at Slide 9 from the presentation, where you talk about '25 supply as a percent of existing stock. I know you've got the red, green and yellow bucket we're coming off of historic levels of supply and thinking about those red bucket. But like what's the number here where you actually worry about supply weighing on fundamentals going forward? Like are some of these yellow markets going to move into the red bucket or 50 to 150 basis points in '25 is just not something to worry about, and we really think you're kind of cleaning things up here in every market as we work through '25."
},
{
"speaker": "Joseph Fisher",
"content": "Jamie, we're definitely leaning than -- if you will, as it was throughout '25. When you look from the green bucket of the red bucket, you do have pretty meaningful deltas and blended lease rate growth plus or minus upwards of 500 basis points, depending on which market you're coming in to. The yellows are in the middle. I think as you migrate throughout the year, and Mike started to kind of allude to this earlier, which we showed back where we give the regional revenue performance. You're going to see some of these red markets start to compress upwards relative to the East and West Coast markets. And so as Sunbelt supply comes down pretty meaningfully, while it's still at a high absolute level, it is going to come down pretty meaningfully from where we're at in '24, which we do think enhances pricing power throughout this year. Then as you go into '26, the part of the reason that the East and West Coast don't see that same decline in supply is really just longer lead times for developments there, more blended high-rise product being delivered, which has a little bit longer development cycle. If you get into '26, you're going to see supply overall frac come off another 30-plus percent, and that's going to be across the border in all 3 of those regions. So we'll gradually see fewer and fewer markets sitting in the red and yellow and more than [indiscernible]."
},
{
"speaker": "Operator",
"content": "The next question is from the line of Steve Sakwa with Evercore ISI."
},
{
"speaker": "Steve Sakwa",
"content": "Yes. Joe, I know you were out at NMHC, and I'm just curious what the discussion was like broadly around development. Everybody is painting this picture of '25 still a little bit of a transition year, high supply, but '26, '27 and beyond looks great. So I'm just curious kind of the discussions around new development and even sounds like you guys might want to start some new developments. So what's the -- I guess, the risk that everybody is seeing the same picture and goes to put shovels in the ground sooner than later?"
},
{
"speaker": "Joseph Fisher",
"content": "Yes. Great question. I do think everybody is generally speaking, seeing that same view -- of the view of the future. as you get into that '26, '27 and you look at some of the slides that we put on here slide -- and prior to that in terms of supply deliveries. You're definitely going to see less supply with the backdrop of very strong relative affordability and hopefully still get demand. And so there is an expectation of outsized growth in those years, which obviously gets developers excited. I think the ability to translate excitement and a thesis on the future into actual shovels in the ground is a little bit more challenging. We have seen construction financing start to come back a little bit from the banks, so they are improving in terms of the availability of that capital. The spreads are still relatively high and kind of plus or minus 300 basis point range. The bigger challenge still seems to be the LP equity. And so can you go out there and raise capital to deploy into development to get those starts done today. So if you have the thesis, yes, I think a lot of us believe in it. Do you have the capital not so much. So not overly concerned about your point on do we see a big surge in supply. And to the extent that we do, I think it's more of a '28 issue. We still have a pretty good runway here for a couple of years. In terms of how it relates to ours, I mentioned kind of 2 or 3 starts potentially teed up here for this year. We look at the yields that we're going to have on those on a current underwritten basis. We're looking for high 5% to 6% on that capital, so full with those projects and moving forward with those."
},
{
"speaker": "Tom Toomey",
"content": "Steve, Tom if I can. You've been through a lot of these cycles. And you know where we're at today, all the developers are trying to keep their shops busy and penciling a lot of deals. The truth is capital is looking over there and saying, why am I building if I can buy below replacement cost. So the acquisition market, sale market is probably going to heat up a little bit more in '25, '26 before the development starts to rewind itself up. It will -- there hasn't been any development where there's rent growth. So that we step back and look at it and say, it's a window where be prudent, but we think there's -- and it's a competitive window for acquisitions right now. Still get out there and see what we can find."
},
{
"speaker": "Steve Sakwa",
"content": "Great. Maybe just quickly on Slide 16, maybe for Mike. Just as you look at the expectations for expense growth in '25 and there's some big deltas from where '24 came in. I'm just looking at like personnel loss was an elevated number in '24, coming down much more in '25, but real estate taxes kind of going the other way around. Just where do you see the risks on more slide? And how have you sort of thought about that in the budget?"
},
{
"speaker": "Michael Lacy",
"content": "Got it, Steve. I'd say, first of all, thinking about '24 and '25. And specific to personnel. Just a reminder, we had the cars refund that we had to deal with last year. And so our personnel cost expense was up about 11%. And that's mainly because of anniversarying off of that. Now we're back to kind of a normal run rate, if you will. And so when we look at our expenses, I mean, we would have been around, call it, 3.5% this year if we didn't deal with that anniversary. Things feel pretty good. The team has been doing a lot around all the different initiatives. We talk a lot about other income, but they've made a lot of progress in things like efficiencies and how we're utilizing technology, try to drive down some of those costs. And we're also doing things with our vendors trying to consolidate that. That's playing out in some of these numbers that you see here today. And so for us, it feels good going into '25, we ended on a good note in '24, and we're off and running '25."
},
{
"speaker": "Steve Sakwa",
"content": "And maybe just taxes real quick. Anything there to speak about?"
},
{
"speaker": "Joseph Fisher",
"content": "Steve, on the real estate tax side, we did have some wins in terms of appeals activity that took place in '24. So it's taking a little bit higher up in the mid-3s. Obviously, we're going to be going after a lot of those same types of deals is really probates out in California. So we look to appeal down that initial number of 3.5%. When you look regionally by markets, to be honest, most of them are plus or minus in that range. I think the only outlier is really -- coming with up in Seattle, we were seeing values come down. And so actually, we're forecasting negative -- over year real estate tax growth there in Seattle, largely the other side, we're seeing rates come in higher in Boston, a little more tax growth there. And then out in Nashville. Also we have the 4-year reset that take place a little bit more pressure in Nashville. But most of our markets right now, we're thinking within that 2.5% to 4.5% range."
},
{
"speaker": "Steve Sakwa",
"content": "Great. It's it for me."
},
{
"speaker": "Operator",
"content": "The next question comes from the line of Jeff Spector with Bank of America."
},
{
"speaker": "Jeffrey Spector",
"content": "Great. Joe, at the top of the call, you -- in your opening remarks, talked about lower supply benefiting I think you said late '25, please confirm if that's correct or not. I guess my question really is on the confidence level here. And how does that tie to, let's say, guidance, right, upper end versus lower end versus midpoint?"
},
{
"speaker": "Joseph Fisher",
"content": "Yes, we do expect to see supply continue to trickle down throughout the year in terms of the deliveries. And on Page 8, we have demonstrated for our markets, which you see it does trend down that really plays into Mike's commentary earlier on blends. And so our first half blend assumption being roughly in line with what we saw first half of '24. And then we start to see that blended number lift as we go into the second half, kind of peak out in 3Q and see some seasonality going into 4Q with a declining a little bit. That's driven across the board, but we did talk about seeing Sunbelt start to accelerate a little bit more as we move throughout the year as they do see a more significant decline in those deliveries. And so I think there's a couple of things that give us a little bit of comfort with that in terms of the higher second half versus first half. We mentioned now the decline in delivery activity, which should help. The other pieces are relative affordability continues to be strong. And obviously, demand environment continues to be strong. So lifting that second half blunt rate growth assumption up into the 3s, which is still well below what we were at pre-COVID. And we're kind of getting into more of a pre-COVID norm when we get into the back half of the year and definitely going into '26 that gives us the comfort on the guidance piece. I do think the other thing I just want to mention, too, Jeff, as we kind of think about this, if you go to Page 14 within the presentation, I'll give Trent just a second there to get it ready for the webcast. But Page 14, when you look at these assumptions between earn and blended lease rate growth, innovation and then occupancy and bad debt. In totality, we get to that 2.25% revenue number, which is basically the exact same as what we put up in 2024. And so we got some questions overnight on the 2.5% blended lease rate growth, which we're talking about right now. But because it is more back half weighted, you can see in there only a 90 basis point contribution coming off of blended lease rate growth. Typically, if you are in a normal seasonality curve, you'd have a midyear convention, that [ 2.5% ] would translate to [ 1.25% ]. So it really tells you that the revenue contribution is pretty typical with what we saw in 2024. So we haven't assumed a lot of acceleration in that rev contribution and the blends that they don't come to fruition in the back half more of a '26 earn-in issue instead of a 2025 guidance or revenue growth issue as most of these somethings look pretty spot on with what we delivered in 2024."
},
{
"speaker": "Jeffrey Spector",
"content": "Okay. And then turning to the tech initiatives. I know you guys are always scouring for new. I'm just curious whether it's AI-driven or just new technology or applications you're seeing. Is there anything exciting on the horizon here that you're looking into?"
},
{
"speaker": "Michael Lacy",
"content": "Yes, a couple of things. I'd say maybe some people saw that we recently just transitioned, we're going to be implementing funnel as our CRM this year. So we're really excited about that -- it's important to it. It's something that's going to help our relation definitely to drive it. And ultimately, we think it's going to allow us to be more effective, more efficient with our -- central team is [indiscernible] and will have to focus on new ideas and not necessarily get bogged down on a lot of the back office. So that's going to be happening over the next 3 to 6 months. We're very excited about that rollout. In addition, some of the other play-based initiatives, things that we're using with technology. It goes back to what we talked about last year, just as it relates to who is coming through the front door, who are allowing to be a resident with us and making sure we're identifying bad actors, if you will, before the event of the doors. So things like ID verification, proof of income, just making sure that we're capturing that playing out. And if you recall, we rolled that out mid last year. we saw our occupancy come down a little bit as we started to roll it out. We feel like we've got our hands around it, and that's really starting to pay dividends today. And just to kind of size them given a few stats -- some of our more riskier residents, if you will, that comes through the door. Our average deposits are up almost 20% at this point. Our cosigners are up 1% or 2%. And our credit scores are actually up about 20 points closer to 730 versus 710. So we think that this is going to continue to try to drive our revenue and make sure that we have good revenues as we move forward."
},
{
"speaker": "Tom Toomey",
"content": "Jeff, this is Tom again. If I could add just a little bit more. I think the key here is that we own our data. So the amount of data Mike could tell me how much we're accumulating every day on every customer interaction from prospect all the way to move out builds an enormous warehouse, if you will, facts to mine trends to look for responses that were missed and so it's not just winding the business model better. It's looking more around the corner, owning that data, what are better ways we can run the business to anticipate the customers position, a market position and then ultimately, how we're pricing our product to those individual customers. So I think it's just the very early stages I think the focus that Mike and the entire team has on it. It's always amazing every money we sit and go through where we stand and how much facts we know about where we are and where we're going, help us run the business better, faster, more efficiently."
},
{
"speaker": "Operator",
"content": "Our next question is come from the line of Austin Wurschmidt with KeyBanc Capital Markets."
},
{
"speaker": "Austin Wurschmidt",
"content": "Great. Mike, I appreciate all the detail you gave across regions. But the question on the same-store revenue guidance, which assume some acceleration in the Sunbelt markets for a lot of the reasons you cited first half versus back half, but you do have deceleration assumed for the coastal markets, despite having a higher earnings. So I guess what's driving that assumed deceleration in the coastal regions this year? And could you actually see some upside given some of the positive dynamics being discussed on the West Coast in particular."
},
{
"speaker": "Michael Lacy",
"content": "Yes, it's a really good question, Austin. I think it's important to point out, when you look at the coast, specific to the West Coast, our blends and our earn-ins are very close to what we experienced last year. And so not really seeing a whole lot of deceleration from that standpoint. The difference is going to come in other income in a place like the West Coast and the main reason is a place like Monterey Peninsula for us. We are now dealing with rent control on that front as well as we're not able to charge for our reimbursements if we don't have sub meters at those assets. So that's actually about a $2 million to $3 million drag for us in '25 and so if we didn't have that driving down the West Coast, we have about 50 basis points more in growth. And so our costs would actually look very similar to 2024. And then specific to the Sunbelt, it really comes back down to the other income growth again, which, again, we had close to 14% growth in 2024. Expectations are that we're going to have around 12% this year. Yes. And then as far as -- just to put a ribbon around [ Sunbelt ] Monterey Peninsula. We do have a plan to try to get back in there, get the submeters going, and so we can start to recapture a lot of that income we're going in '25 and that's probably more of a '26 and '27 initiative."
},
{
"speaker": "Austin Wurschmidt",
"content": "That's really helpful. And then just switching gears kind of high level, maybe Tom or Joe, I'm just kind of interested in your view about a potential privatization of Fannie Mae and Freddie and just the impact you think it could have on broader housing market, transaction market and obviously multifamily."
},
{
"speaker": "Tom Toomey",
"content": "This is Toomey. I'm not sure anybody is going to make a very long living predicting what's coming out of Washington these days. And so I will just pass and let the cards fall where they -- they seem to have a lot of other things that they're working on before they get to the GSCs in that aspect. It's a very high functioning group. It stabilizes the market. I don't think anyone wants to see any of that disappear. And so then in whose hands it's and how it's run. I'll leave it to the people that have a say over that to speculate and deal with."
},
{
"speaker": "Operator",
"content": "Our next question is from the line of Michael Goldsmith with UBS."
},
{
"speaker": "Michael Goldsmith",
"content": "How much occupancy are you willing to sacrifice to push rate in the peak season? And how much rate growth you need to see during that peak season to hit the guidance range?"
},
{
"speaker": "Michael Lacy",
"content": "Sure. I think that's sizes. So I think, first of all, the way we think about -- paid-off. 1% of rent loss approximately $26 per home. It's equal to about $7 million a year, you mentioned. When I think about occupancy, 1% of occupancy is about 550 homes at $2,600. That's about $17 million in a given year. So the way we think about it is if we lower occupancy by, say, 30, 40 basis points, we would need 100 basis points in rent just to breakeven in a given year. I don't know if you can capture that in the shoulder quarters where you have low demand. And so you've seen it with our strategy. As demand starts to pick up, we let our occupancy migrate down, and we're willing to take that bet that if we can't capture another call it, 1% or more on rent. But again, during the shoulder quarters, we think it's a prudent strategy to try to drive that occupancy up and prepare for that period of time where you can really drive your rent."
},
{
"speaker": "Joseph Fisher",
"content": "I do think it's credible to -- Michael. As you think about your comment or question about how much are we willing to sacrifice. Part of that occupancy strategy is occupancy versus rate, but I don't want it to get lost on the group in terms of customer experience and a decreased turnover component. I think Mike referenced earlier the continued decrease in turnover in January, that's part of the surge in that occupancy. So it's not necessarily occupancy and rate trade all the time. Sometimes it's good customer service that just results in better occupancy and residents wanting to stay longer. So there's 2 components to it, as you think through it."
},
{
"speaker": "Michael Goldsmith",
"content": "That's helpful context. And my second question is we've discussed the trajectory of blended rent trend, but maybe looking at same-store revenue growth. Is there any lumpiness in? Or is there any expected lumpiness of that through the year due to [ syncratic ] factors for either positive or negative?"
},
{
"speaker": "Michael Lacy",
"content": "No. I mean, for us, when we look at the cadence of growth throughout the year, expectations are the first half of the year is a little bit lower in the back half, maybe call it 2% to 2.5% and then in the back half. we're probably closer to that 2.5%, maybe reaching upwards of the 3%, but not a whole lot of lumpiness. It's pretty consistent."
},
{
"speaker": "Operator",
"content": "Next question is from the line of Brad Heffern with RBC Capital Markets."
},
{
"speaker": "Brad Heffern",
"content": "You mentioned a number of uncertainties in the slides. All of those are regulatory or political in some way. It seems like you don't want to predict those. I don't blame you for that. But I'm curious if you've risked those items in the guidance at all? And how much specifically with regard to dose and immigration?"
},
{
"speaker": "Joseph Fisher",
"content": "We have not. I mean it's why there is a range around our base case. And I think uncertainties could be both positive and negative in all of these. As you think about regulatory risk, there's the state and local regulatory risk that we talk about a lot with things like rent control or pet fees, deposits -- something of that nature. But there's also less regulation that we think we may see at the federal level both from a legislative and legal perspective, but also just in terms of small business formation, medium-sized business formation, which is really the driver of job growth across this country with over 50% of employment coming from the small business side. So I think if we see what happened in the first administration where you've cut some of that red tape, that actually could be a positive uncertainty in all of this. I think the same thing could be said about those on a federal perspective the question remains as to where they concentrate potentially some of their head cuts or entitlements or pork or anything of that nature. It may impact different markets differently. But at the federal level, it could actually be positive including for the interest rate environment. So we put a range around this to try to factor that in. But it's hard to say they're all negatives are all positives."
},
{
"speaker": "Brad Heffern",
"content": "Okay. Got it. And then a question on the customer experience project. Obviously, everybody has been seeing record low turnover. So I'm curious how you're separating out the benefit specifically of that program. versus just how the broader market is acting. And then what sort of gives us the confidence that you can move turnover even lower from record levels already."
},
{
"speaker": "Michael Lacy",
"content": "Right. Yes. We look at this in both an absolute and a relative basis. And so what I would tell you is going back to 1Q of '23, on an absolute basis, we're down about 3.5%. And on a relative basis over that same period of time, we've improved by about 200 basis points against -- the period. So we watch it against how we can have everybody else. Not just in the fact that everybody's turnover is down. And I'll tell you why we still believe it because we do have a ton of data. Tom talked about it a little bit previously, but it's upwards of [ 800 million ] data elements at this point, [ read a million ] a day. And so we have the team in place. We have the dashboard bill and we have dedicated resources that are watching every day, creating touch points with our residents and we see it playing out. And again, I saw it play out again in January. Expectations are that February is going to be another month that's down on a year-over-year basis. And this isn't even factoring in all the stuff that we have planned for this year. And I'll tell you what I'm most excited about is the fact that we're able to spend a little bit more on NOI-enhancing CapEx to try to drive problems down that we know are an issue at these sites that we do think will be the -- impact to the list. And then also the rollout of funnel, I spoke to a little bit with our CRM. We think that's going to pay a lot of dividends throughout the year, too. So there's a lot more to come on this front. We're still continuing to work on it."
},
{
"speaker": "Operator",
"content": "Next question is from the line of Alexander Goldfarb with Piper Sandler."
},
{
"speaker": "Alexander Goldfarb",
"content": "Here. Two questions. First, on the other income, you guys have certainly been on the forefront of growing different entities, the different services that you offer for your residents. But at the same time, we still talk about earnings growth and revenue growth based on supply/demand in the general apartment sector. So do you feel that these efforts are truly accelerating overall earnings growth? Or is it sort of a pie mix where you can either push rent or push these other fees, but the tenant -- the resident still looks at the whole on shoulder together. They don't say, \"Oh, I can stomach a rent increase and then I can stomach these incremental fees.\""
},
{
"speaker": "Joseph Fisher",
"content": "Alex, that's a constant source of discussion internally. As we think about effectively where we're going is the cannibalization concept of if you're going to pay more over in one bucket, are you willing to pay as much in the other bucket. And we have done a bunch of past work and studies on that to ensure we are capturing what we believe is the total amount of other income that we should receive while not cannibalizing rent component. Now I think one of the things that we do that's very helpful for the resident and gets us kudos from resident is all in pricing upfront on our website where you can go in and select your unit, you can pick what amenities or what other income items you're going to have, you can see what your utility bill will typically be. And so right up front, we're being very transparent, which is a rarity within the industry. I think residents appreciate that because they know now the total check they're coming in with. They're not surprised when they get through their first month of residency. And then when it comes to the deal, we don't have that in [indiscernible] I think we're trying to address it by being transparent with the resident and then also doing a check to make sure we don't cannibalize for us."
},
{
"speaker": "Michael Lacy",
"content": "Alex, just quickly, these are also win-wins for us and our residents. And so when we think about this, like Wi-Fi, as an example, we are very competitive with our pricing. We're trying to provide a benefit that helps them out, it helps us sell. It gives them access to Wi-Fi across the property. And quite frankly, it helps with our self-guided tour process. So there's that -- I mean, things like reserve parking we're trying to identify spots that are actually better for our residents to make it more efficient for them. So a lot of these things we keep in mind how will it benefit them as well as us."
},
{
"speaker": "Alexander Goldfarb",
"content": "Okay. The second question is on the debt and preferred equity business -- can appreciate Philly probably was done. But as you guys look at new investments, Are there any changes to underwriting or geographies that you would no longer look at? Or was the fill sort of an isolated one and these other 2 watchlists are I'm just trying to see, were there any learnings from these that going forward, you would change? Or this is just part of the business and it's why the yields are the way the yields are?"
},
{
"speaker": "Joseph Fisher",
"content": "Yes, it's a great question, and I think it wasn't fun. It's a very fair terminology to utilize and working through that. But I think we had any changes. When you look at the structure of the book, look at the components of how much is on development versus operating assets now. So we've continued to ramp up the amount that we have within the operating kind of recap side of the portfolio. And I think we're up to 30-plus percent of the deals now have a current cash pay component. And so we are pivoting a little bit in terms of the book of business. And then you get into the lessons learned component. I do think there are quite a few that lever time -- I mean from a lower loan-to-cost perspective. I think when we look at development deals going forward, we've definitely committed to ensuring that we're at a lower loan to cost than perhaps we were back during COVID years. I think ensuring some constraints to make sure these don't get as drawn out because when they get drawn out, while we continue to improve earnings, ultimately, it may put the equity partners back against the wall a little bit. More utilization of our marketing and analytics team. A number of these challenges are really driven by supply to some degree. And so we find high supply concentration, definitely negatively impacted rent and NOI growth profiles and therefore, ability to recap these investments. And then I think just the scenario analysis. We did not underwrite that during the COVID years of when we were kind of 4 cap or sub-4 cap that you're going to see a run-up in raise some borrowing cost of [ 100 to 200 ] basis points and an increase in cap rates to that degree. So in area of analysis to work through and ensure that in various scenarios, we do see the paybacks. And so there's a number of lessons learned and approaches to structure the book of business as well."
},
{
"speaker": "Operator",
"content": "The next question is from the line of John Kim with BMO Capital Markets."
},
{
"speaker": "John Kim",
"content": "Just going back to other income, the 65 basis point addition to things to revenue, actually seems a little bit light because it implies $10 million in revenue. Last year, you aim for $10 million in NOI. You're suggesting another $60 million that you're expecting going forward. Can you just comment on that? And also remind us what your typical margins are on the other income?"
},
{
"speaker": "Michael Lacy",
"content": "Yes. The margins vary by initiative, I can tell you for something like the Wi-Fi, we charge around $70 on average, and it cost us around $20 on average. So that's a pretty strong margin and things like parking, obviously, it doesn't cost us anything to try to drive up more reserve parking. So huge margin there. And then things like short-term furnished rentals, we do have a lower margin on that book of business, and we've been actively bringing that down over the last couple of years, just trying to make sure that we're achieving the highest cash flow we can. So they're all a little bit different. But for us, again, the 8% growth last year was very strong. And basically, to repeat that, we feel pretty good about it. Obviously, we're always looking to that [ $60 million ] in that number I referenced earlier into initiatives that we can pick and choose from and try to drive it higher throughout the year, which last year, we had a lower bar and we ended up exceeding it. I hope you're right. I hope we can do that again in 2025 -- those based on everything we see today, we feel like that seen is a pretty good number."
},
{
"speaker": "John Kim",
"content": "Yes. Okay. And then Mike, you mentioned rent control in Monterey Peninsula, which is a little disconcerting because rent certainly haven't gone up that much. But can you comment on whether or not there's a vacancy decontrol components to that new measure? And are you concerned or are you hearing rumblings of similar rent control measures in other markets?"
},
{
"speaker": "Unknown Executive",
"content": "John, this is Chris. We can look at that a little bit further, but it does have to be abided by [ Costa-Hawkins ]. So there is no -- I don't feel that there's a vacancy control measure."
},
{
"speaker": "John Kim",
"content": "And any commentary on other markets?"
},
{
"speaker": "Unknown Executive",
"content": "The biggest thing we're looking at this year, there's commentary out of Washington state. A couple of bills at the state level. Obviously, we're looking at if there's an agency legislation in California, especially at the state level as far as rent freezes, et cetera. Those are kind of the 2 big focal points, I would say, right now."
},
{
"speaker": "Operator",
"content": "Our next questions are from the line of Julien Blouin with Goldman Sachs."
},
{
"speaker": "Julien Blouin",
"content": "I might have missed it, but can you give us a sense of January blends and new lease rate growth by region? And also one of your Sunbelt peers was noting that pricing events in January felt better than normal seasonality. I guess, are you seeing that in your own portfolio?"
},
{
"speaker": "Michael Lacy",
"content": "Hi, Julien. You didn't miss it. We didn't give necessarily the exact numbers, but what I would tell you again is occupancy is higher than we expect it to end of the year, turnover is lower than we expect and we're right on track when we look at our initiatives related to other income as well as our blends. So we feel pretty good about January right now. And quite frankly, we're in February, and that feels pretty good."
},
{
"speaker": "Julien Blouin",
"content": "Okay. Got it. And then maybe a second one. I mean, when we look at some of the really strong Sunbelt absorption numbers that continue to come through in the fourth quarter, on the face of it, it maybe seems even better than I would expect from current levels of job growth or migration trends in those markets. Do you feel that, that speaks to the pent-up demand in those markets from several years about this migration and job growth. And at some point, do we have to start worrying about maybe these high levels of absorption starting to deplete that pent-up demand?"
},
{
"speaker": "Joseph Fisher",
"content": "Julien. it's Joe. I think it's kind of 3 different factors. The first is we've talked a lot about the relative affordability component. So the total household formation activity this year hasn't been materially different than what we've seen in the past. But given the lack of new housing being built and then the lack of existing homes being sold, you've seen more household formations pivot over towards the rentership side, which we've talked about in the past when you got into the mid-20 tons we kind of saw rentership society take place given the relative affordability. So that feels like a multiyear trend, mainly because we don't expect home prices to come down and rates need to come down 100 to 200 basis points just to get back to a pre-COVID level in terms of affordability. So it's a little bit of that. And again, you are hearing -- homes of individuals coming off the couches and some get in other renter's basements. So when you look at younger age cohorts, you're seeing a little bit of that, which there's been a pretty high level of younger age cohorts living at home. And so you're starting to hear a little bit of that as they've built up their savings and got into their income-producing years. And then lastly, as you see more and more return to work and return to office, that does bring people back in and get them off couches at home as well. And so there's a couple of different trends that are providing a tailwind during the phase of record supply. As we talked about, we're kind of going more normal supply here as we move into '25 and decrease in '26. And so I think those trends generally probably remain in place. The big one will obviously just be what even on the demand from a jobs perspective."
},
{
"speaker": "Operator",
"content": "Our next questions are from the line of Alex Kalmus with Zelman & Associates."
},
{
"speaker": "Alex Kalmus",
"content": "First off, congratulations to Mike and Joe, for your new roles at firm, wanted to ask about your strategy for potential acquisitions this year. There's definitely more optimism for unlocked seller supply at NMHC last week and is there any upside to that acquisition volume from what you're hearing? And any particular markets that might be in focus at the moment."
},
{
"speaker": "Joseph Fisher",
"content": "Hi, Alex. It's Joe. There definitely was a lot of optimism in NMHC in terms of not just the go-forward fundamental picture, but a lot of capital out there looking for transactions on the multifamily side. obviously continues to be one of the favorite asset classes out there. I think one of the best challenges, however, is that the sellers see that same dynamic. And so unless you're a force seller due to duration of funding coming up on the end of a fund. Do you have a capital event, such as a refinancing -- that you don't think you're going to be able to effectuate. You're just not seeing many assets come to market. And so the bullishness on the buyer side is kind of lines on the seller side though, that is keeping transaction volumes down where we're focused is, obviously, with our joint venture partner, LaSalle and trying to effectuate a couple of deals there with them. We're talking about a couple of different target markets, which we're still aligning on and making sure we work through. So I'm not prepared to talk about that right now. But it's going to be typically that 2- to 3-year-old product to a maximum is going to have a nice value-add component that we can get off to either our operational team and/or our redevelopment team to try to get a lift in NOI for on-balance sheet transactions, we will continue to look at those as well as continue to look at disposition activity and see if maybe we can enhance the cash flow growth profile of the company over time."
},
{
"speaker": "Alex Kalmus",
"content": "Got it. Makes sense. And I know you touched on it earlier, but just on your recent partnership with funnel, are there any additional details you can provide about the partnership? And maybe more specifically, its effect on NOI or how it fits into the context of the technology and innovation initiatives you've been rolling up."
},
{
"speaker": "Michael Lacy",
"content": "I'll take that. I think for us specific to the rollout of it, it's really going to help allow us to drive the customer experience project even further. And again, it's not the end all be all with how we think about innovation. It's going to allow us to really spend more time on all these other ideas and all the data that we have on the customer experience, how we can leverage that because we're not going to have to deal with a lot of the back office, pieces that we were dealing with because, quite frankly, funnel wasn't around when we started our own CRM probably 3 years ago. And so we've had a -- notion that for quite a long time. This is going to allow us to leverage a group that's done a really good job with it. And I'd say, in addition to that, we had plans around our online leasing process, our move-in process and something we call omni-channel just a more seamless streamlined approach to how we communicate with prospects and residents. So there's a lot of benefits that are going to come with this, and we're just now scratching the service. We're going to learn a lot over the next 3 to 6 months."
},
{
"speaker": "Operator",
"content": "Our next question is from the line of Haendel St. Juste with Mizuho Securities."
},
{
"speaker": "Haendel St. Juste",
"content": "Thanks for hanging in there. Two quick ones for me. First, a follow-up on development. I guess I'm curious..."
},
{
"speaker": "Joseph Fisher",
"content": "You're breaking up."
},
{
"speaker": "Haendel St. Juste",
"content": "My first question is on development. I'm curious how you guys are..."
},
{
"speaker": "Joseph Fisher",
"content": "We lost you again. Operator, can we have a jump back in the queue."
},
{
"speaker": "Operator",
"content": "Our next question is from Linda Tsai with Jefferies."
},
{
"speaker": "Linda Yu Tsai",
"content": "Just one. You said turnover would be 100 bps lower this year. It sounds like it's mostly from operational improvements. Are there certain markets where you see larger opportunities to reduce turnover?"
},
{
"speaker": "Michael Lacy",
"content": "Good question. I'd tell you, again, we put 100 bps into our can for the year. And again, just looking at January, February, we're between 400 and 500 bps better than the prior year. So we're off to a really good start. And I can tell you when I look at our markets, our regions, we're seeing a pretty consistent downward trend across the board. I mean it was pretty amazing to see just January was sub-30% turnover. I've never seen a number like that. And so it's pretty much broad-based across the country because with the implementation of our CRM, all the efforts that we have on the data we are backing in every market, every property and quite frankly, every individual resident that we have at the property. So it should be kind of broad-based."
},
{
"speaker": "Linda Yu Tsai",
"content": "Are there more costs associated with reducing that turnover?"
},
{
"speaker": "Michael Lacy",
"content": "A little bit. This year, we're placing a little bit more of a bigger bet in terms of some of our CapEx spend. And so again, we're going in -- we've identified some properties where we've had just recurring issues as it relates to HVAC or water heaters or things of that nature. And if we can get in there and try to fix some of these recurring issues, we think that we can also limit how many people are moving out on a given basis. So a little bit more as it relates to the CapEx balance, but not necessarily on our OpEx."
},
{
"speaker": "Operator",
"content": "Next question is from the line of Tayo Okusanya with Deutsche Bank."
},
{
"speaker": "Omotayo Okusanya",
"content": "Perfect. Sorry about that. So just a quick question. One of your peers is kind of increasingly doing more in terms of just kind of like townhouse, townhome type product. kind of looking a little bit more like FFR products. I'm just kind of curious how you guys think about that as an opportunity, especially given you already in kind of some of the key FFR markets."
},
{
"speaker": "Tom Toomey",
"content": "This is Toomey. Yes, it's a product I'm quite familiar with and have done in times in the past. And if you go down to our Vitruvian development in Dallas, you'll find that we've put up 85 homes down there on the townhome product, it only fits where you don't have enough density opportunity, okay? And so you look at long-term hold periods and you think about a site and where you would get the most cash flow. Density is always something we're striving for why it just gives us a bigger capital footprint and opportunity to grow. So it fits, it's generally more of a suburban farther out fringe product. It can be a lot of good Phase II type of development activity. So we're familiar with it, when we find sites that fit that template certainly have the capability to execute. Leaning in, I think we look down the whole risk reward grid of our capital deployment, and Joe's in charge of that now."
},
{
"speaker": "Operator",
"content": "Our next question will be coming from Haendel St. Juste."
},
{
"speaker": "Haendel St. Juste",
"content": "I apologize for that earlier. I had 2 quick ones. First is on development. I guess I'm curious how you're factoring in potentially higher input costs from potential tariffs, lumber labor into the high 5 yield targets you mentioned. And of the 2 or 3 projects that you were looking to start near term, how much of those costs are locked in?"
},
{
"speaker": "Joseph Fisher",
"content": "Yes. So you're seeing costs come down there for a short period of time kind of early '24, cost settlements have really kind of stabilized at this point in time. So in our underwriting, have factored in some inflationary pressures. We are out there on our first start out and bidding that out and trying to lock in costs right now. And so that is in process, piece of the project, the starts that could potentially be in the second half of this year. We've got estimates that they are not locked in at this point in time. So that's a little bit fluid. I think while on the tariff front, there's going to be a couple of concerns if, in fact, those tariffs actually stick and at what level. The lumber side of the equation would be kind of the near-term concern with the lumber supply coming from Canada. There's obviously other things like mechanicals and glass and things of that nature that may be at risk to depending on the origin source. The flip side is that as you continue to see start activity plummet, there is greater availability of labor. And so seeing what happens with the labor side and subcontractors being either able to squeeze out margins just to keep our people working would -- and/or just seeing less wage pressure from certain trades. So there's some balancing back to it. But right now, we feel like we've sensitized at least the first deal to make sure that we can move forward with it."
},
{
"speaker": "Haendel St. Juste",
"content": "Got it. Got it. And then looking at the 8 projects in your future pipeline? How many are shovel-ready today? And maybe how many could be within the next couple of quarters? Just curious how soon perhaps you could flex that potential pipeline up here over the next couple of quarters or so?"
},
{
"speaker": "Joseph Fisher",
"content": "Yes. I'd say there's probably 4 to 5 projects right now that if you fast forward over the next 12 months, are either shovel-ready or could be shovel-ready. So some of them going through kind of the tail end of designs, and we continue to value engineer, see what else we can do to enhance yields. Let's say, 4 to 5 of those projects could be ready within the next 12 months if we needed to be."
},
{
"speaker": "Haendel St. Juste",
"content": "And the yields would be about the same?"
},
{
"speaker": "Joseph Fisher",
"content": "Yes, that'd be about the time in the high 5% to 6% is what we're targeting."
},
{
"speaker": "Operator",
"content": "Our final question is from the line of Mason Guell with Baird."
},
{
"speaker": "Mason P. Guell",
"content": "On the preferred equity book. Do you have any update on the [ 1,000 ] investment attrition -- year? And then for [ junction and notes ] maybe other [indiscernible] has there been any change in demand given the hire?"
},
{
"speaker": "Joseph Fisher",
"content": "Hi, Mason, I think we caught part of that. I think you were asking about 1,000 Oaks in demand for that project. if that's not correct, obviously, jump back on and if you could reiterate, but the 1,000 Oaks project has continued to see very strong demand. Unfortunately -- how the implications from the fires. And so we are seeing that. That project has gone from kind of low 90s leased and occupied a few weeks ago up into the mid-90s already and continues to see good momentum. And so that object is performing well in the face of what's an important circumstance."
},
{
"speaker": "Mason P. Guell",
"content": "Can you give me an update on -- I get something mature this year? Do you have any update on that?"
},
{
"speaker": "Joseph Fisher",
"content": "What pace of the maturities?"
},
{
"speaker": "Mason P. Guell",
"content": "On 1,000 Oaks."
},
{
"speaker": "Joseph Fisher",
"content": "On 1,000 Oaks. Yes, just it shows a shorter years to maturity that equity partner is probably going to be looking at a short-term extension on the loan just as we continue to see momentum on the occupancy and that side. So we do think that probably transact this year. They've got good valuation, good equity in that deal. It should trade very well. But I think they'll probably stand here short term to continue to work through what's going on out there in L.A."
},
{
"speaker": "Operator",
"content": "Thank you. I would now like to turn the floor back to Tom Toomey for closing remarks."
},
{
"speaker": "Tom Toomey",
"content": "Once again, thank all of you for your time, interest and support of UDR. We look forward to seeing many of you at upcoming events. And with that, take care."
},
{
"speaker": "Operator",
"content": "This will conclude today's conference. You may disconnect your lines at this time. Thank you for your participation."
}
] |
udr | 2,024 | 3 | [
{
"speaker": "Operator",
"content": "Greetings, and welcome to UDR's Third Quarter 2024 Earnings Call. [Operator Instructions] As a reminder, this conference call is being recorded. And it is now my pleasure to introduce your host, Vice President of Investor Relations, Trent Trujillo. Thank you, Mr. Trujillo. You may begin."
},
{
"speaker": "Trent Trujillo",
"content": "Welcome to UDR's quarterly financial results conference call. Our press release and supplemental disclosure package were distributed yesterday afternoon and posted to the Investor Relations section of our website, ir.udr.com. In the supplement, we have reconciled all non-GAAP financial measures to the most directly comparable GAAP measure in accordance with Reg G requirements. Statements made during this call, which are not historical, may constitute forward-looking statements. Although we believe the expectations reflected in any forward-looking statements are based on reasonable assumptions, we can give no assurance that our expectations will be met. A discussion of risks and risk factors are detailed in our press release and included in our filings with the SEC. We do not undertake a duty to update any forward-looking statements. When we get to the question-and-answer portion, we ask that you be respectful of everyone's time and limit your questions to one plus a follow-up. Management will be available after the call for your questions that did not get answered during the Q&A session today. I will now turn the call over to UDR's Chairman and CEO, Tom Toomey."
},
{
"speaker": "Tom Toomey",
"content": "Thank you, Trent, and welcome to UDR's third quarter 2024 conference call. Presenting on the call with me today are President and Chief Financial Officer; Joe Fisher; and Senior Vice President of Operations, Mike Lacey. Senior Officers, Andrew Cantor and Chris Van Ens are also available during the Q&A portion of the call. Our year-to-date results continue to exceed our prior expectations due to the operating strategies we utilized to drive strong same-store and earnings growth in tandem with improving industry fundamentals. As a result, we raised our full year FFOA per share guidance for the third time this year, while also improving our same-store revenue, expense and NOI growth expectations for the second time this year, in conjunction with yesterday's earnings release. Strategically, we remain focused on three drivers of growth that differentiate us from peers. First, we continue to innovate, which has added to our bottom line in 2024 and will do so for many years to come. This is evident in the results from our value-add initiatives which have consistently grown in the high single-digit range and added 50 or more basis points annually to our same-store revenue growth. Second, we continually listen to our associates and residents which influences our operating tactics and long-term strategy. The customer experience project is a great example of this. The insight we glean from hundreds of thousands of daily touch points with existing and prospective residents has translated into data on satisfaction. We use this information to orchestrate and enhanced UDR living experience, improving retention and lower turnover costs and capital expenditures. We are just scratching the surface and expect further enhancements in the customer experience project will support additional retention advantages versus peers, and drive future margin expansion and cash flow growth. And third, although we remain in a capital-light mode, we maintain an investment-grade balance sheet with substantial liquidity. This positions us well to take advantage of growth opportunities when we have an attractive cost of capital. We continue to explore various forms of external growth, including joint venture acquisitions, OP unit transactions and development to drive future accretion. There's also a variety of positive fundamental drivers for our industry. These include: first, demand remained strong. Employment growth continues to surprise the upside and income growth has outpaced consensus expectations. This has led to more than 450,000 newly delivered apartment homes being absorbed nationally during the first nine months of the year, which is approximately 50% above long-term average. Second, the pace of new supply is slowing. 2024 multifamily completion marks a 50-year high, but absorption has been robust, and pricing on lease-up communities has remained rational. Total housing deliveries through the end of the year appears stable relative to the third quarter and start to continue to decline. We expect the trend of lower starts to persist due to the cost of capital and availability of capital. A future supply pipeline that is below historical average levels bodes well for rent growth in the years ahead. And third, renting apartment is approximately 60% more affordable than owning a single-family home in the markets where we operate, the best level of relative affordability in two decades. These fundamental trends, combined with our operating tactics that have improved resident retention, have led to further revenue expense growth outperformance. Mike will provide additional details in his remarks. Moving on, we continue to build on our position as a recognized leader in stewardship. With the release of the sixth annual ESG report, which we published earlier this month, we detailed the leadership UDR has continually exhibited in setting and achieving various environmental, social and governance goals. Chris Van Ens and our sustainability team deserve credit for advancing our long-term environmental strategy. Collectively, our efforts have enabled UDR to become a more sustainable and resilient company, one that can thrive across a multitude of economic environments and overcome challenges head-on. Together, we have created a desirable workplace with an engaging employee experience that thrives on innovation and collaboration. To my fella associates, I look forward to sharing more success with you in the years to come. As a final thought, macro volatility, election uncertainty, the path of the Fed and their collective efforts on interest rates, the economy and the employment market are all out of our control. However, I remain optimistic about the long-term growth prospects for our country and the multifamily industry. We will continue to focus on what we can control enhance our dynamic and innovative culture and empower our associates to deliver attractive results that create value for UDR's residents and stakeholders. With that, I will turn the call over to Mike."
},
{
"speaker": "Mike Lacy",
"content": "Thanks, Tom. Today, I will cover the following topics: our third quarter same-store results and early fourth quarter results, including regional operating trends, and our improved full year same-store growth guidance, including underlying assumptions. To begin, third quarter year-over-year same-store revenue and NOI growth of 1.2% and 0.8%, respectively, were better than expected given difficult prior year comparisons. Our third quarter results were driven by, first, 1.8% blended lease rate growth, which was driven by renewal rate growth of over 5% and new lease rate growth of approximately negative 2%. Second, 55% annualized resident turnover was nearly 200 basis points below the prior year period and more than 600 basis points better than our 10-year average. This has enabled us to maintain healthy renewal rate pricing and led to more favorable blended lease rate growth. Third, occupancy averaged 96.3%, which is lower than our historical third quarter average. This was strategic as we implemented enhanced AI screening and fraud identification tools used by our associates to enhance the overall credit quality of our residents and mitigate bad debt over the longer term. Healthy levels of traffic and leasing volume combined with higher revenue retention enabled us to increase occupancy in September, and we finished the quarter at 96.5%. And fourth, other income growth was approximately 5% and was driven by our continued innovation along with the delivery of value-add services to our residents. Shifting to expenses. Year-over-year same-store expense growth of 2% in the third quarter came in better than expectations. These positive results were driven by favorable real estate taxes, insurance savings and constrained repair and maintenance expenses due to our improved resident retention. Moving on. Core operating trends have remained resilient in October, and key metrics have largely followed typical seasonality. First, October blended lease rate growth is roughly flat. On a like term basis, which excludes the impact of short-term rentals, October blended lease rate growth is approximately positive 1%, which is slightly below September results and follows normal historical sequential rent growth trends. Given the heightened volume of short-term lease expirations in the September to October timeframe, we expect the impact of short-term rentals on our lease rate growth should ease through year-end. Effective new lease rate growth appears to have stabilized from September to October in the negative 5% range, while we have continued to have success executing renewal lease rate growth in the mid-4% range. Regionally, the East Coast is showing the most strength with blended lease rate growth of approximately 2%. This is followed by slightly positive blends on average in our West Coast portfolio and the Sunbelt at approximately negative 3.5%. Based on current trends, we expect East Coast leadership to persist through at least early 2025. Second, resident retention continues to compare well against historical norms, and October represents the 18th consecutive month our year-over-year turnover has improved. Relative affordability compared to other forms of housing is a benefit to the apartment industry in total. Given the level of home prices and mortgage rates the average cost of only a home across UDR markets is nearly $5,600 per month. By contrast, the average rent for an apartment at UDR is approximately 2,600 per month. thereby creating annual shelter cost savings of $36,000. This disparity has led to a record level of resident moving out to buy a home. We estimate that in order to return to historical average of relative affordability between renting apartment and buying a home. Mortgage rates would need to decrease approximately 150 to 200 basis points, all else equal. Furthermore, with the success of our ongoing customer experience project, our resident retention over the past year has improved by approximately 200 basis points relative to the peer group average. This is a testament to our team's focus and execution on our innovative data-driven approach to customer service. Ultimately, improved retention should drive better pricing power, higher occupancy, increased other income, reduced expenses, lower CapEx and margin expansion. We remain in the early innings of capturing these benefits and believe the opportunity in 2025 and beyond is to capture $10 million to $25 million of incremental run rate NOI. Third, occupancy has trended higher to 96.6% on average in October, a 40 basis point improvement from our year-to-date low of 96.2% in June. Traffic is higher than the same time a year ago, and our 30-day availability is less than 4%, which supports our expectation of occupancy remaining in the mid-96% range through the remainder of 2024. And fourth, other income is growing in the mid- to high single-digit range, slightly higher than what we achieved in the third quarter. As a reminder, other income constitutes roughly 11% of our total revenue. We remain pleased with the trajectory of our other income initiatives such as the rollout and penetration of building wide WiFi as these contribute significantly to incremental same-store revenue growth as well as our resident experience. When considering these factors and more moderate prior year comparisons as compared to the third quarter, we expect year-over-year same-store revenue and NOI growth to accelerate in the fourth quarter. Turning to regional trends. Our coastal results continue to exceed our expectations, while our Sunbelt markets have performed largely in line. More specifically, the East Coast, which comprises approximately 40% of our NOI, was our strongest region in the third quarter and Washington, D.C. was our best-performing market, driven by continued strength in Northern Virginia. Third quarter weighted average occupancy for the East Coast was 96.5%. Blended lease rate growth was nearly 4% and year-over-year same-store revenue growth was approximately 2.5%. With continued healthy demand and relatively low new supply, we expect this region to be our strongest through the rest of the year. The West Coast, which comprises approximately 35% of our NOI, has performed better than expected year-to-date. Third quarter weighted average occupancy for the West Coast was 96.3%. Blended lease rate growth was slightly higher than 2%. And year-over-year same-store revenue growth was approximately 2%. Recent return to office mandates and increased office leasing activity in the Pacific Northwest has supported relative strength in our Seattle portfolio. While incremental public safety and quality of life improvements have led to improved leasing traffic and occupancy in San Francisco. Absolute levels of new supply remain low at less than 2% of existing stock on average across our West Coast markets, which we expect will lead to a favorable supply/demand dynamic in the coming quarters. Lastly, our Sunbelt markets, which comprise roughly 25% of our NOI, continued to lag our coastal markets. Year-to-date revenue growth is largely in line with our original expectations and is supported by other income growth from our value-add initiatives. Third quarter weighted average occupancy for the Sunbelt was 96.1%, blended lease rate growth was negative 2% and year-over-year same-store revenue growth was negative 1.5%. Among our Sunbelt markets, lease rate growth in Florida is holding up the best while elevated new supply is negatively impacting our Texas portfolio. While our Sunbelt markets broadly have more robust job growth than our coastal markets and absorption of new supply has been tremendous, it has come by the way of concessions and a deterioration of pricing power. Based on existing inventory, forthcoming supply and leasing activity trends, our analysis suggests pricing stability in Denver, Dallas, Tampa and Orlando in mid-2025. The timeline for Nashville and Austin are elongated, and we would expect supply/demand equilibrium in late 2025 and into 2026 in those markets. Based on our year-to-date results, we raised our full year 2024 same-store growth guidance for the second time this year in conjunction with yesterday's release. Starting with same-store revenue growth, we raised our midpoint to 2.2% from 2.0%. The 20 basis point increase is driven by: first, a 10 basis point improvement in full year blended lease rate growth which we now forecast to be approximately 140 basis points. Using a midyear convention, our updated blended lease rate growth expectations should contribute an incremental 5 basis points to 2024 same-store revenue growth. Second, we expect the combination of occupancy and bad debt to contribute approximately 10 basis points to same-store revenue growth, an improvement compared to our prior expectations of flat. And third, a 5 basis point improvement in full year revenue contribution from innovation and other operating initiatives. Moving on to same-store expense growth. We lowered our midpoint by 60 basis points to 4.4%. The improvement was driven by constrained insurance, repair and maintenance and real estate tax growth. As a reminder, same-store expense growth of 7.5% in the first quarter was elevated due to comping off a onetime $3.7 million employee retention credit we realized at the beginning of 2023. Absent this factor, we would expect same-store growth for the full year to be in the mid-3% range or approximately 80 basis points lower than our updated midpoint. Looking ahead, the building blocks for 2025 same-store growth are coming into focus. Based on our revised outlook, we are forecasting a 2025 same-store revenue earn-in of approximately 60 to 70 basis points, which is in line with our 2024 earn-in and is approximately half of our historical norm. We will provide 2025 guidance in February, which will address our outlook for market rent growth, occupancy, bad debt contributions from other income and expense growth. In sum, our diversified portfolio enables us to tactically adjust our operating strategy to maximize revenue and NOI growth while continued innovation sets us up well for further margin expansion. My thanks go out to the UDR associates nationwide for your steadfast commitment during a period of unprecedented new supply. Together, we've delivered attractive results and have positioned ourselves for future growth. Finally, a special thanks to our teams in Tampa and Orlando for their immense efforts during the recent hurricanes. You undertook tremendous preparation to ensure the safety of our residents and fellow associates, minimize downtime at our properties and promptly restored them to operable conditions. I have full faith that our people can continue to make a difference as we collectively work to return the vibrancy to these cities and improve the lives of many who have been affected by these storms. I will now turn over the call to Joe."
},
{
"speaker": "Joe Fisher",
"content": "Thank you, Mike. The topics I will cover today include our third quarter results and our updated full year guidance, a summary of recent transactions and capital markets activity and a balance sheet and liquidity update. Our third quarter FFO as adjusted per share of $0.62 achieved the midpoint of our previously provided guidance. This flat sequential result is typical between the second and third quarters when looking back at our history, and was due to nominal changes across NOI, interest expense and G&A. With our most difficult prior year comparisons now in the rearview mirror and a constructive operating trajectory in the year-end, we have raised our same-store growth and FFOA per share guidance ranges. Our updated full year 2024 FFOA per share guidance range is $2.47 to $2.49. The $2.48 midpoint would result in positive year-over-year growth despite record high supply and a more elevated interest rate environment. Since providing initial guidance in February, we have raised FFOA per share guidance 3x by a cumulative $0.06 per share or approximately 3% and have improved the midpoints of our same-store guidance ranges twice, which Mike discussed in his remarks. Looking ahead, our fourth quarter FFOA per share guidance range is $0.62 to $0.64. The $0.63 midpoint is $0.01 or 1.5% higher sequentially and is driven by same-store NOI growth, additional lease-up NOI from recently developed communities and lower interest expense. Next, a transactions and capital markets update. During the quarter, we executed several transactions under our Debt and Preferred Equity Program, which we have renamed from Developer Capital Program given the shift in investment and risk profile towards stabilized operating assets. First, we fully funded a $35 million preferred equity portfolio investment at a 10.75% rate of return on four stabilized communities located in Portland, Oregon as part of a recapitalization. The risk profile is lower than a typical new development project and positive cash flow allows for approximately 2/3 of our contractual return to be paid current in cash. Second, we received an approximately $17 million paydown on our preferred equity investment in Vernon Boulevard, located in Queens, New York. In conjunction with the pay down, we agreed to lower our rate of return from 13% to 11% to reflect the reduced risk in our remaining investment due to the development being completed and more secure positioning in the capital structure, and an increased proportion of the contractual return to be paid current in cash. Third, we originated a $31 million senior loan affiliated with our investment in junction located in Santa Monica, California. The proceeds were used to repay in full the prior senior construction loan, which was scheduled to mature in January 2025. This activity enhances cash flow to the property and better positions UDR to control future outcomes. Simultaneously, we recorded an approximately $8 million noncash impairment loss due to a decrease in the value of the operating community. Finally, our investment grade balance sheet remains liquid and fully capable of funding our capital needs. Some highlights include: first, we have more than $1 billion of liquidity as of September 30. By extending the maturity date of our $1.3 billion senior unsecured revolving credit facility to August of 2028, we have insured ample liquidity for years to come. Second, we have only $536 million or 9% of total consolidated debt and approximately 2.5% of enterprise value scheduled through mature through 2026, thereby reducing refinancing risk. Our proactive approach to managing our balance sheet has resulted in the best three-year liquidity outlook in the sector and the lowest weighted average interest rate amongst the multifamily peer group at 3.4%. And third, our leverage metrics remain strong. Debt to enterprise value was just 28% at quarter end, while net debt-to-EBITDAre was 5.6x, which is approximately half of a turn better versus pre-COVID levels. In all, our balance sheet and liquidity remain in excellent shape. We remain opportunistic in our capital deployment, and we continue to utilize a variety of capital allocation competitive advantages to drive long-term accretion. With that, I will open it up for Q&A. Operator?"
},
{
"speaker": "Operator",
"content": "[Operator Instructions] And our first question comes from the line of Jamie Feldman with Wells Fargo. Please proceed with your question."
},
{
"speaker": "Jamie Feldman",
"content": "I appreciate all the color on other income and some of the initiatives you have on improving tenant credit. But as we think about '25 and think about what growth contributed to '24 or what other income contributed to '24 growth, do you think it will be the same, more or less, as we build out our thoughts on '25? I know you talked about a multiyear view, but just in terms of the specific growth rate, what do you think you could do?"
},
{
"speaker": "Mike Lacy",
"content": "Jamie, it's Mike. I'll tell you first, when you think about 3Q, that 5% number was a little bit lower than we expected. I can tell you going into October and for the rest of the year, we're back in that plus or minus 8% range and a lot of that's around the success of the initiatives that we're rolling out. And so, as we move into next year, my anticipation is that it's actually going to be pretty similar. I'd say in that 70% range again. And a lot of that has to do with the initiatives around WiFi rollout, the success that we're having there. And just to size it, we had about $5 million in NOI from the initiative in 2024, my expectation right now is that's going to be close to double that number next year. So that alone is a big initiative for us as it relates to other income."
},
{
"speaker": "Joe Fisher",
"content": "Jamie, Joe. Just maybe one other thing to add there because I do think we've always been known for our ability to drive other income to a higher growth rate than the rest of the portfolio. But when you do look at a couple of our big initiatives out there, Mike mentioned one with WiFi. But to the other biggest initiatives we have going on, both customer experience and fraud prevention, these have material bottom line impacts, but probably won't show up to the same degree in other income. And so, while other income gets a lot of focus, we do think customer experience between increasing retention and occupancy, pricing power, lowering turn costs, kind of the same thing with fraud, with keeping some bad actors out of the front door, having an impact on a multitude of line items. You'll see it be a little bit more dispersed in terms of where we're focusing our initiative efforts right now versus just other income. So just keep that in mind on a go-forward basis, too."
},
{
"speaker": "Jamie Feldman",
"content": "That's very helpful. And then, I guess, as we think about the debt and preferred equity book, I know you said you had some redemptions. How do we think about '25? Like do you think you'll be able to maintain the balance? Do you think that you'll have more redemptions than ads you think or vice versa? Just trying to think about the impact on the growth rate there."
},
{
"speaker": "Joe Fisher",
"content": "I think you'll probably see us be able to plus or minus maintain it. It can be a little bit, I guess, episodic from period to period. You can see it come down for a quarter, back up for another quarter, but we do have a good number of opportunities that we continue to evaluate. They are primarily on the operating recap side. And you saw us rename that part of the platform here in the quarter to just Debt and Preferred Equity Program as we continue to see that shift from just funding development assets to more operating assets. So, I think you'll see some payoffs as we go into next year. And as we continue to monitor those, we'll look at redeploying within that space. And continue with that platform at plus or minus the level it's at today."
},
{
"speaker": "Operator",
"content": "And the next question comes from the line of Austin Wurschmidt with KeyBanc Capital Markets. Please proceed with your question."
},
{
"speaker": "Austin Wurschmidt",
"content": "Mike, could you just clarify how you would define, I guess, stability with respect to your comment about some of the Sunbelt markets you referenced? And then also, you highlighted same-store revenue growth is reacceleration -- is reaccelerating into the fourth quarter, but I'm wondering if you expect kind of effective lease rate growth or total revenue per occupied home, that you quoted, to also reaccelerate?"
},
{
"speaker": "Mike Lacy",
"content": "Yes. A couple of things there, Austin. Let me back up a little bit and just give a little bit of a high level on what we're seeing with kind of trends today and how we see that playing out by region as well as thinking about next year a little bit. But I'd say, first and foremost, our blends are ahead of our original expectations for the year and our occupancy back up in that high 96% range. And so, when you think about what we've communicated all year, first half, our blends were higher than what we expected. The back half of the year, they're pretty much right in line with where we thought. And I would tell you, when you look at the different regions, they're all playing out where we'd expect it today. That being said, looking at our blends today, we're about 1.6% blended growth year-to-date. As I mentioned in my prepared remarks, expectations are -- will be around 1.4% for the year. So that implies flat blends through the fourth quarter. And specific to what we're seeing in October, this is playing out as expected. I'd tell you one thing, I mentioned in my prepared remarks that had a little bit of a change on us is 20% of our leases were impacted by short to long terms. And when I say that, that means a short-term lease typically has a premium associated with it. And then those people are coming off of, call it, September timeframe from the summer months. We're signing 12-month leases today. That impacted our blends by about 100 basis points. But when we fast forward and we look at November and December, it's actually about half of that exposure. So less than 10% of our leases should be impacted by this, and it's going to be about a 50 basis point impact to our blends. And so again, things are playing out kind of expected. Today, I would tell you it's not a trend. But when I look at the Sunbelt compared to the coastal market, we've actually picked up about 60 basis points in occupancy. So, we were running around 96.1%, 96.2% during the third quarter. We're actually back up around 96.7%, 96.8% today. And our blends, while they've decelerated a little bit, they've actually decelerated at a slower pace than what we've seen in the coastal markets. And some of this has to do with the short to long phenomenon that I just spoke to."
},
{
"speaker": "Austin Wurschmidt",
"content": "I appreciate all the detail there. And then also, thank you for some of the stats on turnover and especially from a historical perspective. I mean, how are you guys thinking about that trend in 2025? And I don't know if you have this at your fingertips, but could you just give us a sense how much a 1% swing or so in turnover impact expense growth?"
},
{
"speaker": "Mike Lacy",
"content": "Yes. Austin, I think this one is another one where maybe I'll back up a little bit and just talk more about what we're doing with the customer experience project because we are still early innings as it relates to this initiative. We think there's a lot more room to gain. And so, if I start there, and then I can go into some of your specific questions, but for us right now, we have about 800 million data elements in the system that we've gathered over the last seven or eight years, and we're adding nearly 1 million data elements a day, and so a lot of information here. And I would tell you over the last 12 months, so not even just this year, we've had about 1,800 less move-outs on a year-over-year basis. And for us, that translates to about $9 million in NOI. When you think about going forward, we still think this is a 5% to 10% sustainable advantage that we can have over our competition. That's about $15 million to $30 million in value. And again, we know that this can be successful because 50% of turnover is control. When you have forwarding addresses and you see individuals that are just going across the street, they effectively failed us, we failed them, and they're moving out, and we need to change that trajectory. And that's what we've been working on. That's what's playing out with the customer experience project. So yes, when you look at that -- those numbers I quoted earlier were about 600 basis points better than our historical averages for this time of the year. A lot of our peers and a lot of the competition are seeing this success as well in terms of just affordability. But when you look at our numbers versus the peers on a relative basis, we were behind them about 170 basis points in the timeframe of, call it, 2022, '23. Today, we're about 70 basis points better. And so you can see that the difference on our focus on the customer is paying dividends. Again, we think that this is going to continue to just get better as we continue to learn more with all the data elements in the system. And so, what we're experiencing today when you look at R&M down around 3% to 4% growth, our expectations would have been around 7% to 8% growth. And so not having all the turnover definitely impacts R&M, but it also impacts our vacant days, our other income as well as CapEx and so for every individual that we save, it's approximately $5,000."
},
{
"speaker": "Operator",
"content": "And the next question comes from the line of Eric Wolfe with Citi. Please proceed with your question."
},
{
"speaker": "Eric Wolfe",
"content": "You mentioned a handful of markets like Orlando, Tampa and Dallas, that could be an equilibrium. I think you said something like that by the middle of next year. Just curious what the implications of that are? Like, does that mean that rent growth is going to a more normal level, like 3%? Does that mean spring [indiscernible] should be sort of more normal? Like what does that mean in equilibrium?"
},
{
"speaker": "Mike Lacy",
"content": "Yes. I'd tell you right now, we're riding the thick of the process of trying to figure out what our budgets look like next year. And so, we typically do a top-down, bottom-up approach, working with the individuals out in the field, understanding what's happening at their specific sites within the markets, what supply is going to do to us and then just having an understanding of the demand that's out there. And so, we're working through that process now. We typically button that up at the end of the year. But we have been having lots of conversations around the supply impacts especially as it relates to the Sunbelt, we do see that that's going to be an impact to the, call it, first three to six months of next year. Ideally, we do get back to that 2% to 3% range as you move throughout the year, and maybe in the back half of the year as you have easier comps, it starts to get even better. But in the first six months, we do expect to see more of the same of what we're experiencing today in terms of blends in those markets."
},
{
"speaker": "Tom Toomey",
"content": "Eric, this is Toomey. Just to add a little bit more color there, and it's a very good question. Mike highlighted the key elements of it. We know what the supply looks like. We know how it's getting priced. It's been very rational at this point in time. What really is the variable on the table is job growth. And we've had a great number in '24, even after revisions pretty solid. I think we're all kind of scratching our head and wondering what '25 brings. So, it's going to be an adjustment based off of that. But every other part of the market, supply-demand aspect of it seems to be in balance. And that's why I think Mike can say it looks like it's stabilizing."
},
{
"speaker": "Eric Wolfe",
"content": "Understood. That's helpful. And then I think you also mentioned that there's 10 bps of that embedded bad debt improvement for next year. Maybe I just misheard that. But I was curious if that means that you're expecting to end the year around 1.4% in bad debt? And how you're thinking about any potential improvement from that level going forward?"
},
{
"speaker": "Joe Fisher",
"content": "Eric, so yes, the incremental improvement really relates to '24, we kind of started out the year on our original forecast [Technical Difficulty] kind of mid-98s collected, kind of 98.5, 98.6. So, kind of just under 1.5% of bad debt. Where we're likely to shake up this year is probably just over 1%. So, we had a little bit of a benefit in this year's numbers. I'd say, as you go forward to next year, Mike talked a little bit about that proactive approach that we took on some of the screening on both income and ID verification. We do expect that to have a continued benefit. We got some of it this year, some will come next year. And it's not just in that revenue line item. Obviously, it's an occupancy and term cost and CapEx, et cetera. But there's probably more to get there. We don't believe we're going back to the long-term average, though, I'll say that. So, when you hear us say we're kind of in the low one today. If historical average is 40 to 50 basis points, very unlikely we get all the way back to that, not necessarily due to having more bad actors. It's really just the bad actors we do have. It takes a lot longer to get them out of the units than it did historically given some of the regulatory restrictions. So still a little bit of a tailwind there, but we'll see how it shakes out next year."
},
{
"speaker": "Operator",
"content": "And the next question comes from the line of Josh Dennerlein with Bank of America. Please proceed with your question."
},
{
"speaker": "Josh Dennerlein",
"content": "I'll try to bring back the enthusiasm. I've spoken to a dead mic. So, if I missed this in the opening remarks, but were your short-term leases like much higher than normal. Is that what you meant by like 20% of leases were impacted by that short- to long-term lease? I just want to make sure I understand that dynamic there."
},
{
"speaker": "Mike Lacy",
"content": "Josh, that's a really good question. What I would tell you is it's a little bit higher than what we normally experience. And I'd tell you a lot of that points to the job and demand dynamics that have occurred over the last six months or so compared to kind of moving through COVID and then right after it. We did see a little bit more, especially in our coastal markets where you had interns coming back to work, you had a little bit more job growth in these markets where people are coming for the summer and then they are leaving in the first part of fall. And so yes, a little bit more and it definitely impacted us more on the Coast than it did in the Sunbelt."
},
{
"speaker": "Josh Dennerlein",
"content": "And then maybe like tying that to the customer experience, is that something that maybe you want to reduce like those short-term leases? I would assume if you have more short-term leases or maybe just in turns in general, many creates a little bit more friction with the customer experience maybe?"
},
{
"speaker": "Mike Lacy",
"content": "It does impact our turnover for sure. So, when you have these short-term leases coming off, it does impact those stats. But at the same time, when we look at this, it's all about profitability. And so, an example I would give you is our short-term furnish program. Not only are we getting a premium for the short-term lease versus a 12- to-14-month lease, but you're also achieving that positive income on that as well. So, it hits our fee income. And so, for us, at the end of the day, it's a very minimal number. I'd tell you, it's less than 1% of our total units at any given time, probably closer to 50 bps. And so, we manage this by market, by property to make sure that we don't have any overexposure to it. But we do go for the profitability piece."
},
{
"speaker": "Operator",
"content": "And the next question comes from the line of Nick Yulico with Scotiabank. Please proceed with your question."
},
{
"speaker": "Nick Yulico",
"content": "I just wanted to talk about capital allocation for a second. I know Tom you talked earlier about capital-light sort of focus of the Company right now. And so, I'm wondering, you guys had that heat map, which I think was last updated in September, but in terms of capital deployment, how are you thinking about stock buybacks right now? Because it does feel like there's a fair amount of interest in the private market to get asset sales done at potentially better pricing than where your stock is. So, what are some latest thoughts on that?"
},
{
"speaker": "Joe Fisher",
"content": "Nick, so we are still in that capital-light mindset and I'd say you've seen us do stock buybacks a number of times in the past. And I think we've done them from a pretty good perspective on timing, we've generally seen some upside appreciation whenever we have done that. It's not necessarily on the menu at these prices today, though. We've been kind of oscillating in the mid 45s here for a while, which kind of puts us in a plus or minus mid-5 cap type of number. We don't think that's fair by any stretch. Andrew can talk about where transaction pricing is today, but we kind of settled into that plus or minus five cap world here for a while. That said, where we do want to deploy, I mentioned earlier, we're kind of in recycling mode within the DPE program. So, as maturities come up, we'll do [Technical Difficulty] deploy there. The other two areas that we're primarily focused on right now. One is on the joint venture acquisition side. We continue to show opportunities to our joint venture partner that we put in place last year and have had some pretty good constructive conversations of late. So, we're hoping in '25, we start to get some traction on that front again. Those are really driven by what do we view from a market and submarket opportunity, but also can we find those deal next door opportunities that are under managed to put onto the ops platform. So definitely want to deploy it there. The other piece is, as you've seen previously, we tried to get creative with some of these OP unit transactions. So, deals where we can name our stock price and look at that more as a 1031 type of trade or a cash accretion trade. We are looking [Technical Difficulty] last year. We're looking at a couple of those right now. They are very long lead time typically and not all get to the finish line. So TBD on if anything comes with that. But that's really where we're spending most of our time today."
},
{
"speaker": "Nick Yulico",
"content": "All right. That's helpful. Just following up on the joint venture acquisition. So that now in the guidance is for none this year, there was some potential in guidance earlier this year. Can you just speak to what's driving that sort of, I guess, delay in getting some of those acquisitions done if it's your cost of capital, your partner's thinking? And then also, is there an opportunity to expand to additional partners in that program, given that feel this is in capital that wants to get into the sector with a good operating platform?"
},
{
"speaker": "Joe Fisher",
"content": "No, good question. We did originally have acquisitions in our original guidance throughout the year, which we've now taken to zero within the joint venture bucket. I wouldn't say that it's a lack of opportunities. There's plenty of opportunities out there that can check a lot of boxes for us. That said, our partner and their source of capital, they go through every five-year or so big mandate review of all global mandates. And we just happened to catch it during that period of time where kind of what pencils down in the middle of the year as they reevaluated everything. We're expecting in the next 60 days to come out of that just fine and continue to get back to work with them. Given that fact, as you asked about other potential joint ventures or partners, we selected this partner for a lot of really good reasons in terms of alignment with them, in terms of operational thinking, transactional thinking and a really good and deep source of capital long term. So really like the partners that we have and not really looking to add to that platform today."
},
{
"speaker": "Operator",
"content": "And the next question comes from the line of Rich Anderson with Wedbush. Please proceed with your question."
},
{
"speaker": "Rich Anderson",
"content": "So, on the former DCP platform now renamed for the reasons you explained doing more from a stabilized asset point of view. Why is that happening? Is that what the market is giving you? Or is there some sort of new governor you're placing on yourself in terms of the risk profile of what the money you want to put out? I'm curious as to why that change has happened and affected the name change as well?"
},
{
"speaker": "Tom Toomey",
"content": "Rich, it's good to hear your voice. It's real simple. There's not a lot of development going on that pencils it make sense. And we're going to always be thoughtful about the market and where the sweet spot is. And the transactions that we're doing, we get current pay, we get a good return. And we still are at the table when the asset ultimately is going to trade. And so, it still has a good alignment with shareholders. and capital allocation makes certainly a lot of sense at this juncture. When we're back at '27 and everybody has announced a new wave of development, we'll probably rename the damn program and get back to that."
},
{
"speaker": "Rich Anderson",
"content": "Okay. Maybe we'll have the word Toomey me in it."
},
{
"speaker": "Tom Toomey",
"content": "I think so. And good luck with Halloween tonight, my friend."
},
{
"speaker": "Rich Anderson",
"content": "The second follow-up question is -- bigger picture, as I normally do. Like you have some interesting disagreement amongst your peers about the timing of the Sunbelt recovery? I think you said pricing power returns in some cases, mid-next year to late next year. And that's probably a more optimistic view than what Equity Residential is saying and some of the others that are making their way into the space. You guys are already kind of at that efficient frontier, 75, 25. Do you have a view as to why there's a difference of opinion in terms of when we actually start to see cash flow regenerate in the Sunbelt, whether it's next year or the year after? I'm just curious where you stand? I know you're saying pricing power returns, but does that mean cash flow also starts to return next year?"
},
{
"speaker": "Joe Fisher",
"content": "Rich, I guess I'd say, number one, when we went through the analysis, when did we reach equilibrium, and we're really talking about some of these markets like Dallas and Nashville, Austin, that have been a little bit more hit by high supply we looked at typical absorbing rates, what's available from a stock perspective today and what's being delivered on a go-forward basis. And we kind of got back to equilibrium plus or minus, middle of next year, kind of 2Q, 3Q. So that's why we say we expect to see some pricing power return at that point in time. So renewal has been strong, but you will see supply coming down. And I think supply overall in the Sunbelt probably comes down from 4% to 5% of stock next year, down upwards of 30%. So you're down into that 2.5% to 3% of stock range still above long-term averages on a full year basis. So not back to typical pricing power for a full year basis but you do get back to a better number potentially by the second half of next year. A lot of that's going to depend, as Tom said earlier, on the wildcard out there what takes place with jobs and wages, household formation, et cetera. But the time tell you next year, second half, you start to get a little bit more pricing power than we have this year. It takes a while to obviously work its way into the rent stack and get through all the lease turns and get end of cash flow. So it's bit by bit and works its way into same-store revenue growth, but we think we'll start to see the signs of it mid-second half."
},
{
"speaker": "Mike Lacy",
"content": "Joe, if I could just add one thing, too, because -- one thing we've seen success in this year and compared to our peers and others that are talking about the Sunbelt, it's our other income. The initiatives that we have going on in those markets today. When we sit here and we talk about 7% to 8% growth on our other income line, our Sunbelt has been performing around the 12% to 13% growth compared to the cost around 5% or 6%. So significantly more coming from our initiatives down in those parts of the country. So that's been allowing us to do a fairly good job as it relates to relative performance, and we expect more of the same as we go into next year."
},
{
"speaker": "Operator",
"content": "And the next question comes from the line of John Kim with BMO Capital Markets. Please proceed with your question."
},
{
"speaker": "John Kim",
"content": "I think in your prepared remarks, you mentioned an improvement in blended lease growth rates to 140 basis points this year. That's up 10 basis points from prior. But at the same time, earn-in expectations are now 60 to 70 basis points. And last quarter, it was 70. So, I know this is only 10 or 15 basis points, but I thought those two items would have been correlated positively and it seems like they're not. I'm just wondering why that's the case?"
},
{
"speaker": "Mike Lacy",
"content": "Yes, John, the way that I think about this and where our earning is tracking today is -- give you an example. If you go back to 2Q through 4Q of last year and you look at our blends, our 2Q growth was 3.1%, 3Q was 1.6% and 4Q was negative 0.5%. So, when you add all those up, you're right around 1.6% growth. When you look at this year, our 2Q was 2.4%, 3Q was 1.8% and our expectations right now is flat growth in the fourth quarter. That's about 1.5% growth. And so very similar blend on a nine-month trailing basis as you go into the new year. So, earning today feels very similar to what we saw and experienced as we went into this year, as we said in the prepared remarks."
},
{
"speaker": "Tom Toomey",
"content": "Yes, John, let me ask Mike, a follow-up question because I think sometimes, we get, it's great to be precise. But when you're talking 10 bps or 100 bps on a $2,600 a month rent, what does that equate to?"
},
{
"speaker": "Mike Lacy",
"content": "Yes. You're looking at $26 on average for our rent. So, it doesn't take much, and it's not a whole law on the absolute number for rents."
},
{
"speaker": "John Kim",
"content": "And Mike, you mentioned new lease rates in October of minus 5%. I think we all understand the supply pressures in the Sunbelt. But what other markets are you seeing deterioration of new lease rates that were maybe a little bit surprising?"
},
{
"speaker": "Mike Lacy",
"content": "Yes. I'd tell you, first, maybe start out with the regions. And again, for us, the East Coast still performing the best on an absolute basis. And so, for October, what we're experiencing, and again, this is blend. I'll get into some of the new lease growth here in a second. Our blends in the East Coast were around 1.5% compared to 3% in the third quarter. West Coast is closer to, call it, 0.5%. That compares to 2% in the third quarter. The Sunbelt dropped a little bit, about 100 bps. I'd say in October, we're seeing around negative 3% blends, and that compares to negative 2% in the second -- in the third quarter. But again, all of these regions are seeing an increase in our occupancy. So that's only helping that line item, but it also helps our other income. That's leading to that increase from 5% other income growth to 8% as we move forward. And so -- that's what we're seeing on a regional basis. But to your question, new lease growth kind of in the regions. It was actually the coast where we saw a little bit more pressure on our new lease growth. And again, a lot of that has to do with what I referenced with short-term leases going to long-term leases. In those markets, you typically have more interns, you have more individuals that are coming in for the summer and we've been working through that. And again, just to remind everybody, our blends, we include everything. And so, we don't typically talk about the short to long phenomenon. It's usually, it is what it is. But in this case, it did have an impact on those coastal markets. expectations again. It impacted October to a greater degree. It's probably going to be about half of that going forward. And then as you go into next year and you start to sign more short-term leases, it typically helps you out in the leasing season months."
},
{
"speaker": "Operator",
"content": "And the next question comes from the line of Michael Goldsmith with UBS. Please proceed with your question."
},
{
"speaker": "Michael Goldsmith",
"content": "There's been some choppiness in rental growth rates relative to typical seasonality over the last couple of years. Is this variability within the normal range when you look back at the pre-COVID years? Or is there something that's leading to increased seasonal volatility? And do you expect that to kind of continue going forward?"
},
{
"speaker": "Mike Lacy",
"content": "Yes. For us, it goes back to the supply. If you look at places like the Sunbelt, again, we've been talking about this all year long. We knew that this was going to continue to be a headwind for us. It's playing out exactly like we saw, but that is the difference between just normal seasonality. You are dealing with peak supply right now, and you're probably going to deal with it through the first and second quarter of next year in a period of time where demand starts to fall off. So, I'd say trajectory-wise, it feels pretty seasonal in nature, but at the same time, you do have a little bit more impact just coming from the supply markets."
},
{
"speaker": "Michael Goldsmith",
"content": "I appreciate your thoughts there. And while you don't have a lot of lease-up exposure, I'm wondering, how has the absorption pace has been trending on new developments in UDR markets or at properties which compete with the UDR properties? How much of the -- how much are you feeling that pressure?"
},
{
"speaker": "Mike Lacy",
"content": "No, it's been pretty incredible. I'll give you an example. This time of year on our stabilized asset we typically see about 1.2% of our homes being leased in a given week. On our development deals and one in particular, down in Tampa, we are seeing about 3x that. So, we've been leasing about 3% of our homes per week over the last few weeks. And so again, we don't have a lot of it today, not a lot of exposure. But what we do have is been leasing up, I'd say, fairly well."
},
{
"speaker": "Joe Fisher",
"content": "And I think for the broader market, when you look at some of the stats that are out there, obviously, from a delivery perspective, nationally, we're kind of a 30- or 40-year highs. But when you look at absorption, we're also a kind of a 30- or 40-year high. So, when you look at private market deliveries and what they're seeing absorption, they're generally getting about 15 to 20 units a month, which is pretty standard on their side. And so that's what's leading to better rent growth than we originally forecast. It's leading to better absorption, a little bit less of a concessionary environment than we forecast originally. I think a lot of that has to do with that relative affordability piece. Obviously, jobs have been there this year. Wages have been there, but renter-ship has continued to take well more than their fair share, just given how incredibly expensive it's become to own a home. I think if you go back to pre-COVID, single-family home prices are up 50% going back to 2019. At the same time that mortgage rates are up materially. You look at what's going on with multifamily rents during that period, it's about half that amount, basically exactly in line with income growth during that period of time. So rent-to-incomes really haven't changed. It's that relative affordability of the alternative option in single-family housing. So that's, I think, probably the biggest story this year that we've seen from people coming in the front door and then not leaving the back door."
},
{
"speaker": "Operator",
"content": "And the next question comes from the line of Adam Kramer with Morgan Stanley. Please proceed with your question."
},
{
"speaker": "Adam Kramer",
"content": "When you're thinking about potentially starting your own new developments here, how close would you say you are in terms of kind of potential yields on developments relative to your cost of capital? What's that spread and what would that spread need to be for you to kind of start a new project?"
},
{
"speaker": "Joe Fisher",
"content": "Adam, it's Joe. I'd say we're having a lot of active discussions on that topic right now. We've got a number of good parcels and projects that are shovel-ready and ready to go. What we continue to debate is the current yield and the stabilized yield relative to that cost of capital. The fact that we haven't started any thus far this year can tell you we're not quite there. But we do feel that we're getting close. Obviously, with a somewhat volatile interest rate environment, it creates a little bit more volatility in what that source of capital is and the price of that capital. So you want to make sure that you've accounted for that. And then obviously really locking into what we think the rents are from a tangibility perspective. And so, I think we're close. We'll probably see some starts going forward. They may not be this year, but definitely in '25 most likely."
},
{
"speaker": "Tom Toomey",
"content": "A good follow-up, Joe. I might be explaining our approach on redevelopment because redevelopment pencils a heck of a lot quicker than development."
},
{
"speaker": "Joe Fisher",
"content": "Yes, we've continued to have a lot of success both on the redevelopment side and then NOI enhancing front. So, we're spending plus or minus $75 million this year just on redevelopment opportunities. So going in and doing from kind of a renovation light, just kind of the K&B type of upgrade to more of a fulsome repositioning of assets. And so, we've had really good opportunities on that front. We got a good pipeline there that will take into next year and probably have another $75 million, maybe upwards of that into 2025 as well. So, deploying capital on that front, refreshing the portfolio and trying to get the consumer a better product, also raising the NOI profile."
},
{
"speaker": "Adam Kramer",
"content": "Great. I appreciate all that color. And I was going to ask about kind of capital allocation priorities here given the development comment. It seems like this redevelopment program is high on that list. Is that right? I mean I think you guys talked a little bit about repurchases earlier too, it seems like that's lower on relative at this point?"
},
{
"speaker": "Joe Fisher",
"content": "Correct. Yes, the redevelopment generally is a pretty core part of the business that we're always going to be doing in some way, shape or form. We'll pivot it a little bit higher, a little bit lower depending on cycle and opportunities. From a bigger picture perspective, though, it's still that recycling of the DPE looking for joint venture acquisition opportunities and focusing in on some of these creative OP unit transactions that we're finding out there in the market."
},
{
"speaker": "Operator",
"content": "And the next question comes from the line of Alexander Goldfarb with Piper Sandler. Please proceed with your question."
},
{
"speaker": "Alexander Goldfarb",
"content": "Just two questions. First, Joe, just going to the Queens, the Long Island City project, can you just walk us through the decision to take the coupon down? Yes, there are other players in raw land that do deferred equity. And this -- it stood out. So, you guys are a pretty big company, plenty of liquidity. So, it's not like you couldn't take control of the project if you had to. So, can you just walk us through the strategy of reducing the coupon?"
},
{
"speaker": "Andrew Cantor",
"content": "Sure. Alex, this is Andrew. It's good to talk to you. So, I think it's important just to go back and just start from the beginning on this project. When this project started in the fourth quarter of 2019, it was raw land, the construction on this deal was completed in 2022, and it stabilized in the first part of '24. Our partner came to us and wanted to recapitalize the deal. As a reminder, they put in $42 million into this deal. They paid off $25 million in pref and then reduced our accrual by about $10 million. The way that it's structured, about 70% of our coupon will be paid current. The top dollar on this deal is in like the 60 -- the kind of mid-60% LTV. And our basis is at our dollars are about -- is below $500,000 a door. So, for us, we like our partner. We like the product. We know it well. And so, this was an opportunity for us to reinvest in something we wanted to reinvest it, not something that we had to reinvest in. And as Joe talked about, we are in the situation where we get paid back, and we have to go find new opportunities we felt this opportunity was one we would invest in. And so we made the decision to lower the rate because we're in a much lower risk situation than we were when it was under development."
},
{
"speaker": "Joe Fisher",
"content": "So just to drive that home, Alex, I want to make sure you understand it's not one of the watchlist deals that we had. This wasn't a deal that was under distress. There was simply a choice on our part of do we take the last $50 million back in our investment and get paid off fully and take that $50 million and go find a new opportunity and put our team to work on something new. Or just take a deal that we know with a partner we know and say, we'll let $50 million stay out there. But given the change in risk profile, the market rate for that investment has definitely come down from when it was in development."
},
{
"speaker": "Alexander Goldfarb",
"content": "Okay. So, what you're saying is the guy could have -- he had the capital, you're saying he had the capital to pay you off, you just chose to not effectively to put back in rather than getting paid off fully. Is that what you're saying?"
},
{
"speaker": "Andrew Cantor",
"content": "Correct. Correct."
},
{
"speaker": "Joe Fisher",
"content": "They put $42 million of additional fresh equity into that deal, paying down a portion of our pref, but we also had a pref partner in our position that was [indiscernible] with us. So, pay down that entire partner's position. So, our last dollar risk came down materially with a lot of fresh equity coming into the deal. And as Andrew said, at 60-plus percent LTV, 70% current pay the risk profile changes materially from a new development that was earning 13% to now a stabilized deal earning 11%."
},
{
"speaker": "Alexander Goldfarb",
"content": "Okay. Second question is on the short-term leases, this isn't new, like this is part of always happens in terms -- the short-term leases or other reasons. So, was there something unusual about this year's short-term leases? Or it's just -- it was part of the normal budgetary mix and the whole discussion about short-term mix leases is just walking us through. I'm trying to understand if there was something unusual about this year with the short-term leases or if it's just a discussion of explaining why some of the rent trends happen the way they happened?"
},
{
"speaker": "Mike Lacy",
"content": "Yes, it's kind of both, Alex. I'll tell you, we get a lot of questions just around blends in general. And since everybody kind of has different definitions, some people do the like-for-like, some people do everything. We want to make sure that we're clearly showing what it looks like on both a like-for-like as well as all-in basis. And then for us, like I said earlier, it was a little bit more of a factor than we would have expected this time of the year just because we did have more interns coming in. We actually did see more people that were taking short-term furnished rentals throughout the summer. And so, I'll tell you, for that program alone, I saw about a 20% to 30% increase in our fee income, which tells me that we did have significantly more people doing those type of leases. And so, we're just cycling off of them. And so just in full transparency, that's what we're providing."
},
{
"speaker": "Tom Toomey",
"content": "Alex, a little bit more color. I mean how often do you have this type of supply being delivered at the same time that you're losing the short-term rental play. And so that's why you see it's probably more if you will, exaggerated than it is a reality. And as I expect it to go forward, it will probably start looking a lot like the last 30 years."
},
{
"speaker": "Operator",
"content": "The next question comes from the line of John Pawlowski with Green Street. Please proceed with your question."
},
{
"speaker": "John Pawlowski",
"content": "Just one question on expenses for me. So, I can get a handle on two-line items that have been really volatile over the last several years, personnel and repair and maintenance. So obviously, personnel saw a pretty big cumulative decline, 21% to 23%. Some of those costs were pushed into R&M and then you had pandemic impacts on R&M. So, the question, Joe, is, is the operating model in terms of the bodies, UDR bodies, on the ground both in personnel and R&M functions, stabilize today? Or should we continue to expect to see above inflationary costs continue for personnel and R&M?"
},
{
"speaker": "Mike Lacy",
"content": "Yes, John, it's Mike. I would tell you, it's better than stabilized going forward. And so, we've been working through a lot of those changes, as you alluded to, with personnel and R&M. The difference what we're seeing today is a couple of items. First, we had to anniversary off of the cares refund this year. So, our personnel was significantly higher than it would have been, we would probably be in that 2% to 3% range. So just under inflationary numbers there. As we go forward, I expect more of the same. But I'd tell you for this third quarter, we do pay our teams based on performance. And so, when you look at our relative performance versus our peers through the first six months of the year, they were doing a really good job in terms of top line revenue against the peers within their markets. And so, some of our personnel costs were due to that. And then I'd say on turnover going forward, we're going to continue to lean into that customer experience project. We expect that our turnover will continue to be down. And I'd tell you, in fact, looking at October numbers, we're looking at probably the 19th consecutive month with year-over-year reduction in turnover. So I think going forward, these line items will be more muted than they have been in the past."
},
{
"speaker": "John Pawlowski",
"content": "Okay. Is there any -- is there still a tail on basically heavily damaged units from evictions that will prop up the -- basically the repair and maintenance expense growth next year a little bit more than typical inflationary levels?"
},
{
"speaker": "Mike Lacy",
"content": "I don't think so. When we look at kind of that population of squatters, if you will, it's back to those historical norms of plus or minus a couple of hundred and we're not seeing people that are near damaging to the same degree that we saw during COVID. And so I don't think that that's going to be as much of a factor as we move forward."
},
{
"speaker": "Operator",
"content": "And the next question comes from the line of Alexander Kalmus with Zelman & Associates. Please proceed with your question."
},
{
"speaker": "Alexander Kalmus",
"content": "I know we covered a lot of ground today, but I just wanted to ask about the wider third quarter spread recorded between your renewal move-in rent growth figures with kind of new supply still impacting front-end pricing. At what point do you think that spread returns to like the pre-COVID average? And are there any additional drivers to consider?"
},
{
"speaker": "Mike Lacy",
"content": "That's a really good point. It's something that we watch very closely. And I can tell you as you get into the shoulder quarters, the fourth quarter and the first quarter every year, you typically see your new lease and your renewal spreads gap out. And so, we've been watching it. I'll tell you what gives me a sense of relief, if you will, is going back to those turnover numbers again. The fact that we're about 600 basis points better than historical norms. We're not seeing people hand in their keys. We're not seeing our move-out reasons for rent increases, increase. And so, we are going to continue to send out plus or minus 4% to 4.5% into the future here because our turnover looks great. We think everything we're doing on our customer experience project is paying dividends. And so not only will our turnover be better, but we do believe that we can maintain a pretty high renewal growth as we move forward."
},
{
"speaker": "Operator",
"content": "And the next question comes from the line of Linda Tsai with Jefferies. Please proceed with your question."
},
{
"speaker": "Linda Tsai",
"content": "Just one for me. In terms of the $5,000 benefit from saving customers/reducing turnover, are there any upfront costs associated with improving that churn? And if so, does that go down over time?"
},
{
"speaker": "Mike Lacy",
"content": "No. Right now, what we're finding is it's pretty minimal. And so when we're going through all these data points, and again, we have a dashboard for every individual resident. We understand when they moved in with us when they've had a good experience or a bad experience, we're proactively reaching out to them now and just trying to identify what those issues are, how we maybe all solve them, can we do it quickly. And then at times, we are offering gift cards, small concessions here and there if there's something that we did wrong that we can improve on. And so, they're minimal cost today, but it's something that we're continuing to learn from. And so, as we move forward, I think we're going to find the sweet spot on what those gift cards are. And I don't think it's equal for everybody. We have residents that have been with us for multiple years that house level rents versus some that have been with us for a short period of time, and they may be in a studio. It's not a one size fits all, but it is something that we're identifying and we're proactively reaching out on."
},
{
"speaker": "Joe Fisher",
"content": "I think, too, with all the data that we have now that Mike was talking about earlier, it's less about additional cost. I think it's being smarter with the resources that we do have. So, what were the things that we thought were value-add that we were doing that perhaps a customer didn't find value in. And so, pivoting on our individual people resources, but also on the capital side, trying to figure out where we can spend our capital in a smarter way to address recurring issues that pop up either at an individual level or at a property level that have caused some consternation and therefore, turnover. So, it's not necessarily added cost, but I think the data that we have is making us much smarter on where we do expend resources today."
},
{
"speaker": "Tom Toomey",
"content": "Linda, just because I love this topic and you can hear the passion from the team on it and the potential of it. I mean we set out on a goal really to just change how this business is done. And if it's historically always been 50% turnover and you can find a path to 40% or lower, you dynamically change the margin your pricing power, your cost structure, your CapEx, you changed how the whole dam business is done. And we have now the resources, the capability and the culture to actually drive through this and expand that margin. And ultimately, who wins in margin usually wins the long game. So, it's a long journey. We're in the early innings of it. You can see the early innings results, and we're encouraged by the long prospects of this project effort and its value for our shareholders."
},
{
"speaker": "Operator",
"content": "And the next question comes from the line of Haendel St. Juste with Mizuho Securities. Apologies, he is no longer in the queue. There are no further questions in the queue. I'd like to hand the call back over to Chairman and CEO, Mr. Toomey for any closing comments."
},
{
"speaker": "Tom Toomey",
"content": "Thank you for all your time and interest and support of UDR. I know the call went a little long today, but I find it very beneficial when we expand upon how we think about the business, how we're running it and how we are going to continue to improve it. So, we look forward to seeing many of you at NAREIT conference in November and certainly a lot of other upcoming events. With that, take care."
},
{
"speaker": "Operator",
"content": "Ladies and gentlemen, that does conclude today's teleconference. You may disconnect your lines at this time. Thank you for your participation."
}
] |
udr | 2,024 | 2 | [
{
"speaker": "Operator",
"content": "Hello, and welcome to UDR's Second Quarter 2024 Earnings Call [Operator Instructions]. As a reminder, this conference is being recorded. It's now my pleasure to turn the call over to Trent Trujillo, Vice President, Investor Relations. Please go ahead, Trent."
},
{
"speaker": "Trent Trujillo",
"content": "Welcome to UDR's quarterly financial results conference call. Our press release and supplemental disclosure package were distributed yesterday afternoon and posted to the Investor Relations section of our Web site ir.udr.com. In the supplement, we have reconciled all non-GAAP financial measures to the most directly comparable GAAP measure in accordance with Reg G requirements. Statements made during this call, which are not historical, may constitute forward-looking statements. Although we believe the expectations reflected in any forward-looking statements are based on reasonable assumptions, we can give no assurance that our expectations will be met. A discussion of risks and risk factors are detailed in our press release and included in our filings with the SEC. We do not undertake a duty to update any forward-looking statements. When we get to the question-and-answer portion, we ask that you be respectful of everyone's time and limit your questions to one plus a follow-up. Management will be available after the call for your questions that did not get answered during the Q&A session today. I will now turn the call over to UDR's Chairman and CEO, Tom Toomey."
},
{
"speaker": "Tom Toomey",
"content": "Thank you, Trent. And welcome to UDR's second quarter 2024 conference call. Presenting on the call with me today are President and Chief Financial Officer, Joe Fisher; and Senior Vice President of Operations, Mike Lacy; Senior Officers, Andrew Kantor; and Chris Vans Ens, will also be available during the Q&A portion of the call. First half results exceeded our initial expectations provided back in February due to ongoing solid fundamentals and the core operating strategies we continue to utilize to drive strong same store and earnings growth. Positive fundamental drivers for our industry include, first, year-to-date employment growth of approximately 1.3 million jobs has well outpaced initial full year consensus expectations. Additionally, year-to-date household income growth has remained robust at approximately 5%. Taken together, this has driven strong demand for housing while also reinforcing healthy affordability metrics. Second, more than 250,000 newly delivered apartment homes were absorbed nationally during the first half of the year, a near two decade record. Adding to that, total housing deliveries appear stable through the end of the year, and development starts continue to decline to levels below historical norms. This dynamic bodes well for rent growth in the years ahead. And third, renting an apartment is on average 60% more affordable than owning a single family home in the markets where we operate, the best level of relative affordability in two decades. These fundamental trends, combined with our operating tactics that have improved resident retention, led to revenue and expense growth outperformance in the first half of 2024. Drivers include more robust pricing power, higher occupancy, improved in the month rent collections, higher ancillary income growth, lower resident turnover and lower turnover related expenses than originally expected. In all, this led us to raise our full year FFOA per share guidance for the second time this year, while also increasing our same store growth expectations in yesterday's release. Mike will provide additional details in his remarks. We feel good about the year-to-date results and the opportunities ahead of us in the second half of the year. However, we also remain cognizant of the slowing growth rate in the recent employment data and the effect that may have on pricing in the face of still elevated new supply through the rest of 2024. Moving on, we continue to build on our position as a recognized ESG leader, with UDR recently being named a 2024 Top Workplace winner in the real estate industry. This achievement reflects the engaging employee experience we have built and solidifies our stature as an employer of choice. Key to our success is an innovative and adaptive culture, and this recognition is one that all our stakeholders should be proud of. Big picture, I remain optimistic about the long term growth prospects of the multifamily industry and UDR's unique competitive advantages that should enhance our relative results. We have a strong culture that empowers our associates to deliver best-in-class service to our residents and create outsized value. With that, I'll turn the call over to Mike."
},
{
"speaker": "Mike Lacy",
"content": "Thanks, Tom. Today, I'll cover the following topics; our second quarter same-store results, early third quarter operating trends, our improved full year same store growth guidance, including underlying assumptions and regional operating trends. To begin, second quarter year-over-year same store revenue and NOI growth of 2.5% and 2% respectively were slightly above our expectations. Quarterly sequential same store results also outpaced initial forecast. These results were driven by, first, 2.4% blended lease rate growth, which was driven by renewal rate growth just shy of 4% and new lease rate growth of 50 basis points. New lease rate growth improved by 300 basis points versus the first quarter as concession stabilized and demand increased, which resulted in improved pricing power. Second, 47% annualized resident turnover was 300 basis points below the prior year period and our best second quarter retention in more than a decade. This has enabled us to increase renewal rate pricing through at least August and has led to more favorable blended lease rate growth. Third, occupancy remained strong at 96.8%, supported by healthy traffic and leasing volume. New York, Boston, Washington, D.C. and Seattle, which collectively constitute 40% of our same store pool or standouts, averaging higher than 97% occupancy during the quarter. And fourth, other income growth was nearly 9% and was driven by our continued innovation along with the delivery of value add services to our residents. Shifting to expenses. Quarterly year-over-year same-store expense growth of 3.7% came in better than expectations and was primarily driven by reduced repair and maintenance costs as well as insurance savings. Repair and maintenance growth of less than 1% was partly due to our improved resident retention and having 500 fewer unit terms than a year ago while insurance savings of nearly 5% was driven by lower claims activity. Moving on, core operating trends have remained resilient in July and key metrics have largely followed typical seasonality. First, July blended lease rate growth is expected to be in the mid 2% range, which is slightly higher than June results and follows normal historical sequential rent growth trends. New lease rate growth is slightly negative on average while we have had success increasing our renewal lease rate growth closer to 5% from 4% in the second quarter. In terms of relative performance, the East Coast is showing the most strength with blended lease rate growth of approximately 4%. This is followed by the West Coast at 3% on average and the Sunbelt at approximately negative 1%. Based on current trends, we expect East Coast leadership to persist through at least the remainder of the third quarter. Second, resident retention continues to compare well against historical norms and July will represent the 15th consecutive month our year-over-year turnover has improved. Relative affordability compared to other forms of housing is a benefit to the apartment industry in total. Given the level of home prices and mortgage rates, the average cost of owning a home across UDR markets is nearly 5,500 per month. By contrast, the average rent for UDR apartment home is approximately $2,500 per month, thereby creating annual shelter cost savings of $36,000. This disparity has led to a record low level of our residents moving out to buy a home. Furthermore, because of our ongoing customer experience project, our resident retention over the past year has improved by approximately 210 basis points relative to the peer group average. This is a testament to our team's focus and execution on our innovative data driven approach to customer service. Ultimately, improved retention should drive better pricing power, higher occupancy, increased other income, reduced expenses, lower CapEx and margin expansion. We are still early in the innings of capturing these benefits but believe the incremental opportunity is in the $15 million to $30 million range. Third, occupancy remains high but has trended slightly lower to 96.2% to 96.3% in July due to elevated new supply coming online and typical seasonal operating trends. Markets facing heavy supply, including Nashville, Dallas and Tampa, 16% of our NOI, have seen occupancy decline by approximately 100 basis points on average compared to the second quarter. Conversely, occupancy remains in the mid to high 96% range on average across markets facing less supply, such as New York, San Francisco and Orange County, which make up 26% of our NOI. Strategically, we anticipate regaining portfolio occupancy later in the third quarter as we tactically adjust our operating approach ahead of a seasonally slower leasing period. And fourth, other income continues to grow in the high single digit range in July, similar to what we achieved in the first half of the year. As a reminder, other income constitutes roughly 11% of total revenue. We remain pleased with the trajectory of other income initiatives, such as the rollout and penetration of building-wide Wi-Fi as these contribute significantly to incremental same store revenue growth. Based on our results for the first seven months of the year, we raised our full year 2024 same store growth guidance in conjunction with yesterday's release. We are encouraged by the resiliency of various forward demand indicators such as year-to-date job growth and wage growth, but we remain somewhat cautious given there’s potential for macroeconomic volatility in an election year combined with elevated supply deliveries in the back half of 2024. To provide details on our guidance increases, starting with same store revenue growth, we raised our midpoint by 50 basis points, resulting in a new range of 1% to 3%. The primary building blocks to achieve the 2% midpoint include the following. First, our 2024 earning of 70 basis points. Second, portfolio blended lease rate growth is forecast to be approximately 130 basis points in 2024. This represents a 60 basis point increase compared to our initial guidance. Given blended lease rate growth of approximately 180 basis points through the first seven months of the year, this implies a deceleration to 60 basis points on average for the remaining five months of the year. Using a midyear convention, our full year blended lease rate growth expectation should add about 65 basis points to 2024 same store revenue growth, reflecting a 30 basis point improvement versus our prior expectations. Underlying our full year blended rate growth forecast are assumptions of 3.5% to 4% renewal rate growth and approximately negative 1% new lease rate growth. Third, we expect the combination of occupancy and bad debt to be roughly flat year-over-year in 2024, in line with our prior expectation. And fourth, innovation and other operating initiatives are expected to add 70 basis points to our 2024 same store revenue growth, which is an increase of 25 basis points versus our prior guidance. The bulk of this growth should come from the continued rollout of property-wide Wi-Fi initiatives along with a variety of other property enhancements. 3% of high end of our same store revenue growth range is achievable through improved year-over-year occupancy, additional accretion from innovation, higher blended lease rate growth or a combination thereof. Conversely, the low end of 1% reflects full year blended lease rate growth of approximately 50 basis points, some level of occupancy loss and the moderation in other income generated by our innovation. Moving on to same store expense growth. We lowered our midpoint by 25 basis points to 5% with the full year range now at 4% to 6%. The improvement was primarily driven by constrained insurance and repair and maintenance expense growth. As a reminder, same store expense growth of 7.5% in the first quarter was elevated due to comping off of a onetime $3.7 million employee retention credit we realized at the beginning of 2023. Absent this factor, we would expect normalized same store expense growth for the full year to be in the low 4% range or approximately 80 basis points lower than our [updated] midpoint. Turning to regional trends. Our coastal results have exceeded our expectations while our Sunbelt markets are largely in line. More specifically, the East Coast, which comprises approximately 40% of our NOI, was our strongest region in the second quarter, and Washington, D.C. was our best-performing market driven by strength in Northern Virginia. Second quarter weighted average occupancy for the East Coast was 97.1%, blended lease rate growth was 4.7% and year-over-year same-store revenue growth was 3.8%. With continued healthy demand and relatively low new supply, we expect this region to be our strongest throughout the rest of the year. The West Coast, which comprises approximately 35% of our NOI, has performed better than expected year-to-date but stabilized somewhat in the second quarter following tremendous momentum in the first quarter. We are encouraged by various employers more strictly enforcing return to office mandates as well as increased office leasing activity from technology and AI companies but are also cognizant of corporate relocations that influence job and wage growth. Absolute levels of new supply remain low at less than 2% of existing stock on average across our West Coast markets, which we expect will lead to a more favorable supply dynamic in the coming quarters. Lastly, our Sunbelt markets, which comprise roughly 25% of our NOI, continue to lag our coastal markets. Year-to-date performance was in line with our original expectations through the beginning of June, at which time we began to see some pricing deterioration due to elevated new supply and the concessions that came with it. We tactically decided to hold grade to best set up our rent roll for future quarters, which resulted in occupancy drifting lower. While our Sunbelt markets broadly have more robust job growth than our coastal markets, we remain cautious on the region in the near term, given the very high absolute levels of new supply coming online. To close, our coastal markets, which comprise 75% of our NOI have performed above initial expectations. While our Sunbelt markets, which comprise 25% of our NOI, are largely in line with expectations. Our diversified portfolio enables us to be surgical with regard to how we operate each market and each asset, allowing us to leverage the strong fundamentals of our industry. This, coupled with continued innovation that will further expand our operating margin over time, maximizes revenue and NOI growth. My thanks go out to our UDR associates nationwide for your dedication towards meeting the challenges we face head on as we continuously innovate to drive strong results. I will now turn over the call to Joe."
},
{
"speaker": "Joe Fisher",
"content": "Thank you, Mike. The topics I will cover today include, our second quarter results and our updated full year guidance, a summary of recent transactions and capital markets activity and a balance sheet and liquidity update. Our second quarter FFO as adjusted per share of $0.62 achieved the high end of our previously provided guidance. The $0.01 per share sequential increase was supported by strong same store NOI growth, driven by higher than expected blended lease rate growth and lower than expected expense growth across both controllable and noncontrollable categories. Year-to-date operating results have exceeded our initial expectations, which led us to raise our same store and FFOA per share guidance ranges. Our new full year 2024 FFOA per share guidance range is $2.42 to $2.50 with a midpoint of $2.46. Since providing initial guidance in February, we have raised FFOA per share guidance twice by a cumulative of $0.04 per share or approximately 2% and have improved the midpoints of our same store guidance ranges. Current trends suggest upside to our midpoint but we believe a cautious approach is prudent given the risk of elevated new supply, election uncertainty and macroeconomic volatility. Looking ahead, our third quarter FFOA per share guidance range is $0.61 to $0.63. The $0.62 midpoint is flat sequentially, which is similar to our historical average earnings results from the second to third quarter and is due to minimal expected changes across NOI, interest expense and G&A. Next, a transactions and capital markets update. First, during the quarter, we completed construction of 101 North Meridian, a $134 million, 330 home community located adjacent to another UDR community in Tampa. Due to robust demand, the community is already 40% occupied as of today, which is twice the level we expected at this point in it's lease up. When combined with attractive rental rate pricing, the yield on the project is trending approximately 75 basis points ahead of underwriting. With the completion of this community, we have no active development projects. However, we are evaluating up to four potential starts in the next 12 to 18 months. Second, subsequent to quarter end, we went under contract to fund a $35 million preferred equity DCP investment at a 10.75% rate of return on four communities located in Portland as part of their recapitalization. Each of the four communities has achieved stabilized occupancy and is generating positive cash flow. Therefore, the risk profile is lower than a typical new development DCP project and positive cash flows allow approximately two thirds of our contractual return to be paid in cash. And third, subsequent to quarter end, we received an approximately $17 million paydown on our preferred equity DCP investment in Vernon Boulevard located in Queens, New York. In conjunction with the paydown, we agreed to lower our rate of return from 13% to 11% to reflect the reduced risk in our investment due to the development being completed and a more secure positioning in the capital structure. Finally, our investment grade balance sheet remains liquid and fully capable of funding our capital needs. Some highlights include: first, we have nearly $1 billion of liquidity as of June 30; second, we have only $112 million of consolidated debt or approximately 0.5% of enterprise value scheduled to mature through the end of the year and only 11% of total consolidated debt scheduled to mature through 2026, thereby reducing refinancing risk. Our proactive approach to managing our balance sheet has resulted in the best three year liquidity outlook in the sector and the lowest weighted average interest rate amongst the multifamily peer group at 3.4%. And third, our leverage metrics remain strong. Debt to enterprise value was just 28% at quarter end while net debt to EBITDAre was 5.7 times. In all, our balance sheet and liquidity remain in excellent shape. We remain opportunistic in our capital deployment and we continue to utilize a variety of capital allocation competitive advantages to drive long term accretion. With that, I will open it up for Q&A. Operator?"
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Our first question is coming from Eric Wolfe from Citigroup."
},
{
"speaker": "Eric Wolfe",
"content": "Can you talk a bit more about what you saw in June and July in your coastal markets versus the Sunbelt? I was specifically wondering about how much occupancy fell in the Sunbelt versus the coastal markets? And if that's impacting your pricing strategy for both going forward?"
},
{
"speaker": "Mike Lacy",
"content": "So let me try to capture all that. First and foremost, one month is not a good trend line. I tend to look at it over 90 days. During peak leasing from May to June through July, we actually averaged right around 2.5% blend, which was 100 basis points over our original expectations. Second to that, May was so strong for us that we actually pushed our market rent, pretty much double compared to what we see pre-COVID, right around 2% versus 1% on a month-over-month basis. So very strong trends led us to push our rents that led us to pushing our renewals higher through 3Q, which is helping to offset new lease growth. So to that point, I spend a little bit more time just on our renewal strategy and how it's playing out before I give you some of the numbers. But we are sending out about 5% through September at this point. We typically achieve between 20 and 30 basis points of what we send out. And I'll tell you our strategy around getting more aggressive by about 100 basis points from the first half of the year was really stemming off of our customer experience project, just given the fact that we've had closer to 900 fewer move outs through the first six, seven months of the year and our turnover were down 3% year-over-year, along with the fact that we change the trajectory of our relative basis versus our peer group by over 200 basis points. We wanted to test that pricing strategy and right now, it feels like it's playing out. To your point on the occupancy, we did lose a little bit of ground over the last 30, 60 days. We've seen that stabilize as of [late] and I think it's important to size it for us. When you have, call it, 10 bps lower occupancy, that's 50 homes, which is approximately $100,000 during the month. So while it's down a little bit, it's not material and we're starting to see it stabilize into August. To your point just on some of the stats around the regions, what I would tell you is the East Coast in July still hovering around 96.5%, the West Coast and the Sun Belt, a little bit lower, right around 96.%. But on the blends, we are still seeing 4% growth on East Coast, 3% growth on the West Coast and the Sunbelt is -- had somewhat stabilized in that negative 1% range similar to what we saw in May, June and throughout the second quarter. So overall, trending kind of as expected."
},
{
"speaker": "Eric Wolfe",
"content": "And then I guess, based on your guidance for the full year, it seems like you're sort of guiding around 0.9% or something around there for the back half of the year, which is I think, pretty close to your original guidance. I mean, would you say that's more of a conservative placeholder or do you think it's sort of reflective of a more conservative position, just given some of the things you mentioned? Just trying to understand what's going into that back half estimate for blended rent growth?"
},
{
"speaker": "Joe Fisher",
"content": "Maybe just to lead off to how we approached it. Versus original guidance, we had taken kind of consensus estimates, layered in our bottoms up forecast to come up with that initial forecast. I think, since that period of time, we've clearly seen jobs coming better, wages coming better, GDP come in better, supply has been about as expected with developers acting fairly rational from a concessionary perspective. And then the relative affordability piece, I think, is one that has been clearly a nice tailwind for us from either a move outs to buy or just capture rate on new household formation. So that's really what's driven kind of our year-to-date market rent growth. We're seeing an effective market rent growth on a year-to-date basis, up about 4%, which is under 200 basis points better than we expected originally. So that's what drove those blends in the first seven months. So as we approach kind of back half of the year and full year guidance, the way we did it was really just take what was put in the bank for the first seven months. So what we knew it happened here through July updated guidance for that impact, and we really want the back half assumptions alone. And so the implied number for the last five months of the year is only about 60 basis points in blended lease rate growth. Obviously, Mike mentioned where we're sending out August renewals. We'll talk to the street once we get more visibility on news as we go into September, but we have factored in some conservatism on that front under the view that you still have supply out there, still have unknowns on the macroeconomic front and on the election front, and we typically see some degree of seasonal slowdown anyway on blends as you go into the back half. So everything we're seeing to date tells us we have continued momentum with that kind of mid-2s blends, but I think it's still prudent to be a little bit conservative on that front as we approach guidance and then update as we move into the back half of the year."
},
{
"speaker": "Operator",
"content": "Next question is coming from Steve Sakwa from Evercore ISI."
},
{
"speaker": "Unidentified Analyst",
"content": "This is Sanket on for Steve. We had a question around -- I think you guys raised the guidance for DCP funding from 0 to $15 million. Can we expect more on this front in the back half of the year?"
},
{
"speaker": "Joe Fisher",
"content": "So that $15 million is really the net of a couple of items. We originally had zero in there. I think everybody saw in the press release, we did the $35 million investment in a recap portfolio in Portland, which Andrew can give you more details on here in a second. We also got the payback on Vernon, which is part of a bigger payback for both us and our partner, which we can provide some more color on as well. And then we have a couple of other cash pays and small prepayments. So that nets to that $15 million. As we look out to the rest of the year, we really don't have much coming up on the maturity front. I think our next maturities from a senior loan perspective were the first part of '25. So that would be the first action we have from additional prepayments or potential extensions there. And on the investment front, really no major discussions right now, but not to say that we aren't looking. We're just not far enough along to really commit to increasing guidance on DCP deployments. But as we think to next year and assume that we have additional prepayments or payoffs, I would expect us to be active on that front and looking to deploy that capital even if it takes place ahead of time."
},
{
"speaker": "Andrew Kantor",
"content": "As it relates to the DCP activity for the quarter, Vernon, which is a DCP deal that we have in the Astoria West neighborhood of New York, originally funded it in June of 2022, we had a partner that was originally pari passu with us in that transaction who had invested $15 million next to our $40 million. At the time of the redemption, their accrual was $10 million and their entire amount was fully refunded. So $25 million, that's in addition to our $17 million that was refunded. And as Joe said, this is now a -- this is a recapitalization of a completed and stabilized development. The property is 95%, 96% occupied. And then on very similar situation we had on the Portland DCP recap where we invested in four stabilized assets, one of which will close shortly but that as well as in both of these new DCP investments are about two thirds of our accrual will be paid current."
},
{
"speaker": "Operator",
"content": "Our next question today is coming from Austin Wurschmidt from KeyBanc Capital Markets."
},
{
"speaker": "Austin Wurschmidt",
"content": "I wanted to hit back on the July, more specifically, new lease rate growth trends. Mike, you had highlighted that Nashville, Dallas and Tampa had -- were primarily driving down occupancy. But I'm curious if these markets also drove the moderation in new lease rate growth or were there other markets or regions that have seen a similar degree of new lease rate growth moderation into July versus what you saw in May and June?"
},
{
"speaker": "Mike Lacy",
"content": "What's interesting, obviously, from May to June, we saw a little bit more of a deceleration in blends and then coming through July, we saw that uptick a bit. So really, the way I look at it is from May to July, we saw close to 100 basis points, let's call it, 50 to 100 basis points across all regions with the Sunbelt being a little bit weaker than we thought over the last 30 days or so. But again, it's been pretty stable as we've gone towards the end of the month and we're still hovering around negative 1% today. In terms of the new lease growth, we're still seeing negative 5% to negative 6% down in the Sunbelt where we're seeing upwards of 2% growth in the East Coast, 1% on the West Coast. So on an absolute basis, still strongest coming out of the coast, a little bit weaker in the Sunbelt as expected."
},
{
"speaker": "Joe Fisher",
"content": "Just to follow up on that, too, as you think about the occupancy number, a little bit of insight beyond just the pricing strategy that Mike has talked about. We've talked a lot in the past about our fraud prevention efforts and kind of the $25 million to $50 million opportunity that bad debt represents for us over time. We've talked about starting to roll out in pilot some new AI platforms on both income and ID verification. We're also trying to be a little bit more robust and disciplined on our deposit strategies on our credit scores around the portfolio. So as we continue to ramp up that we are seeing some of our denial rates increase, which will temporarily does impact occupancy to the negative. It's not necessarily reflective of traffic, which still continues to be good, apps continue to be good. It's just that we're kicking more of those individuals out of the system, taking the hit today on occupancy. But we do believe longer term that's going to get us better residents in place that stay with us longer and continue to pay. So it's a longer term trade off to take the occupancy hit today, get the better numbers in the future. Although, I'd say for bad debt, we have not factored that into our numbers. We're still assuming in guidance that we’re plus or minus kind of flat on a year-over-year basis, even though we're trending slightly ahead at this point in time."
},
{
"speaker": "Austin Wurschmidt",
"content": "And you partially, I think, you answered my next question, which is really around the size of the supply and concessions impact in July. I was curious about the slowdown in traffic and any impact to these near record absorption levels we've kind of heard about throughout the first half of the year. But maybe on top of that, I guess, how have concessions trended can you kind of quantify that, and then how does that stack up versus last year?"
},
{
"speaker": "Mike Lacy",
"content": "Austin, I think that's a really good point. I think just stepping back a little bit, just thinking about the consumer and how healthy they are, a few stats that we typically look at in addition to concessions, I would tell you, first of all, not seen doubling up. So we still have 1.8 residents per home. We've seen the single occupant go up about 1.5% to 42% of our homes. And we're seeing a stable rent-to-income ratio across the board at 22%, with places like Boston, Dallas, DC, San Francisco and Tampa, even down a little bit, where places like Seattle are up just slightly, given the fact that we've been able to push rents so much. But to your point on concessions, we're right around half a week today, which is pretty consistent where we were pre-COVID. It's kind of normal steady state today, obviously, with the Sunbelt being a little bit higher and then the Coast being next to nothing."
},
{
"speaker": "Operator",
"content": "Your next question is coming from Josh Dennerlein from Bank of America."
},
{
"speaker": "Josh Dennerlein",
"content": "Mike, I just wanted to follow up on some comments you made in one of your answers to a question. It sounds like you feel more confident on pushing rate because of your platform initiatives related to like data on the customers. I guess, when did you kind of start pushing a little bit harder than you would have in the past? And then how do you think about the ability to kind of continue pushing like rate -- renewal rate even harder from here in the future?"
},
{
"speaker": "Mike Lacy",
"content": "It goes back to what I was saying with what we're seeing in May. And so when we had very strong dynamics in the marketplace, we're able to start driving our market rents up, again, about 2% compared to normal historical averages of 1%. That gives us more confidence to get a little bit more aggressive as we started to price our renewals 60, 90 days out. And so that's what you're seeing play out in front of us today. And in addition to that, I think it goes back to what we're seeing with that customer experience project. A lot of that work has been done over the last year or so. And what we looked at is when we compared ourselves to our peers on a relative basis, we were about 200 basis points below them. Over the last six to nine months, we've actually changed that trajectory. We're closer to 50 basis points above them. And so it gave us the confidence to continue to try to push in there and test a different thing, if you will, test out our pricing strategy, see if we can get a little bit more aggressive on renewals. Again, I feel like it's playing out today. We'll know more here over the next 30, 60 days, but it feels good."
},
{
"speaker": "Josh Dennerlein",
"content": "And then just -- what is it you're above peers on or you were below and now you're above? What was that?"
},
{
"speaker": "Mike Lacy",
"content": "So turnover, when we compared ourselves against the peer group and turnover, we were lagging the group, and that's what led us to really dive into the customer experience project, to try to change that trajectory. And we believe that we were on to something, we see it playing out in front of us but we also know that we have a long ways to go. And we think that this could potentially continue to drive, call it, $15 million to $30 million in value over the next couple of years by holding a sustainable lower turnover than the peer group going forward."
},
{
"speaker": "Operator",
"content": "Next question is coming from Jamie Feldman from Wells Fargo."
},
{
"speaker": "Jamie Feldman",
"content": "So I appreciate your commentary on -- you talked a lot about the guidance for kind of top line revenue, but also your comments around you've got a lot of uncertainty, the election, the consumer rates. What are the other line items where you would say in your guidance, you think you have the most room or you're the most conservative on or if things go well and things don't really turn downward, you could actually see meaningful uptick?"
},
{
"speaker": "Mike Lacy",
"content": "Jamie, that's a good question. I'll tell you where we're feeling pretty good today and you could see it in our guidance. Expenses, and I'm seeing across the board. It's not just on our controllables, it's also on the noncontrollables. And so when we went into the year, we had a midpoint of around 5.25% and today we're closer to 5%. Based on everything we're seeing with the customer experience, the fact that turnover is down, we're getting a little bit more aggressive with our turn vendors, people on site that do a lot of the work for us. We're able to sharpen our pencil there. So we're continuing to see strength on that line item. And so I'd say that's probably the biggest one for me."
},
{
"speaker": "Joe Fisher",
"content": "And I think real estate tax as well, when you look at what we came into the year at, we were expected more in the 4% to 5% range. Today, depending on what [Technical Difficulty] the appeal activity as well as I think we have some opportunities in Florida to improve our numbers based on values and rates. We think we could trend that real estate tax number down into 3% to 4% range. We've not fully factored that into our expectations yet because there's still unknowns out there but I think real estate tax still is an opportunity for upside. Insurance, we've had really good year-to-date activity from a claims perspective. A lot of that driven by expense saving ROIs, doing a lot of asset quality work and then a little bit of luck just coming off of higher claims activity, but we've had really good success on a year-to-date basis there. We have not factored that into continuing into the back half to the same degree. But if we see that trend continue, we probably have some upside there in expenses as well. So expenses is probably a good variable for us on a go forward basis."
},
{
"speaker": "Jamie Feldman",
"content": "And then, I guess, just kind of sitting where we are in the cycle, everyone's talking about very low level of starts. I guess that means a stronger '26, '27 across all markets, rates pulling back a little bit. We'll see what spending looks like from the different candidates out there if rates stay low. But you talked about how strong your balance sheet is. How aggressive do you feel like you need to be right now on the investment front to kind of catch the early part of the cycle or do you think you can be patient? And just what does the landscape look like, whether it's from your perspective or competing buyers' perspective on the macro picture and putting capital to work?"
},
{
"speaker": "Joe Fisher",
"content": "Maybe I'll kick it off just from a high-level perspective, how we're thinking about capital and then toss it to Andrew, he can kind of talk about what we're seeing in the market with buyers and sellers and cap rates today. So I'd say right now, it's a continued capital light strategy for us. We don't have the cost of equity that's compelling today. We don't have a lot that we need to do either on the debt maturity side or the development commitment side today. From an external growth perspective going out there and acquiring utilizing balance sheet capacity isn't really something that makes sense for us in terms of levering up for minimal accretion. When you look at where cap rates are today that Andrew will talk about relative to that cost you're kind of in line to possibly even negative leverage today. And so going out there and utilize the balance sheet capacity for that isn't overly compelling from an FFO accretion perspective. So I'd say continue with the capital light strategy. We are building up a lot of optionality within the development pipeline. And we've got plus or minus four deals that could start in the next 12 to 18 months. So we continue to try to whittle cost out there, wait for rents to come our way, wait for yields and cap rates to keep coming our way. But I think that's where we'll lean in as we get more conviction on the cycle and the cost of capital."
},
{
"speaker": "Andrew Kantor",
"content": "As Joe mentioned, we're going to continue our capital light strategy. We're focused on underwriting deals and presenting those to our joint venture partner. But for the most part, what we're seeing in the market today is many of the large heavyweight firms have signaled that the markets have bottomed out. Cap rates today are plus or minus 5% based on location. The thing that we're seeing that's a little different than we have in the past is that rates have normalized across different markets, and those with higher growth are trading lower -- or trending lower, and those with slower growth are a bit higher and we're seeing that across the board. We're also seeing investors make decisions based on discount to replacement cost in the markets where there's a large disconnect between the cost to build and the cost to buy. We're seeing increased activity in certain buyer groups and that's also helping on the IRR as many investors are able to push reversion values down -- push cap rates down and the reversion to push values up, and their IRR up as some of these markets have substantial discounts to replacement cost."
},
{
"speaker": "Jamie Feldman",
"content": "Just to confirm, so you're seeing that cap rates are -- there's a gap in cap rates between higher growth and lower growth markets? Like what's the delta between the higher and lower growth?"
},
{
"speaker": "Andrew Kantor",
"content": "I mean, I would say that cap rates are anywhere from 4.75% to 5.25% for the majority of the assets that are trading today. And so in markets where you don't have a discount to replacement cost and you have low growth, you're obviously going to have to -- those assets are trading at the higher cap rate and then where markets where you have high growth people are willing to push harder for that and that pricing is going to be at the lower cap rates."
},
{
"speaker": "Operator",
"content": "Your next question is coming from Nick Yulico from Scotiabank."
},
{
"speaker": "Daniel Tricarico",
"content": "It's Daniel Tricarico on for Nick. A question for Mike. With respect to the incremental 60 basis points rental rate growth for the year versus the initial guide. Could you put some numbers around how that changed between your different regional exposures?"
},
{
"speaker": "Mike Lacy",
"content": "I think, first and foremost, when you think about the 60 bps, what we're assuming for the back half of the year is renewals being, call it, that 4% range, so it would have to be closer to negative 2.5% to get to that number. And so when you think about what that means by region, obviously, we're still sending out 5% through September at this point. There's not a big difference between regions. I'd tell you at the low end, we're probably closer to 3%, 3.5% in the Sunbelt, slightly above that on the Coast. And then when you get to the new lease side what I've been seeing is negative 5%, negative 6% in the Sunbelt. Expectations are that could get a little bit worse as we go into the back half of the year just given that supply is going to still be peaking and you have less demand. But with the Coast, you're probably coming down marginally but not anything significant."
},
{
"speaker": "Joe Fisher",
"content": "And relative to kind of first half, that 60 bps pickup that we saw, we continue to see Sunbelt operating about as expected. The positive surprises have really been coming on the Coast. And I think as we talked about before, DC has been a nice positive surprise for us as well as, San Fran and Seattle picking up on the West Coast. So it's really been the coast of driven the upside to that improved blended lease rate expectation for the full year."
},
{
"speaker": "Daniel Tricarico",
"content": "And actually just following up on DC, there's obviously -- it's been outperforming this year. There's obviously been some benefit on the election and maybe the defense sector spending. So just looking ahead, would you anticipate some level of normalization into next year, especially maybe considering a potential change in administration?"
},
{
"speaker": "Mike Lacy",
"content": "I'd tell you, first, what we're seeing there, just size of this market, D.C. has been doing tremendous over the last 60, 90 days. And again, this is 15% of our NOI market. So a very important market for us. We're 40% urban, 60% suburban. Occupancy is in the 97% range today and blends were 5.9% during the quarter compared to 3.4% in the first quarter. So DC has been a strong performer for us. Expectations as we move forward, we're going to have a little bit more supply down around the 14th Street corridor also along the Navy Yard. So we'll continue to see a little bit of pressure there. As it relates to just demand and job growth there, it's too early to tell kind of how that shakes out. But right now, we feel good about that market."
},
{
"speaker": "Tom Toomey",
"content": "I would tell you, election cycles, particularly presidential and the impact on DC, there's not much of a bump. It just turns out these guys put on new jerseys and go to work for somebody else and stay in the marketplace. So I think the dynamic in DC that could change is returned to office and if that takes root and sees a significant return to office, if you will. So we'll wait and see how it plays out. I think we know in about 97 days kind of where that one is going to play."
},
{
"speaker": "Operator",
"content": "Your next question is coming from John Kim from BMO Capital Markets."
},
{
"speaker": "John Kim",
"content": "I wanted to follow up with Mike on an answer you gave to Austin's question on new lease rates in July. And I know we don't want to focus too much on one month of data. But I think you mentioned that the July was down 5% to 6% in Sunbelt, up 1% to 2% in coastal markets. That would basically imply that the weakening of the July rates was driven by the coastal sequentially versus Sunbelt. I just wanted to make sure that was the case."
},
{
"speaker": "Mike Lacy",
"content": "John, it's kind of across the board. Like I was saying, when you go from May to July, we saw a little bit more deceleration in the East Coast and now it's probably more specific to a place like Baltimore. New York, DC, they were humming right around 5% to 6% growth. So they've come down a little bit. But for the most part, it's been across the board in terms of new lease growth. And at the same time, we're seeing renewals actually a little bit higher than the Sunbelt today than we were seeing back in May as it relates to some of the coastal markets, upwards of -- we're pushing around 4%, 4.5% in July versus sub-3% back in May in the Sunbelt. And then I'll tell you for the coast it's up closer to 50 to 70 basis points. So a little bit weaker on the new lease side, a little bit stronger on the renewal side and the Sunbelt right now."
},
{
"speaker": "John Kim",
"content": "And then, Joe, you mentioned looking at potentially four different development starts over the next couple of years. What kind of development yields or IRRs do you need to achieve to move forward with those? And you compare that with your DCP investments where you're investing in [indiscernible] or do you compare that versus acquisition yields?"
},
{
"speaker": "Joe Fisher",
"content": "So from a development yield perspective, I think the absolute yields that we're seeing available in the marketplace today are actually quite compelling relative to history. The challenge is a little bit was a spread investor relative to either where cap rates are that 5% or our own cost of capital, that's what keeps us a little bit cautious still from a new start perspective. But what we're looking at on those deals is generally on a current basis kind of in that high 5s type of number and then obviously trending higher. So day one, you're kind of looking at a plus or minus 75 to 100 basis point yield differential versus comparable cap rate in that market for that product type and then growing over time. So that's kind of how we're thinking about that piece. We are thinking about, as we've done over time, I think one of the good things about our platform is by investing in a lot of different areas, be it development, DCP, acquisitions, joint ventures, into the platform and to read out whatever it may be, we do tend to pivot and flex those within reason. And so we are looking across DCP and acquisitions as we compare and contrast the returns on the risk. That said, the acquisition side, we are trying to allocate capital there with our joint venture partner, which, as you know, has been a little bit slower. DCP, I'd say, we're a little bit more in that steady state part of the business, that's kind of just under 3% of enterprise and earnings right now. So we feel comfortable with it there. So that's probably more of a recycling piece. So a little bit less of a pivot and compare and contrast amongst DCP and development."
},
{
"speaker": "Operator",
"content": "Next question is coming from Rich Anderson from Wedbush."
},
{
"speaker": "Rich Anderson",
"content": "So just a broader question from me. When you think about the challenges that lay out -- I know you're kind of laying out some conservatism in your numbers for the back half of the year. But when you think of the compounding impact of supply, some stuff that's delivered but 40% or 50% finished. Other stuff that's just getting delivered now is maybe 10% occupied. Are the challenges ahead tougher than they were in the rearview mirror or do you feel like you're kind of past the worst of it right now, when you consider some of the jobs numbers you mentioned and income growth and all that sort of stuff? I'm just curious where your mind is from that standpoint."
},
{
"speaker": "Joe Fisher",
"content": "I guess, maybe kicking it off and others may jump in. As you look at where we're at, let's kind of fall back to last year, kind of September, October, November time frame, that's really where we saw that increase in concessionary activity as deliveries start to ramp up. I think we are in a very different market than where we're at that point in time, right? You look at the capital environment, obviously, and we had a pretty big surge in rates, a gap out in spreads, you also had a drying up of capital availability. And at that point, we were talking about cap rates potentially being in the high 5s up to 6% type of level. So a very different capital environment at that point in time. Also, if you're a developer, you're in kind of seasonally weak period of time, plus looking up at a big stack of deliveries in the year ahead. So a little bit more nervous as you face a refi and think about your rent roll. So I think we've kind of fast forward to a different environment where we, obviously, to date, have avoided the recession, supply, as you look forward over the next year, over the next 12 months, it's better on deliveries than it has been over the last 12 months and the capital environment and demand for assets is much better than anticipated or at least as it was last 4Q. So the environment definitely feels better. That said, we continue to have deliveries that are kind of at levels that we saw in 2Q and 3Q and going into 4Q. So I think that's what keeps us cautious is we don't want to get out over our skis knowing that there's still macro risk out there. And there's also a macro opportunity if jobs keep coming in better, household formations keep coming on better. So it's kind of right to be cautious for now, get through that seasonally weak period of time. And hopefully, we put up better numbers than what we've laid out here and then we'll report back on them and see how that year ends up, but for now being prudent."
},
{
"speaker": "Tom Toomey",
"content": "It's a very provocative question. And it really depends on the time horizon you're trying to look through. And my perspective, the last five years we see more volatility and challenges in the business that we'll probably see in the future. And this feels a lot more like fundamental blocking and tackling type business, which is going to benefit the companies that have diverse investment base and diverse value creators. So as we think about the future, it looks like interest rates are going to settle around about 5%, we're going to continue to print deficits. And that's a very financeable product, meaning multifamily. Supply demand fundamentals always in a shortage. Can you time out the window when you get into a market and when you get out? I think we've been pretty darn good at that. And then at the core, can you operate it better than anybody else in the space, and we're really focused on that aspect. So we think all the value creators that we have built over time have an opportunity in the future. And we've got to be smart about pivoting to it. The window in the short run, seen supply quite a bit bigger than this in market basis. It just takes time to absorb threat, price it, adjust. There will be opportunities in those markets. And then it is United States. It is a resilient, capable country that always finds a way to grow. So I'm encouraged about the future. Grateful for the last five years were kind of in the rearview mirror for us."
},
{
"speaker": "Rich Anderson",
"content": "The second question, both EQR Avalon Bay are looking at 25% exposure to the Sunbelt, you're already there. I wonder imitation best form of flattery, I don't know what to make of that. Is that the efficient frontier, though, in your mind, that balance of coastal versus Sunbelt when you've gone through what you're going through now?"
},
{
"speaker": "Tom Toomey",
"content": "I think it's an interesting question. Joe probably have a lot more thoughtful answer. We like our balance to present. I like what Chris and the team have done when they look at it on an analytical basis and trying to uncover cities of the future, if you will. If you realized 10 years ago, Nashville was kind of a warehouse of capital for us and turned out to be a dynamic city that grew tremendously, Austin, the similar type aspect. So trying to find the next wave of cities that will prosper in a new economy, I think it's really kind of where we're thinking about. We like the base that we're starting with. We certainly like the theory of buying the one next door where we have a low risk, high success rate. So I like the platform as is. We'll always look at kind of what markets we need to grow to and which markets we need to shrink. But that's a dynamic aspect that we sit back and look at three year windows, five year windows and 10 years."
},
{
"speaker": "Operator",
"content": "Next question is coming from Adam Kramer from Morgan Stanley."
},
{
"speaker": "Adam Kramer",
"content": "Just looking at the same store revenue guidance range, it looks like it's a 200 basis point kind of range low end to the high end. If I compare us to the peers or compare that to even kind of your own guidance range in the past and in the second quarter, I think it's a bit wider than those. So just wondering, thinking about kind of your comments earlier, too, about kind of an unchanged view with regards to the second half relative to your guidance earlier in the year. Wondering kind of what drives that wider range of potential outcomes for kind of the second half of the year?"
},
{
"speaker": "Joe Fisher",
"content": "I mean there's certain specific drivers as you go in, right, between occupancy volatility, do we continue to have a great performance in other income as we have in the first half, how does lender lease rates and market rent growth perform. And so given the aspects of volatility that we kind of laid out there and the unknowns, it just felt prudent. I think it's not lost on any of us here on this side of the table at least that last year we probably tried to get a little bit too tight and get a little bit more accurate as we went into the back half. And we are surprised with a little bit of a swing in activity in September, October, November. And I don't think anyone here has the desire to repeat that. And so does a wider range help with that? Of course. Does being conservative in the back half help with that? Of course. So I think it's going to be about how do we finish the rates, not how do we update throughout the year. So hopefully, we can deliver strong and be talking about it on our third quarter call as we kind of have greater visibility into closing out the year and then, of course, the earn in into next year, which we're clearly very focused on as we push these renewals up."
},
{
"speaker": "Adam Kramer",
"content": "And then just kind of maybe tying back to your answer, Rich, from a couple of minutes ago. Just thinking about kind of the cadence of deliveries, you mentioned this fall, obviously, into next year. And then again, not asking you for a specific month or maybe even a specific quarter here. But just thinking about kind of when pricing power will return in the Sunbelt, right, kind of given the cadence of deliveries. When do you think you'll be able to kind of push pricing kind of push market rent growth again kind of above and beyond the typical CECL curve?"
},
{
"speaker": "Mike Lacy",
"content": "It's something we're going to continue to monitor very closely, Adam. And I'd tell you right now, it's -- you're not going to see new lease growth go positive here in the near term. But obviously, as we turn the corner next year, you're starting to anniversary of easier comps and you are seeing us get a little bit more aggressive as it relates to renewal growth. So could blend start to go up as we get into next year, I think they could. But for now, we're taking a day by day and obviously looking at our total revenue growth as our strategy going forward."
},
{
"speaker": "Operator",
"content": "The next question is coming from [Indiscernible] from UBS."
},
{
"speaker": "Unidentified Analyst",
"content": "Just one for me. To get a better apples-to-apples comparison with peers who are seeing a same store revenue benefit from improving bad debt. Do you have a calculation for what your same store revenue growth would be if you were using the same or similar accrual process as peers?"
},
{
"speaker": "Joe Fisher",
"content": "We do not have that. To be honest, I don't think any of us really provide full and absolute disclosure on methodologies. I think all of us try to utilize the methodology that's most appropriate and what we believe best represents kind of the existing residence base and AR that we have. And so we've been very consistent throughout on our approach. I don't think we have necessarily the same volatility that perhaps others do as you have residents go in and out of the different pools. But I think it has worked for us, I'd say we're roughly 50% reserved today on our total AR balance, which really is meant to cover what those individuals are that are in eviction at this point in time that we don't think they are going to be collectible. The rest is due to our typical slightly late payers or payment plans that may be out there. So we feel good about where we're at today. We continue to see long term delinquents come down in the portfolio. So we had been stuck at kind of 250 or so long term delinquents. I think a lot of the activity that we've had from a screening perspective, from a credit standard perspective, process improvements, we've gone under 200 on that front, so that's helping whittle down some of that AR and the need for reserve. And cash collections, obviously and versus that, they continue to improve a little bit on the margin. So we've seen first half bad debt come in a little bit better. So maybe it's help in the numbers plus minus 10 bps year-over-year. We believe there's more to come in the second half as we get these long term delinquents down in some of the screening we talked about earlier. So hopefully, that is a upside to our numbers as we go forward, but it's hard to say what peers would be at."
},
{
"speaker": "Operator",
"content": "Next question is coming from Alexander Goldfarb from Piper Sandler."
},
{
"speaker": "Alexander Goldfarb",
"content": "I'll just ask one question. There's a lot of discussion over this early peak of June versus is there going to be a double peak. You guys have obviously talked about the nuance and what's going on leasing East Coast, West Coast, Sunbelt. But it really seems like we're splitting hairs. I mean most of the percentages are within a few points of each other and generally almost seem like normal seasonality volatility like normal course. So is your view that what you guys are talking about and what we're hearing from peers is really anything other than normal seasonality and normal variances or are there truly specific things that you're seeing that give you true pause?"
},
{
"speaker": "Joe Fisher",
"content": "I don't think there is anything that's giving us true pause today. Mike talked about still being at the 1.8 residents per unit, the collections, the traffic. The volatility in our blends, as Mike talked about, is really the result of a pricing strategy. We felt really good in April and May with high occupancy. We are seeing good traffic. We're going into the first part of leasing season. So if you're going to test rents that's the time to do it. We were seeing really good numbers. So we pushed aggressively. Mike said, we pushed over 2x what we normally would at that point in time. And ultimately, the market reacted. We tried to push, market reacted, we lost a little bit of occupancy and we pulled back, we found the equilibrium. And so that's why occupancy stabilized, that's why news and blends are stabilizing here. So I think that's the volatility. If we didn't do that, I don't think we'd be doing our job. We saw a window to push, we pushed it the right time of the year. At the same time, I think Mike has talked a lot about kind of the separate pricing strategy that exists on renewals where retention and customer experience are going great. And so why don't we push there and that seems to be working out. So I think you're right, it's normal course volatility. We're talking kind of 25, 50 bps here and there but it's a result of what we're trying to push and the market push backed a little bit."
},
{
"speaker": "Operator",
"content": "Next question is coming from [Ann Chan] from Green Street."
},
{
"speaker": "Unidentified Analyst",
"content": "Just one question for me. Out of the 300 bps retention improvement achieved in 2Q, it looks like most regions saw around a 50 bps year-over-year improvement. West Coast a little bit more flat. Could you comment on particular markets or trends by strategy that might cap retention growth a little bit more muted relative to the other regions, and how that reads through for the rest of the year?"
},
{
"speaker": "Mike Lacy",
"content": "I would tell you, with some of these regions, you do have some markets that have a little bit more volatility. And for us, I think we have Monterey Peninsula where we do have migrant workers that come in and out of that market. So that's typically higher on the turnover. But for the others, it's been pretty consistent. We've seen a decrease pretty much across the board. And while some of this has to do with the fact that we have just far fewer people moving out to buy homes pretty much across the board, a lot of this has to do with all the things that we put into the customer experience project. And again, we think that this will continue to pay dividends. But Joe just mentioned it again as well, we do want to test our rents as well. And so we'll look at different levers to see what we can drive through this initiative. But so far, so good. But again, West Coast, you have to really dive into some of the markets and I think a lot of that was driven by [Salinas]."
},
{
"speaker": "Operator",
"content": "Your next question is coming from Linda Tsai from Jefferies."
},
{
"speaker": "Linda Tsai",
"content": "Just one question. Sunbelt market from where you sit today to see new lease growth hit flat or slightly positive soonest?"
},
{
"speaker": "Mike Lacy",
"content": "Not Austin. Austin is continuing to see probably the lease growth, and I expect that's going to continue for a little while. Starting to see a little bit more inflection in places like Florida for us compared to Texas. And so maybe we could see it in Tampa as we go into next year. But right now, I'd say, Texas is probably a little bit more under fire followed by Nashville and then Florida would be third in terms of Sunbelt markets."
},
{
"speaker": "Operator",
"content": "Our next question is coming from Mason Guell from Baird."
},
{
"speaker": "Mason Guell",
"content": "On the preferred equity investments that are maturing soon, what are your plans for these investments now the associated assets stabilized?"
},
{
"speaker": "Andrew Kantor",
"content": "So if you look at the numbers that are in the supplement for the maturity dates on those different investments, those are without extension options. So currently, all of the DCPs that are maturing within the year have some form of extension option available. So we're talking to those developers, those developers are looking at different opportunities to either recap their asset, to sell their assets or to extend their asset, but each is a different conversation."
},
{
"speaker": "Operator",
"content": "We reached the end of our question-and-answer session. I'd like to hand the floor back over to Chairman and CEO, Mr. Toomey, for closing comments."
},
{
"speaker": "Tom Toomey",
"content": "Thank you, operator. And thank you all for your time, interest and support of UDR. We look forward to seeing many of you at the Evercore ISI and Bank of America Conferences in September and other upcoming events and tours. So with that, enjoy the balance of your summer. Take care."
},
{
"speaker": "Operator",
"content": "Thank you. That does conclude today's teleconference. You may disconnect your line at this time, and have a wonderful day. We thank you for your participation today."
}
] |
udr | 2,024 | 1 | [
{
"speaker": "Operator",
"content": "Greetings, and welcome to UDR's First Quarter 2024 Earnings Call. [Operator Instructions]. As a reminder, this conference is being recorded."
},
{
"speaker": "",
"content": "It is now my pleasure to introduce your host, Vice President of Investor Relations, Trent Trujillo. Thank you. Mr. Trujillo, you may begin."
},
{
"speaker": "Trent Trujillo",
"content": "Welcome to UDR's Quarterly Financial Results Conference Call. Our press release and supplemental disclosure package were distributed yesterday afternoon and posted to the Investor Relations section of our website ir.udr.com. In the supplement, we have reconciled all non-GAAP financial measures to the most directly comparable GAAP measure in accordance with Reg G requirements."
},
{
"speaker": "",
"content": "Statements made during this call, which are not historical, may constitute forward-looking statements. Although we believe the expectations reflected in any forward-looking statements are based on reasonable assumptions, we can give no assurance that our expectations will be met. A discussion of risks and risk factors are detailed in our release and included in our filings with the SEC. We do not undertake a duty to update any forward-looking statements."
},
{
"speaker": "",
"content": "When we get to the question-and-answer portion, we ask that you be respectful of everyone's time and limit your questions to 1 plus a follow-up. Management will be available after the call for your questions that did not get answered on the call today."
},
{
"speaker": "",
"content": "I will now turn the call over to UDR's Chairman and CEO, Tom Toomey."
},
{
"speaker": "Tom Toomey",
"content": "Thank you, Trent, and welcome to UDR's First Quarter 2024 Conference Call. Presenting on the call with me today are President and Chief Financial Officer, Joe Fisher; and Senior Vice President of Operations, Mike Lacy; Senior Officers, Andrew Cantor; and Chris Van Ens will also be available during the Q&A at the end of the call."
},
{
"speaker": "2024 is off to a very solid start. Due to better fundamental backdrop than initially expected and the operating strategies we continue to employ to outgrow competitors in our markets. Positive fundamental drivers for industry include",
"content": "first, year-to-date employment creation of approximately 800,000 jobs has already exceeded initial full year economist consensus growth expectations."
},
{
"speaker": "",
"content": "Second, more than 100,000 newly delivered apartment homes were absorbed during the first quarter. The strongest first quarter in over 2 decades. Adding to that, total housing deliveries remained stable and development starts continue to decline. This bodes well for rent growth in the years ahead. And third, renting an apartment is on average 60% more affordable than owning a single-family home in the markets where we operate. A cycle best level of relative affordability."
},
{
"speaker": "",
"content": "These trends, combined with the operating tactics we utilize have led to positive momentum across all key operating metrics. This includes more robust traffic, higher leasing activity, lower turnover, lower concessions, higher occupancy and better pricing power than originally expected. In all, this translates to what I would characterize as green sprouts. Mike will provide additional details in his remarks."
},
{
"speaker": "",
"content": "However, as we only have completed the first 4 months of the year, we remain wary of the volatile and elevated interest rate environment and the effect it may have on pricing and concessions of lease up communities, given the heightened new supply the industry faces in 2024. We feel good about 2024 thus far, but we would like to see more evidence of continued operating momentum as we progress through a peak leasing season before revisiting our full year guidance."
},
{
"speaker": "",
"content": "Big picture, I remain optimistic on the long-term growth prospects of the multifamily industry and UDR's unique competitive advantages that should enhance that growth. We have a strong culture, a talented team with a robust track record of performance, and we continue to invest in our associates and embrace technology to create value for all of UDR stakeholders."
},
{
"speaker": "",
"content": "Finally, I'd like to take a moment to celebrate the upcoming retirement of Senior Vice President and Chief Investment Officer, Harry Alcock who will soon be transitioning to a consulting role with a focus on sourcing transactions. Harry and I have worked together for approximately 30 years, and he has been a trusted partner through all of it. He helped UDR grow to be a thriving $20 billion enterprise we are today while also grooming our next wave of talented investment and development professionals. Harry, thank you for all you have done and we all look forward to working with you in your new role."
},
{
"speaker": "",
"content": "With that, I will turn the call over to Mike."
},
{
"speaker": "Michael Lacy",
"content": "Thanks, Tom. Today, I'll cover the following topics. Our first quarter same-store results, early second quarter 2024 trends and how they factor into our full year 2024 same-store growth guidance. An update on our various innovation initiatives and expectations for operating trends across our regions."
},
{
"speaker": "To begin, first quarter year-over-year same-store revenue and NOI growth of 3.1% and 1.2%, respectively, and 0.4% sequential same-store revenue growth were slightly above our expectations. These results were driven by",
"content": "first, 0.8% blended lease rate growth, which resulted from nearly 4% renewal rate growth and new lease rate growth of negative 2.5%. New lease rate growth improved 260 basis points versus fourth quarter results as concessions decreased by approximately half of a week on average."
},
{
"speaker": "",
"content": "Second, 35% annualized resident [ turn ] was 400 basis points better than the prior year. The 630 basis point delta between new and renewal rate growth when combined with higher retention led to a favorable outcome. And third, occupancy remained strong at 97.1%, supported by healthy traffic and leasing volume."
},
{
"speaker": "",
"content": "New York, Washington, D.C., San Francisco and Seattle, which collectively constitute 36% of our same-store pool for standouts, averaging nearly 98% during the quarter."
},
{
"speaker": "",
"content": "Shifting to expenses. Year-over-year same-store expense growth of 7.5% in the first quarter was in line with our expectations and inflated by a tough comp against the onetime $3.7 million payroll tax credit we recorded and disclosed in the first quarter of 2023. After excluding this credit, our year-over-year same-store expense growth would have been a more reasonable 4%."
},
{
"speaker": "",
"content": "Moving on, strong core operating trends have continued into the second quarter and every key revenue metric is exceeding our expectations through the first 4 months of the year. First, blended lease rate growth continued to accelerate from approximately 1% in March to roughly 2% in April, with concessions stabilizing at lower levels than the fourth quarter of 2023. All regions have demonstrated sequential blended lease rate growth improvement versus March. With our West Coast and mid-Atlantic regions showing the most strength at approximately 3.5%."
},
{
"speaker": "",
"content": "Based on current trends, we expect May blended lease rate growth to demonstrate further sequential improvement."
},
{
"speaker": "",
"content": "Second, resident retention continues to compare well against historical norms. Due in part to our customer experience project, which I will touch on later, April retention is 400 basis points above prior year levels, representing the 12th consecutive month our year-over-year turnover has improved."
},
{
"speaker": "",
"content": "Third, occupancy is holding firm in the high 96% range. Strong demand from continued job and wage growth has allowed us to simultaneously operate with high occupancy and push rental rate while maintaining rent income levels in the low 20% range."
},
{
"speaker": "",
"content": "And fourth, other income continued to grow at approximately 10% in April, similar to what we achieved in the first quarter. As a reminder, other income constitutes roughly 10% of our total revenue. We remain pleased with the trajectory of our other income initiatives such as the rollout and penetration of building-wide WiFi, which contributes significantly to incremental same-store revenue growth."
},
{
"speaker": "",
"content": "Looking ahead, we reaffirmed our full year 2024 same-store growth guidance in conjunction with our release. We are encouraged by the strength of macroeconomic indicators, such as year-to-date job growth and wage growth and the effect those demand drivers have had on our key performance indicators thus far. But we remain somewhat cautious given the volatile and elevated interest rate environment combined with peak supply deliveries yet to come."
},
{
"speaker": "",
"content": "Turning to regional trends. Our coastal results have been above our expectations, while Sunbelt markets are in line and trending better. More specifically, the East Coast, which comprises approximately 40% of our NOI, was our strongest region in the first quarter. Boston, Washington, D.C. and New York all performed well with weighted average occupancy of 97.5%."
},
{
"speaker": "",
"content": "Blended lease rate growth was nearly 2.5%, and same-store revenue growth was 4.25%, which is slightly above the high end of our full year expectations for the region. We expect this regional strength to continue."
},
{
"speaker": "",
"content": "The West Coast, which comprises approximately 35% of our NOI has performed better than expected. At the beginning of the year, we anticipated San Francisco and Seattle would lag our West Coast markets. While revenue growth results in the first quarter show this to be true on an absolute basis, both markets saw new lease rate growth improved by nearly 900 points compared to our fourth quarter results. The momentum in these markets has exceeded our expectations due to various employers, more strictly enforcing return to office mandates as well as increased office leasing activity from technology and AI companies."
},
{
"speaker": "",
"content": "Lastly, our Sunbelt markets, which comprise roughly 25% of our NOI, continue to lag our coastal markets due to elevated levels of new supply, but have performed in line with our expectations. Better drop growth in these markets appear to be bolstering demand and absorption. And similar to other regions, we have seen Sunbelt concessions stabilize."
},
{
"speaker": "",
"content": "Sequential blended lease rate growth accelerate and retention improve. We remain cautious on the Sunbelt in the near term but have been pleasantly surprised by its recent trajectory. These regional dynamics reinforce the value of a diversified portfolio across markets and price points that allow us to pivot our short- and long-term operating strategies to maximize revenue and NOI growth."
},
{
"speaker": "",
"content": "Moving on, we continue to make progress on various innovation projects that will benefit same-store growth in 2024 and beyond. One example of this is our customer experience project. We have consistently outperformed the public and private markets on NOI and margins over time due to the focus on our leading operating platform and innovative culture, which has historically driven all aspects of income growth, operating efficiencies and contained our cost structure."
},
{
"speaker": "",
"content": "We are now turning to the next phase of our platform which focuses on customer experience and retention. Through our proprietary data hub and the millions of data points we have accumulated over the last 7 years, we have found that 50% of resident turnover is controllable. In that, those residents with positive experiences and scores were new at a rate, 20% higher than those with bad experiences. Knowing this, we see an opportunity to improve retention by 5% to 10% versus the industry average of 50%, resulting in a $15 million to $30 million incremental NOI opportunity."
},
{
"speaker": "",
"content": "To capture this upside, we now track and score every interaction with our residents. This has allowed us to make a transformational shift in the way we do business with a move from being transactional in nature to a focus on the lifetime value of our customer. We are equipping our UDR team members with tools, training and the ability to prevent or rectify bad customer experiences which we believe over the coming 2 to 3 years will materially improve the [ rent ] experience and our relative turnover. This should positively impact pricing occupancy, other income, expenses and margin as well."
},
{
"speaker": "",
"content": "My thanks go out to the UDR associates nationwide, they remain committed to delivering on our strategic priorities. You rightfully deserve credit for embracing our innovative culture and improving how we conduct our business."
},
{
"speaker": "",
"content": "I will now turn over the call to Joe."
},
{
"speaker": "Joseph Fisher",
"content": "Thank you, Mike. The topics I will cover today include our first quarter results and our updated full year guidance, a summary of recent transactions and capital markets activity and a balance sheet and liquidity update. Our first quarter FFO as adjusted per share of $0.61 achieved the midpoint of our previously provided guidance and was supported by same-store revenue and NOI growth that was slightly above our expectations. The modest sequential FFOA decline was driven by an approximately [ $0.015 ] decrease from same-store NOI, primarily due to higher expenses attributable to seasonal patterns and approximately [ $0.005 ] decrease from higher interest expense and G&A."
},
{
"speaker": "",
"content": "Looking ahead, our second quarter FFOA per share guidance range is $0.60 to $0.62 with a $0.61 midpoint flat compared to the first quarter due to nominal expected changes across NOI, interest expense and G&A."
},
{
"speaker": "",
"content": "Year-to-date, operating results are trending above our initial expectations. But with macro uncertainty and peak leasing season ahead of us, we have reaffirmed our full year 2024 same-store growth guidance ranges and plan to revisit them in the future. However, we did increase our full year FFOA per share guidance range by $0.02 due to the joint venture successful refinancing of its senior construction loan at our DCP investment in Philadelphia with no additional investment from UDR. Having addressed this risk, there are no remaining DCP senior loan maturities until 2025."
},
{
"speaker": "",
"content": "In addition to the Philadelphia investment, there remain 3 additional DCP investments totaling approximately $50 million on our watch list with no material changes since the fourth quarter. Beyond this, our remaining $440 million of DCP investments are performing well as they were primarily 2021 and 2022 vintage developments, which have not encountered material construction cost overruns or delays and are performing in line to above pro forma on rents."
},
{
"speaker": "",
"content": "Next, a transactions and capital markets update. First, in alignment with our capital-light strategy, we made no acquisitions, new DCP investments or development starts during the first quarter. We remain active in evaluating potential acquisitions through our joint venture with LaSalle and are optimistic on the ability to complete additional accretive deals in the coming quarters."
},
{
"speaker": "",
"content": "Second, during the quarter, we completed construction of a $54 million 85-unit townhome community in Dallas, Texas. This community adds density to our existing Addison portfolio while offering residents a complementary living option. Our current development pipeline consists of just 1 community in Tampa, Florida, totaling 330 homes at a budgeted cost of $134 million with 94% of this cost already incurred, thereby limiting our forward funding commitments."
},
{
"speaker": "",
"content": "And third, during the quarter, we completed the previously disclosed sale of Crescent Falls Church, a 214-home apartment community in the Washington, D.C. area at a mid-5% buyer's cap rate for proceeds of approximately $100 million."
},
{
"speaker": "Finally, our investment-grade balance sheet remains liquid and fully capable of funding our capital needs. Some highlights include",
"content": "first, we have nearly $1 billion of liquidity as of March 31. Second, we have only [ $113 ] million of consolidated debt or approximately 0.6% of enterprise value scheduled to mature through the end of the year and only 11% of total consolidated debt scheduled to mature through 2026, thereby reducing future refinancing risk."
},
{
"speaker": "",
"content": "Our proactive approach to manage on our balance sheet has resulted in the best 3-year liquidity outlook in the sector and the lowest weighted average interest rate amongst the multifamily peer group at 3.4%. And third, our leverage metrics remain strong. Debt-to-enterprise value was just 30% at quarter end, while net debt-to-EBITDAre was 5.7x, which is approximately a half turn better versus pre-COVID levels."
},
{
"speaker": "",
"content": "In all, our balance sheet and liquidity remain in excellent shape. We remain opportunistic in our capital deployment, and we continue to utilize a variety of capital allocation competitive advantages to drive long-term accretion. With that, I will open it up for Q&A. Operator?"
},
{
"speaker": "Operator",
"content": "[Operator Instructions]. Your first question comes from Nick Joseph with Citi."
},
{
"speaker": "Nicholas Joseph",
"content": "Maybe just starting on the same-store revenue. Obviously, the first quarter was a bit better than what you expected, but hoping you could actually quantify kind of what your expectations were versus the 3.1% that you put up?"
},
{
"speaker": "Michael Lacy",
"content": "Nick, it's Mike. I'll take the first crack at it. What we're looking at, and as a reminder, we had 70 basis points of blends for the year. And I would tell you, our blends right now in the first quarter, running about 20 basis points higher to start the year. But April, May trend even higher, I'd say, about 100 basis points higher than what we had in our original business plan going into the year."
},
{
"speaker": "",
"content": "So to quantify that, if we were able to sustain that 1%, that equals to about $8 million and for us on our revenue line, that's about 50 basis points. So again, it's early in the season right now. We want to see how the next 30, 60 days play out, but right now, we feel really good about where we're trending."
},
{
"speaker": "Nicholas Joseph",
"content": "That's helpful. And how about on the occupancy and the other income side relative to initial expectations?"
},
{
"speaker": "Michael Lacy",
"content": "Occupancy in the first quarter was about 10, 20 basis higher than we expected. And over the last 30 days or so, we brought that down. So we're running right around [ 96.9% ] today. Expectations are, we'll continue to see that probably migrate down maybe 10 or 20 bps as we continue to push our blends a little bit higher. So overall, I'd say occupancy is pretty much on target through the first 4 months or so."
},
{
"speaker": "",
"content": "Other income, though, great. I mean I'll tell you, we were 10% above last year to start the year. April is trending in the same direction. That's probably 200 to 300 basis points higher than we originally thought. And a lot of that has to do with the success from the teams and it is really driving these initiatives home. So right now, other income feels really strong. And a lot of this just point back to our strategy, and we've talked about this over the last couple of months. It's start the year with high occupancy, start to push our blends, test the water as we have demand, and it's all starting to play out for us today."
},
{
"speaker": "Nicholas Joseph",
"content": "That's helpful. And then you touched on the prepared remarks about the benefits of the low turnover that continues to drive lower the high retention. When you look at the renewals you've sent out for May and June, I guess. First of all, where are those renewals going out? And then is there anything from a take perspective or a negotiating perspective that gives you any indications that turnover won't continue to stay low or even trend lower from here?"
},
{
"speaker": "Michael Lacy",
"content": "Mike, again, good question, Nick. Right now, we're sending out around, was around [ 3.8% ] through June on renewals. And then in July, we just sent out about 4.5% growth. So we are getting a little bit more aggressive on renewals, but at the same time, we're really pushing our market rents. So we're trying to compress the new and renewals. And I think what you saw from us in the first quarter was about a 600 basis point difference between new and renewal. My expectations -- that's going to come down to around 300 to 400 basis points as we move throughout the second quarter. And that's really setting us up to drive total blends, which is equating to total revenue growth a little bit ahead of our expectations."
},
{
"speaker": "Operator",
"content": "Next question, Austin Wurschmidt with KeyBanc Capital Markets."
},
{
"speaker": "Austin Wurschmidt",
"content": "Mike, you commented -- I want to hit back on the leasing trends about May, lease rate growth improving versus April. You talked about how things have kind of trended. I think, through the first quarter into April relative to expectation. But which markets are really driving that improvement into May? And maybe where are you becoming a little bit more aggressive on the renewal rate growth. And then do you think you can kind of keep retention or keep occupancy high while pushing a little bit harder?"
},
{
"speaker": "Michael Lacy",
"content": "Yes. Great question, Austin. We are seeing more strength based on our own expectations coming into the year really out of the West Coast. Right now, we've talked a little bit about what we've experienced in Seattle and San Francisco. And we're starting to see same thing coming out of the East Coast, New York is really picking up as demand picks up. So a lot of strength coming out of our coastal markets, and that's where we're seeing on an absolute basis, the highest rents."
},
{
"speaker": "",
"content": "And I'll tell you the one that's benefit price as of late and thankfully, it's 15% of our NOI is D.C. It's really starting to come on strong, starting to see blends in that plus 4% to 5% growth. And a lot of that has to do with getting more aggressive to your point on renewal, seeing that they're very sticky, and it's allowing us to drive our market ramp up as well and it's translating into positive new lease growth. So overall, the Coast feel very strong. But in addition to that, Sunbelt's hanging in there. And what I'm experiencing today is momentum on a month-over-month basis, seeing positive trends coming out of those parts of the country as well. So overall, things feel very positive there."
},
{
"speaker": "Austin Wurschmidt",
"content": "So yes, my follow-up kind of wanted to dig in a little further on sort of the positive surprise or seemingly like you're -- I feel fairly good about the Sunbelt relative to expectations. So I mean, would you be willing to say that the worst is behind you in the Sunbelt and that potentially the benefit of better job growth and maybe easier comps in the back half of the year could lead to continued acceleration? What are sort of the updated thoughts on the outlook through the balance of the year?"
},
{
"speaker": "Michael Lacy",
"content": "Yes, Austin. That's been getting a lot of questions on the Sunbelt. So maybe let me step back a second, just give you a little bit more color. And as a reminder to the group is, that's about 25% of our NOI. And to your point, we know supply is -- it's a certainty. And it's in front of us. Peak deliveries are still right around the corner, but at the same time, it's during peak demand. So that's a positive, and we're seeing stronger job growth as well as demand is a little bit stronger. And a lot of that has to do with record absorption. So overall, while it feels good, we're cautiously optimistic just given that supply is still coming."
},
{
"speaker": "",
"content": "But just to give you a little bit more color on what we're seeing on the ground, I think things that we look at, first and foremost, are the concessions. And I would point to, in Texas today, we're seeing 1.5 weeks. And in Florida, it's about a half a week of concession on our portfolio, which is a pretty significant improvement over the last 6 months and lower than what we're seeing from some of the comps in those areas."
},
{
"speaker": "",
"content": "In addition to that, occupancy in the Sunbelt, we're running around 96.5% to 96.7% today. So still very healthy occupancy. And again, we're seeing blends improving on a month-over-month basis. And just to give you a couple of stuff. In April, we were negative 1.5% in the Sunbelt for blends. That compares to negative 2.2% during the first quarter. And I'd tell you, May is shaping up to be even better. So overall, blends continue to improve. But where I'm most excited is our other income. And we've been driving home some of our initiatives in the Sun Belt, I think specifically the bulk Internet rollout that's really taking hold. It's allowing us to drive our other income above 10% in that part of the country, and it's allowing us to drive our total revenue. So again, cautiously optimistic given that peak supply is in front of us. But it's a much better position knowing that demand is also coming at the same time."
},
{
"speaker": "Austin Wurschmidt",
"content": "And then can you just clarify, did you guys underwrite 5% other income growth for the year?"
},
{
"speaker": "Michael Lacy",
"content": "We were between 5% to 7% growth on our other income line. And again, we're holding around 10% today. So that's a 200 to 300 basis points improvement from what we originally expected."
},
{
"speaker": "Operator",
"content": "Next question is Steve Sakwa with Evercore ISI."
},
{
"speaker": "Steve Sakwa",
"content": "Mike, I appreciate all the comments on some of the trends by market. I'm just curious in the Sunbelt, given that we've got heavy deliveries coming over the next 4 quarters. Is it your expectation that the better trends continue? Or has this maybe been either a little bit of low in supply or maybe stronger demand? And like, I guess, how are you thinking about those concession trends maybe over the next several quarters?"
},
{
"speaker": "Michael Lacy",
"content": "Yes, Steve, we still think that peak supply is -- it's going to hit us here in the next couple of quarters. So we're going to continue to watch that, lean into the things that we control. And again, that's where we're hitting our other income and driving our results against the peers on a relative basis. But we do expect that we're going to continue to take the headwind just given supplies in front of us for the next 6 to 12 months in that market."
},
{
"speaker": "Tom Toomey",
"content": "Steve, this is Toomey. Just to add some more color, and I think we had it in our prepared remarks. The record absorption in the first quarter, high for 2 decades. The jobs number, I think, has surprised us all through the balance of the year. If that continues, the Sunbelt has a pretty good path, if you will, and absorb it. I'm not sure betting on the jobs market, going into an election cycle is a very strong bet on that piece of equation."
},
{
"speaker": "",
"content": "Second, we're still a little low from last September, October when we saw interest rates spike and we saw a developer's panic and go to a heavy concession template in that supply type market, setting."
},
{
"speaker": "",
"content": "And I think we just will kind of be prudent for us to just play it through and see how it falls. I wouldn't get overly optimistic or pessimistic. It's just easier for us to say we're going to play it month by month and see what the traction is with respect to new and renewals. But right now, after 4 months, headed into the [indiscernible] feel better than we expected."
},
{
"speaker": "Steve Sakwa",
"content": "Okay. And then maybe one for Joe. Just as you think about maybe any opportunities for capital deployment. I know you probably don't like where your stock is trading, but how are you thinking about any kind of investment opportunities, whether it's DCP or land purchases for future developments? Like just kind of where are the recurrent opportunities? Where is the opportunity set today?"
},
{
"speaker": "Joseph Fisher",
"content": "Yes. Steve. So I'd say number one, balance sheet remains in a phenomenal position. So liquidity-wise, maturities sources and uses all look to be in a really good position. So we're able to kind of sit back and be in this capital environment and wait to pivot to offense. I'd say opportunity wise, the transaction market was finding -- footing there in terms of agreement on where cap rates were and buyers and sellers were coming together. Obviously, this recent surge in rates creates a little bit more of an unknown in that environment. And so we're kind of sit back trying to see where valuation starts to settle out here a little bit."
},
{
"speaker": "",
"content": "But where we probably tried to target today 2 different areas. One is on the JV acquisition side. JV that we put together with LaSalle last year, we'd, of course, like to continue to deploy with them as we did in the fourth quarter. So trying to find deals in our existing markets, deals down the street and then get the additional upside from the fee stream that comes off of that. So continue to show them a lot of transactions to help to get some things done here in the coming quarters with them."
},
{
"speaker": "",
"content": "The other area is within the DCP pipeline, while we're not seeing much on traditional DCP given that we're not seeing a lot of new starts and activity there. We are seeing a little bit more on the recap opportunity side. And so as we look ahead to potential paydowns or payoffs that may come out of that DCP pipeline in the next 12 months, we're starting to evaluate some opportunities for redeployment to put some capital out there on that front."
},
{
"speaker": "",
"content": "On the development side, you mentioned that we've got a really good land pipeline right now with a lot of deals that are shovel ready. And so that team has just continued to work out cost and monitor the market and wait to see where we get on some of those yields before we start some of those. But we've got a really good opportunity to hit that hard as well once the market comes into our favor."
},
{
"speaker": "Operator",
"content": "The next question, Josh Dennerlein with Bank of America."
},
{
"speaker": "Joshua Dennerlein",
"content": "Just wanted to hit on some of the expenses. I was looking at Attachment 8. There's a couple of markets where you had some pretty big jumps year-over-year like Seattle, Boston, Monterey Peninsula. Anything going on in those markets that we should be aware of on the expense side?"
},
{
"speaker": "Michael Lacy",
"content": "Yes. Josh, I would say, first and foremost, you have to remember the CARES, we're anniversarying off of that. So as a whole, that had about, call it, 350 basis point growth rate. So if we didn't have that, we would have been 4% overall. But specific to some of these markets, Seattle, as an example, we had taxes go up about 9%. So that drove a little bit more growth there, a place like Monterey Peninsula, utilities were up 7%. So you have some of these other factors that are in play in addition to what we're anniversarying off of given the CARES Act. So that's driving some of the higher growth if you will."
},
{
"speaker": "Joseph Fisher",
"content": "Just to add to that because we did get a couple of questions overnight on the expense number. I think we did a great job of telegraphing what was going on there with the CARES Act comp in 1Q. And I think a lot of notes noted that, but that was in line to slightly better than we had expected. So that 7.5% overall expense growth number was definitely not a surprise to us. So as it relates to the range for the rest of the year, we definitely see the path to see that year-over-year number come down here for the next 3 quarters. And when you look at the initiatives around that, be it additional automation of leasing, more no staff properties, some of the stuff we're doing with sweet spot maintenance, some of the purchasing. We still got a lot of initiatives out there to keep that expense number controlled as we have in the past. So I would not let 1Q scare you in terms of is that going to be a recurring issue for us."
},
{
"speaker": "Joshua Dennerlein",
"content": "Okay. I appreciate that. And then back on other income, just kind of curious what's driving the outperformance in the other income line? You mentioned the building-wide WiFi. Is that like people can sign up any time? Or I kind of thought is that like lease renewal or when there's a new lease signed. So any color there would be great."
},
{
"speaker": "Michael Lacy",
"content": "Yes. So let me give you a little bit more color just again -- the other income, it does make up over 10% of our total revenue. And so on our stack, we're looking at about, call it, $40 million and 1/4 of that growth came from the rollout of our bulk Internet. And so we did see about $1 million benefit during the quarter compared to about $100,000 last year. So the majority of it is coming from rolling out that initiative."
},
{
"speaker": "",
"content": "In addition to that, I'd tell you, the team is doing a really good job just driving some of our other initiatives as it relates to running out common area spaces or adding parking, in terms of more of sign spots there. We're pushing up some of our short-term furnished rentals and then will continue to lean into some of the package lockers. So you put all that together and you're looking at about a 10% increase on a year-over-year basis. And again, April, May look like they're tracking the same."
},
{
"speaker": "Operator",
"content": "Next question, Jamie Feldman with Wells Fargo."
},
{
"speaker": "James Feldman",
"content": "I was hoping you could talk a little bit more about how Class A versus B is performing across the markets, across your portfolio?"
},
{
"speaker": "Michael Lacy",
"content": "Sure. I'll take that. So B outperformed our A's on a blended basis at the portfolio level by about 50 basis points. So what we saw was 1% growth versus 0.5%. And I'll tell you the Sunbelt deviated from the recent trends we talked about last year where B's were underperforming A's across the board. And this does suggest that the supply dynamics are impacting A's more than B's across the Sunbelt, which is more in line with traditional supply dynamics. So overall, it feels like it's normal steady state today, and these are doing a little bit better."
},
{
"speaker": "James Feldman",
"content": "Okay. And then you talked broadly about the Sunbelt, but can you just get a little bit more granular on the trends? You mentioned Texas, but as Dallas different than Austin and then even Florida, Tampa, Orlando and then Nashville, which, of course, it's not Florida. But can you just talk more granularly about those markets? Or are they all pretty much doing exactly what you said in your broader Sunbelt comments?"
},
{
"speaker": "Michael Lacy",
"content": "I may give you a little bit more color on the makeup of those regions and what we're seeing today. I think first and foremost, starting with Florida. Florida makes up about 10% of our NOI, and it's really split between Tampa and Orlando. Let's say, Tampa, we have about 20% urban, 80% suburban portfolio. We're seeing concessions around 0.3 weeks today. Occupancy is running in that mid-96% range. and Orlando is very similar. So we're seeing about 0.3% weeks concession. Occupancy is a little bit higher at 96.9%. Blends are still slightly negative, but they continue to improve. And so Florida feels like it's on track with our original expectations for the year, specific to Texas, similar in the sense that Texas is about 10% of our NOI, but the majority of this is coming out of Dallas."
},
{
"speaker": "",
"content": "So Dallas is 8% of our NOI market, where 15% urban, 85% suburban. We are seeing elevated concessions around 1.5 weeks today, but that has improved from 2.5 weeks about 60 days ago. And we're able to run occupancy in that mid-96% range. So overall, pretty decent numbers coming out of Dallas."
},
{
"speaker": "",
"content": "Austin, probably one of the weaker-performing markets today for us. And again, this is only 2% of our NOI. So it's a relatively small market, seeing concessions in that 2-week range, which is probably the highest in our entire portfolio, and that's where we're facing the majority of our supply. But we're still running 96.7% occupancy. You can see in here, volumes are still negative, but they are improving. So again, cautiously optimistic on a lot of these Sunbelt markets. But today, they're performing at expectations."
},
{
"speaker": "Operator",
"content": "Next question is Anthony Paolone with JPMorgan."
},
{
"speaker": "Anthony Paolone",
"content": "Maybe, Mike, for you -- I mean you talked about how high the retention is and just the strength of the renewal rates. And so I'm just wondering, like is there a loss-to-lease in portfolio still? Or as we look over the course of the year, does -- do you think this flips to like a gain-to-lease, or how should we think about that and that divergence between new and renewal spreads?"
},
{
"speaker": "Michael Lacy",
"content": "Yes. Tony, what we're seeing today is a loss to lease right around, call it, 2% to 2.5%. Typically, that grows as you go through the demand period over the next 3 to 6 months, and then it starts to trail off towards the end of the year. But right now, our loss-to-lease is hovering right around that 2% to 2.5% range today."
},
{
"speaker": "",
"content": "And I got to tell you, I'm really excited about what the team has done with the customer experience project. And I gave a lot of high level information in my prepared remarks. But I think it's important just to dive into some of the things that we're doing. And I think, first and foremost, our intention was to capture millions of data points. And by that, I mean, we captured every voice mail, text message, e-mail, surveys, service requests, every personal interaction."
},
{
"speaker": "",
"content": "And so secondary to that was to develop these proprietary resident community-specific dashboards that chronologically align interactions. I think that's the keyword. It's chronologically putting these in order, so our teams know exactly what's happening at any given time. And I'll tell you finally taking all this information and scoring each experience to gauge real-time sentiment to orchestrate a better leading experience has been huge for us."
},
{
"speaker": "",
"content": "And so while it doesn't go unnoticed that people aren't moving out to buy homes as much as they were, say, last year or the year before, this is a big dial mover for us and something that our teams are really leaning into."
},
{
"speaker": "Joseph Fisher",
"content": "One, just one other thing, too, in terms of kind of that momentum and that loss to lease question, I think probably one of the things we're most excited about on a year-to-date basis, when you look at the combination of our gross rents and that concessionary number coming down since the start of the year, we're actually up plus or minus 3% on effective rents on a year-to-date basis, which through the first 120 days is a really good result relative to historical averages. Obviously, that's being led by East and West Coast doing a little bit better. But even Sunbelt, as Mike talked about, we're seeing market rents move higher there. And so when you worry about that gain to lease, the fact that market rents continue to move higher at the same time that we're pushing our blends both on renewal and new base is higher. We feel pretty good about that trajectory in terms of -- as a forward indicator."
},
{
"speaker": "Anthony Paolone",
"content": "Okay. That's helpful. And then just the other one, can you comment on what bad debts were in 1Q and whether you expect any improvement from here for the rest of the year?"
},
{
"speaker": "Joseph Fisher",
"content": "Yes. So when we put together guidance, we had assumed a flat year-over-year number from '23 to '24 for bad debts. Most of that really being due to the fact that we think we did a really good job of assessing the AR balances historically and knowing kind of what we are going to receive over time. And I'd say that's continued to play out."
},
{
"speaker": "",
"content": "The good thing is, from a trend perspective, we are seeing some of those long-term delinquents, but a number of them as well as our average balances, have actually been coming down a little bit as we've seen some of those eviction moratoriums come off and seeing the courts open up. And so we're seeing the numbers get better there. We're seeing end of month and subsequent to month-end collections, continue to improve and be some of the strongest that we've seen throughout COVID."
},
{
"speaker": "",
"content": "And so the trends right now look pretty good. I'd say, so we're probably a little bit ahead from a bad debt perspective. So I think when we revisit guidance in the future, we'll iron out that number and talk about it a little bit more. But we are really excited about the potential perhaps this year, but definitely going into the future, the actions we're taking and the opportunity that it creates. We've talked about the kind of 1.5% bad debt that we're running at. That's about $25 million a year."
},
{
"speaker": "",
"content": "But when you factor in all the other costs from vacancy, turn costs, legal spots, CapEx, that's another $25 million right there. So it's kind of a $50 million total opportunity. I'd say the actions on the front door being taken today, be it the ID and income verification and utilizing some of those AI-based tools, adjusting some of our processes and oversight and just getting more eyes on that area. And then raising some of the thresholds around deposit requirements, income verification requirements, credit scores, some of that. We're pretty excited about what that has the potential to do as we move forward into the back half of this year and into next year. And so we hope that that's another leg up in terms of that collection percentage and some of the delinquency stats as we move into the back half. But I think by middle of year this year, we'll hopefully have a little bit more visibility to speak to on some of that."
},
{
"speaker": "Operator",
"content": "Next question, Michael Goldsmith with UBS."
},
{
"speaker": "Unknown Analyst",
"content": "This is Amy with Michael. San Francisco and Seattle get a lot of attention, but the UDR portfolio has some significant exposure to Orange County and Monterey within the West Coast markets as well. So I was hoping that you could touch on the supply-demand trends in those markets."
},
{
"speaker": "Michael Lacy",
"content": "Yes. Let me give you a little bit of color on all of them. I think first, starting with Seattle and San Francisco because we do get a lot of questions regarding those markets. First and foremost, performing better than we would have expected. And a lot of this has to do with things that are unique to our portfolio. So I'll give you an example. Seattle for us, we're not located down in Seattle. So we're not facing as much of the supply pressure as some others are. We're more located in Bellevue and then out in the suburbs. And what we're seeing in a place like Seattle is Amazon's return to work has really helped demand."
},
{
"speaker": "",
"content": "And in addition to that, the light rail actually just opened up in the last week or so, and that's allowing people who get to Redmond in at least every 10 minutes. So that's allowing some of the Microsoft employees to live in more of these urban settings and have EV access to the suburbs. So that's helped out demand to some degree."
},
{
"speaker": "",
"content": "I'll tell you what we're seeing in Seattle today, it blends are around 4.5%, and our occupancy is running around 97%. So overall, the fact that we don't have a lot of supply there, it's definitely been helpful. San Francisco, we're 50-50, urban, suburban, we're down in SoMa as well as the Peninsula."
},
{
"speaker": "",
"content": "We're seeing concessions come down pretty significantly. We're right around 1 week today compared to 2 to 3 weeks, just [indiscernible] days ago. And a lot of this has to do with return to office. I would tell you, incremental steps to cleaning up the city. And then we're seeing AI and biotech jobs return, and we're seeing jobs return as well."
},
{
"speaker": "",
"content": "So a little bit more demand in San Francisco and not a lot of supply to speak to. So those markets have allowed us to really drive our blends into 2Q. And again, both markets are in that, call it, 4% to 4.5% range."
},
{
"speaker": "",
"content": "Specific to Orange County, that is 11% of our NOI, was mainly suburban, seeing a lot more growth in the Newport Beach area than call it Huntington Beach as well as Irvine just because we have a little bit more supply that's putting pressure on us there. But overall, Orange County is performing as expected and feels pretty good today."
},
{
"speaker": "Unknown Analyst",
"content": "Great. And then a quick question on the other income. Improving turnover is certainly positive both for the revenue and expense side. But I'm hoping that you can provide some examples of what sort of that experiences you're seeing that you think that you can do better on from a resident experience side? Like is this, people complaining about loud trash removal or their neighbors or how do you think that you can do better on these items?"
},
{
"speaker": "Michael Lacy",
"content": "That's a really good question. And you'd be surprised to know that rent increases meanwhile, it's a factor, it's 1 of 15 factors, and it's not even in the top 5. And so some of the things that we're finding with going through these millions of data points, it comes down to what you're saying. It comes down to trash, pet waste, noise, the move-in experience. You have to make sure that that's bulletproof. As well as even [ pet ] issues."
},
{
"speaker": "",
"content": "And so a lot of things that are very controllable, and that's why we're leaning into it. The team is very focused on it. If we can adjust some of these things, we think we can change the trajectory and we're seeing it play out in front of us. But I'll tell you there's a lot more to come. I think there's probably another year to 2 years of learning, and we're going to continue to put training in place. We'll continue to do [indiscernible] testings, and we'll drive this even further as we move throughout this year and into next year."
},
{
"speaker": "Operator",
"content": "Next question, Nicholas Yulico with Scotiabank."
},
{
"speaker": "Nicholas Yulico",
"content": "I guess first question, Mike, sorry if I missed this, but -- did you give the new lease rate growth, how that's looking in April for the Northeast? Could you also just explain why that number was a little bit weaker than some other markets in the portfolio in the first quarter."
},
{
"speaker": "Michael Lacy",
"content": "So we did not provide that, but I'm trying to look through some of my notes here quickly. What I would tell you is new lease growth continues to improve. And when you think about what we just put out there as a whole, on our blends being roughly around call it 2% in April. Our new lease growth is roughly flat. And as we move throughout May, expectations are that's going to turn positive. And I think what we're seeing across the board, whether it's the Northeast or even the West and Southwest regions we're seeing improvement there. And a lot of that has to do with pushing our retention up, holding our renewals at a pretty steady rate and trying to find a happy medium on those blends between new and renewal. We're going to continue to test the water as well we can and see where it takes us. But overall, what we're seeing is a positive momentum pretty much across the board."
},
{
"speaker": "Nicholas Yulico",
"content": "Okay. Second question is maybe for Tom or Joe, in terms of -- it seems like you have the policy of not revising same-store guidance in the first quarter. And I know you talked about you still want to see the leasing season in the spring play out, and there are some reasons to be cautious in some instances, but you are, it sounds like you are trending above the guidance. So I guess I'm just wondering what is the reason at this point to have that policy since a lot of your peers do adjust in the first quarter. And in fact, I'd say much of the broader REIT market is willing to adjust guidance in the first quarter. So if you could just remind us sort of why you feel strongly about that policy? Or if this is just an instance of situation on the ground. There's still a reason for caution, Sunbelt supply, whatever it is driving that decision."
},
{
"speaker": "Joseph Fisher",
"content": "Yes. Nick, it's Joe. I'd say as it relates to the broader REIT market, we don't pay a lot of attention to their policies, but I'd just remind everybody, by and large, the broader REIT market is a longer lease duration sector. So maybe a little bit less exposed to the volatility of supply or macros that comes quarter-to-quarter. So as we look at ours -- we've traditionally had that policy with the exception of during COVID when we saw meaningful outperformance to start the year back in '22."
},
{
"speaker": "",
"content": "And so we traditionally said we're only 120 days in the year. We've got a lot of the leasing season left. We've got a lot of actions that we can take from a capital markets activity perspective, a lot of opportunity to innovate and drive performance, but also a lot of opportunities for supply to creep up on us or macro to creep up on us. And so we typically like to stay conservative, see how the market comes to us, focus on what we can control. And then as we have that news to deliver, we deliver the good news throughout the year and try not to get out of our SKUs."
},
{
"speaker": "",
"content": "Last year, as Tom mentioned, we were surprised by the reaction from some of the developers on the concessionary side to higher rates and some of the new supply coming on. And that surprised us September, October and November, and we had to reduce guidance. By no means is that something that we want to repeat this year at any point in the future. And so that's definitely in the back of our minds as well."
},
{
"speaker": "",
"content": "And I would say, as it relates to the range, we think the range is still good. If we were well outside the range, then I think we'd have to give it a good thought. But as Mike said, we're trending ahead, ahead does not mean we're exceeding the high end of the range at this point in time based off our internal forecast. So that range is still a good range at this point in time, and we're just doing better than the midpoint."
},
{
"speaker": "Operator",
"content": "Next question, John Kim with BMO Capital Markets."
},
{
"speaker": "John Kim",
"content": "I don't think anyone's asked it yet, so I'll give it a shot. Your Attachment 8(E), you no longer provide the market detail on new and renewal spreads. And I was just wondering why decrease that disclosure. I found it very helpful in the past."
},
{
"speaker": "Joseph Fisher",
"content": "John. So that's part of our annual review that we do with the disclosure committee. They go through and look at best practices throughout the broader REIT space, but also adjust within the multifamily peer group. And so when we looked at what others did around disclosure and the blends, we found that some do regional, some just do portfolio, but we're definitely an outlier with the level of detail that we provided on 20 different markets."
},
{
"speaker": "",
"content": "And so when we looked at that and looked at the fact that some of these markets may only have 1,000 units in them. When you look at L.A. or Monterey Peninsula, at Richmond and Austin, those are 3 or 4 assets. And I know a lot of investors and analysts utilize us as a read-through to some of the other portfolios that are out there, be it Coastal or Sunbelt."
},
{
"speaker": "",
"content": "To the extent that you only have 1,000 units in the market, you can get more volatility off of a couple of assets. It's probably not fair for a REIT to do, carry on to others. So we felt that regional, still provided everybody across those 6 or so regions, the amount of detail that they needed to understand, what was going on with our portfolio and potentially regionally for other portfolios. But we did want to remove the detail on individual markets, which Mike can still speak to, but I just want to pull it back a little bit."
},
{
"speaker": "John Pawlowski",
"content": "Okay. Got it. Joe, you also mentioned on the DCP, the watch list remains at $50 million over 3 investments. It didn't move despite the favorable resolution of 1,300 Fairmount. Can I ask what investment got added to the watch list and what's the likelihood of consolidating when these assets are among these 3 investments?"
},
{
"speaker": "Joseph Fisher",
"content": "Yes. So I'd say it's no change to the watch list. So there's a total of 4 assets on that watch list. It's that Philadelphia DCP that we just went through the successful refi for, plus the 3 others that were still in their last quarter. So 4 in total totaling $150 million."
},
{
"speaker": "",
"content": "So while we are obviously very pleased on the 1,300 Fairmount transaction to see that refi get done, with no additional investment required from us or the equity partner. That buys 2 years plus a 1-year extension to continue to focus on operations there. Get the NOI trajectory up, get into a potential of different capital markets environment and work through a lot of the supply that's in that submarket right now. So it's kind of a live to fight another day situation. And I'd say, thus far, really pleased with the leasing trends in the last 30 to 60 days. As we see that occupancy number start to pick up from the, call it, high 70s into the mid-80s. And so like the trajectory they're on, but we're still keeping them on the watch list for the time being."
},
{
"speaker": "",
"content": "The 3 others are roughly $50 million across 3 investments. No change there, it's just simply the NOI yields or the debt yields on those are kind of in that 6% to 7% range. We'd like to see those in the high-single digits as the rest of our portfolio is."
},
{
"speaker": "",
"content": "And specific to those 4 deals, they kind of had a confluence of the 3 major risks that are out there, right? They had delays or cost overruns due to COVID because they are older vintages. They had challenging submarkets, which pushed down rents and the cash flow stream. And then what everybody is dealing with, which is lower valuations, higher interest rates. So those are kind of the 4 assets that really have only the confluence of those 3. The rest of the portfolio were different vintages, kind of '21, '22 type of vintages where they're in lease-up, the pro formas are in line ahead of expectations. And so debt yields are materially higher. And so we just don't see risk in the rest of the portfolio at this point."
},
{
"speaker": "John Kim",
"content": "Does your current guidance contemplate unfavorable outcome for any of these 3 investments? In other words, could there be other upside?"
},
{
"speaker": "Joseph Fisher",
"content": "No, that's -- yes, it's a great question. I should have clarified that. Thank you. Now the upgraded guidance took the downside risk from the Philadelphia out of the equation. So no FFOA risk related to that or the other 3 that we see this year. The next maturity for one of those is January of '25. And thereafter, the other 3 are in mid-'26 generally. And so we have time on all of those. I'd say if you wanted to bracket the potential downside, if all 4 of those transactions, that $150 million, if we had to go off of the accrual and buy in at the lower yield, it'd probably be about $0.03. But between now and 2 years from now, obviously, we expect upside on NOI from those assets. And so we don't see that full risk into fruition, even if all 3 of those did eventually have to be taken back at their maturity."
},
{
"speaker": "Operator",
"content": "Next question Adam Kramer with Morgan Stanley."
},
{
"speaker": "Adam Kramer",
"content": "Just wanted to ask maybe a little bit more of a high level, maybe theoretical conceptual question. You talked a little bit about the kind of robust job growth we've had so far this year, and I think it's something to certainly focus on when it comes to apartment demand. Maybe just walk us through, is there any kind of -- I don't know if it's a rule of thumb or a way that you guys think about for x number of new jobs created. How many apartment renters are created or what that does in terms of kind of quantifying apartment demand for you guys?"
},
{
"speaker": "Joseph Fisher",
"content": "Yes, it's good because we kind of took a look at that as we step back, if you remember, when we put together our initial guidance, we have put together our top-down perspective as well as the bottom-up budgeting process that we always do. And our assumptions that led to that plus or minus 1% rent growth or roughly 70 basis points of blends for the year, that was driven by a multitude of factors, including GDP, wages, job growth, all being low-single digits based off consensus. We had a decline in homeownership rate and then the higher supply number that we [ knew ]and expected."
},
{
"speaker": "",
"content": "And so the general rule of thumb is that for the 2 biggest drivers of that number, wages and jobs, about 1% in the combination of those 2 relates to about 1% increase in rents. And so really, the only changes to our forecast at this point that we're seeing from a macro perspective. Supply, homeownership, GDP, all trending as we expected. It's really been jobs and wages have been coming in about 1% or so better. And so that percent better would translate, if you will, and to maybe 1% or so better rents over this year. If that holds obviously, that's consensus, and it can change. But I think that's a lot of why you're seeing some of the performance that Mike talked about coming in better than we expected. It's been a much better backdrop in terms of the demand environment to date."
},
{
"speaker": "Adam Kramer",
"content": "Great. That's really helpful. Maybe just one a little bit more on the ground, if you will. You talked about it a little bit earlier, but just, I think you guys were really kind of present and clear with the narrative last fall post-Labor Day. It's kind of what happened with the 10-year at that time and kind of what that meant for concession usage on the ground. And maybe taking about the 10-year is today, maybe not quite where it peaked out, but certainly could be higher than it has been in the last number of months. Maybe just walk us through, are you seeing kind of elevated level of concessions again, are you seeing developers maybe change their behavior given where the 10-year is relative to 2, 3, 4 months ago."
},
{
"speaker": "Michael Lacy",
"content": "Adam, I'll kick it off and kick it over to Joe. I'll tell you what we're seeing on the ground, and as you can see it in our numbers, concessions have been coming down. And I think, this is due in large part to the fact that a lot of these deliveries are coming at a time where you also have demand picking up. And that's the big difference between what we experienced back in 3Q of last year. You had a lot of deliveries coming when -- very demand was starting to go the other way. And so there's a big difference there. There's still more supply to come. So we're, again, cautiously optimistic of where this is headed. But from what we can see on the ground today, concessions have actually come down a little better."
},
{
"speaker": "Tom Toomey",
"content": "This is Toomey. I'd probably just add a little bit more to it. And in the developer's mindset, he's looking to add this rollover loan in what terms you can get in proceeds. And so in case of last year or third quarter, we really faced with falling rates, slow traffic, 50 bps spike in your refi and your proceeds coming off 10% to 20%. So that you got squeezed from every angle possible, and you just drop rate to try to fill up to get some level of cash flow because what's probably your most stressful point isn't necessarily the rate. It's the proceeds number. And on a debt service coverage ratio, that squeeze right there means your check to rebalance your loan, if it's $100 million and it went from $10 million to $20 million, you don't have extra $20 million in your pocket. So you hit the panic button, then you try to respond that way. And can that happen again unlikely, but it can. And I think we want to be prudent and see how that emerges. And anyone that can figure out where the 10-year treasury is headed. Please call me because it's a lot easier than buying lottery tickets."
},
{
"speaker": "Operator",
"content": "Next question, Alexander Goldfarb with Piper Sandler."
},
{
"speaker": "Alexander Goldfarb",
"content": "Two questions. First, just looking at New York with the recent rent law changes. One, do you see any DCP opportunities for you to help finance third-party office to resi conversions? And then two, with the new laws really do you see any buildings where either they're pre-2009 or you don't see a sightline to exceeding the luxury rents to escape good cause that you would look to prune?"
},
{
"speaker": "H. Andrew Cantor",
"content": "Alex, this is Andrew. I'll take the first question and then pass it off to Chris for the second one. As it relates to DCP opportunities, we're always open to underwriting any transactions that we see in the marketplace. To date, we haven't seen anything yet. But we evaluate each opportunity based on its merits. And if it's the right deal, then we'll move forward. So at this point, there's nothing we're working on, but it's not [ red bind ] by any stretch."
},
{
"speaker": "Christopher Van ens",
"content": "Yes, Alex, it's Chris. Before I dive into New York rent control, maybe let me first step back, talk to the big picture a little bit more on the regulatory side. So first, I would say many of our state legislative sessions have convened for the year while we continue to see bill signed and a lot that impact our -- really our business at the margin. This really was the second year in a row where major legislation like extremely restricted rent control, I would say, for example, that could negatively impact our business in a significant way. It was largely defeated in most of the areas we operate. Obviously, a good trend for the industry, trend we hope continues in the year ahead. So really big things goes out to our advocacy partners around the country."
},
{
"speaker": "",
"content": "As far as New York rent control, you talked about pre -- or 2009 buildings, it really seems like it will be business as usual for us right now. I mean we've lived with similar restrictions in California and Oregon for a number of years now. We've continued to generate good growth, good returns in those areas. We don't see it being much different moving forward in New York. It's only very rare years, I would say, where market rent growth is likely to be above CPI plus 5 or a cap of 10."
},
{
"speaker": "",
"content": "Lastly, I'd say, of course, there's always the risk of a slippery slope, right? The CPI plus 5 become more restrictive over time. Something we'll continue to monitor. But again, we had the same concerns when 1482 was passed in California, and those concerns have not manifested today. So all in all, New York included, we feel relatively, I would say, okay, about the regulatory environment right now."
},
{
"speaker": "Alexander Goldfarb",
"content": "Okay. And then the second question is, you guys have spoken about a pretty strong operating environment echoing your peers. It's interesting because on the office front, there's still a sense of corporates outside of maybe Midtown Manhattan still being hesitant to lease or to take space. So what are your property managers seeing is driving the demand? Is it really -- is it just a lot of small businesses hiring and there's a disconnect? Or are they seeing a lot of corporate jobs that are coming in to rent -- employees renting apartments and therefore, that's -- you guys are indicating a sign that the corporates are going to return in a growth mode. Just trying to understand the disconnect between what the apartments and you guys are saying about healthier-than-expected demand versus some of the comments from other REIT sectors."
},
{
"speaker": "Michael Lacy",
"content": "Alex, it's Mike. Funny enough, I actually spent last week with our teams out there in New York and ask them that same question and a lot of this comes back to lifestyle. So they're still saying that people are coming back to the market. They just want to live in Manhattan. They want to feel the experience of being there. And expectations are that they've somewhat plateaued in terms of people returning to the office, but there's still room for that to continue to grow. And if and when that happens, that will only help demand even more."
},
{
"speaker": "",
"content": "But we're continuing to see occupancy of almost 98%, and our blends are back up in that 4% range."
},
{
"speaker": "",
"content": "So very strong demand in that market. And we expect that to continue throughout the summer months just given the fact that there's not a lot of supply to speak to in the city. You definitely have more in the -- in, call it, Brooklyn, Long Island City, places like that. And as long as they don't go to 2- to 3-month concession, that's not going to pull people out of the city. And so we feel really good about New York today."
},
{
"speaker": "Alexander Goldfarb",
"content": "Right. But Mike, across all markets that you guys are in, you're seeing a similar dynamic. It's just people wanting to live in the different markets, not necessarily meaningful job growth? I'm just trying to understand the difference."
},
{
"speaker": "Michael Lacy",
"content": "Yes, Alex, I think that's a fair point. I don't think every market is created equal. And I think as an example, I talked a little bit about San Francisco earlier, that market is still getting cleaned up. And I think once they get that cleaned up a little bit more, people want to live down there, and it will be a similar dynamic to what we're facing in a place like New York. But every market is created a little bit different. But overall, I'd say, yes, those sentiments are the same across the board."
},
{
"speaker": "Joseph Fisher",
"content": "And I'd say too Alex, just as it relates to the demand. I mean, we talked about jobs and wages both coming in ahead of expectations. The consensus is well over 1 million jobs at this point in time. And so while we focus a lot on the multifamily supply picture as we should, and kind of that national picture of, call it, 600,000 or so units being delivered this year. Keep in mind, the lion share housing is over on the single-family side, which has seen minimal increase on a year-over-year supply basis at around 1.1 million units. You're also seeing from an existing supply perspective, really no homes being sold, you're back to kind of GSE lows. And so you kind of do get into this environment where what's available for all those jobs that are being created and therefore new households that are being created."
},
{
"speaker": "",
"content": "And when you have the relative affordability component in multi where we are 60% less expensive than a single-family home and then if you come around with us, you can put an extra $35,000 a year in your pocket versus buying a home. That's pretty darn compelling. And so you're seeing renter shift gain more than their fair share of that demand that's been put out there into the market right now. And so I think that's a big driver of what we're seeing."
},
{
"speaker": "Operator",
"content": "Next question, Linda Tsai with Jefferies."
},
{
"speaker": "Linda Yu Tsai",
"content": "In terms of April retention improving 400 bps from a year ago, is this consistent across your portfolio? Or are there regional differences?"
},
{
"speaker": "Michael Lacy",
"content": "It's pretty consistent. Again, what we're seeing is a lot of these actions that are put in place from what we're doing with the customer experience project. And so I'd say relatively consistent across the board. The only difference I would tell you is in a place like the Sunbelt, historically, what we would have experienced is call it, 20% of our move-outs were leaving to buy a home. Today, that's closer to 10%. And so significantly less people moving out to buy homes in places where it was historically more affordable. But other than that, a lot of this has to do with the actions that we're putting in place through our innovation."
},
{
"speaker": "Linda Yu Tsai",
"content": "And then in terms of automation, as you move forward, does it ever become apparent that automation is being relied upon too soon that efficacy falls short and impact service levels and then you have to recalibrate and move people back into seats. If so, how do you monitor and correct that?"
},
{
"speaker": "Michael Lacy",
"content": "Yes, Linda, that's a fair point. That's something we've experienced as we transition from, call it, Platform 1.0, where the intention was to go to that self-service model, and we reduced our headcount by about 40%. We have found that there are cases where you have to add bodies back that will drive value in the long term. And so we've been going through that over probably the last 12 months or so. And we're still trying to find opportunities where we can run what we call the unmanned sites. And today, we're around 20% of the portfolio. We are adding back from the customer service type positions in the field to make sure that we're acting all these items that we mentioned earlier as it relates to how you change that trajectory and retention."
},
{
"speaker": "",
"content": "So I think there are cases where you can find opportunities to drive value and sometimes if you have to add bodies back."
},
{
"speaker": "Operator",
"content": "Next question is [indiscernible] with Baird."
},
{
"speaker": "Unknown Analyst",
"content": "Have your views changed for the Sunbelt and the timing to absorb all the new supply, given the strong absorption trends you've been seeing?"
},
{
"speaker": "Joseph Fisher",
"content": "I don't think, as we kind of look through it, obviously, we go through the peak delivery cycle here over the next couple of quarters. And so 2Q, 3Q is kind of your peak, but it's not a dramatic drop off. It's going to take a while to work through the lease-up of those deliveries. But even into 2025, when you look at overall deliveries coming that year, it's going to be a pretty normal year in terms of relative to long-term averages with the Coast actually coming in a little bit lower as they start to see it drop off a little bit quicker in terms of new starts and permits activity."
},
{
"speaker": "",
"content": "So Sunbelt still stays a little bit elevated as you go into '25. I think it's still late '25 that you really get the benefit of that, call it, fourth quarter of '23 drop-off and [ seize ] up in capital markets where you saw starts fall of a cliff down. They're going to $200,000, $250,000 on an annualized business in 4Q '23."
},
{
"speaker": "",
"content": "And so next year is probably a little bit more normal year, still some pressure on the Sunbelt. '26 has the potential to be a pretty phenomenal year in terms of the lack of housing that's available out there and what that could mean for fundamentals for our sector."
},
{
"speaker": "Operator",
"content": "I would like to turn the floor over to Tom Toomey for closing remarks."
},
{
"speaker": "Tom Toomey",
"content": "Thank you, operator, and thanks to all of you for your interest and support of UDR. And we look forward to seeing many of you at the Wells Fargo conference next week and NAREIT in June. So with that, we'll close this today. We're always available to take your follow-up calls and take care."
},
{
"speaker": "Operator",
"content": "This concludes today's teleconference. You may disconnect your lines at this time, and thank you for your participation."
}
] |
uhs | 2,024 | 3 | [
{
"speaker": "Operator",
"content": "Good day, and thank you for standing by. Welcome to the Third Quarter 2024 Universal Health Services Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker's presentation, there will be question-and-answer session. [Operator Instructions] Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Steve Filton, Executive Vice President and CFO. Please go ahead sir."
},
{
"speaker": "Steve Filton",
"content": "Thank you. Good morning and welcome to this review of Universal Health Services Results for the third quarter ended September 30, 2024. During the conference call, I’ll be using words such as believes, expects, anticipates, estimates and similar words that represent forecasts, projections and forward-looking statements. For anyone not familiar with the risks and uncertainties inherent in these forward-looking statements, I recommend a careful reading of the section on Risk Factors and forward-looking statements and risk factors in our Form 10-K for the year ended December 31, 2023 and our Form 10-Q for the quarter ended June 30, 2024. I'd like to highlight just a couple of developments and business trends before opening the call up to questions. As discussed in our press release last night, the company recorded net income attributable to UHS per diluted share of $3.80 for the third quarter of 2024 after adjusting for the impact of the items reflected on the supplemental schedule as included with the press release, our adjusted net income attributable to UHS per diluted share was $3.71 for the quarter ended September 30, 2024. As we anticipated, acute care volumes have moderated somewhat and have gradually begun to resemble the patterns we experienced before the pandemic. Adjusted admissions to our acute hospitals increased 1.5% year-over-year, with surgical growth slowing. Overall revenue growth was still a solid 8.6% excluding the impact of our insurance subsidiary. Meanwhile, expenses were well controlled. Specifically, the amount of premium pay in the third quarter was $60 million, reflecting a 12% decline from the prior year quarter. Included in our operating results during the third quarter of 2024, were aggregate net incremental reimbursements of approximately $20 million recorded in connection with various state supplemental Medicaid programs, approximately half of which was earned by our acute care hospitals. These net reimbursements were in excess of the supplemental program projections included in our earnings guidance for the full year of 2024 as revised on July 24, 2024. On a same facility basis, EBITDA at our acute care hospitals increased 36% during the third quarter of 2024 as compared to the comparable prior year quarter and the increase was 17% when excluding the impact of the incremental Medicaid supplemental payments earned in Nevada during the third quarter of 2024. The increase in operating income comparison to last year's third quarter for our acute hospitals is a further step towards a more extended margin recovery we hope to sustain for the next several periods. In our acute segment, physician expense, which was a significant headwind in 2023, has stabilized at approximately 7.2% of revenues thus far in 2024. During the third quarter, same facility revenues at our behavioral health hospitals increased by 10.5% primarily driven by an 8.5% increase in revenue per adjusted patient day. Even after adjusting for Medicaid supplemental payments not included in our original 2024 guidance, facility revenues increased 8.3% and same facility EBITDA increased 9.6% in the third quarter of 2024 as compared to the comparable prior year period. As a result of unfavorable trends experienced during the last several years during the third quarter of 2024, we recorded a $30 million increase to our reserves for self-insured, professional and general liability claims. Our cash generated from operating activities was $1.4 billion during the first nine months of 2024 as compared to $815 million during the same period in 2023. In the first nine months of 2024, we spent $698 million on capital expenditures and acquired 1.7 million of our own shares at a total cost of approximately $350 million. Since 2019, we have repurchased approximately 31% of the company's outstanding shares. As of September 30, 2024, we had 1.01 billion aggregate available borrowing capacity pursuant to our 1.3 billion revolving credit facility. In our acute care segment, we continue to develop additional inpatient and ambulatory care capacity. Construction continues on our de novo acute care hospitals consisting of the 150 bed West Henderson Hospital in Las Vegas, Nevada, which is expected to open shortly, the 136 bed Cedar Hill Regional Medical center in Washington, D.C. which is expected to open in the spring of 2025 and the 150 bed Allen B. Miller Medical center in Palm Beach Gardens, Florida, which is expected to open in the Spring of 2026. In our behavioral health segment, we recently opened the 128 bed Riva Vista Behavioral Health Hospital in Madera, California and we are developing the 96 bed Southridge Behavioral Health Hospital in West Michigan, a joint venture with Trinity Health Michigan, which is expected to open in the spring of 2025. The approval processes continue in connection with new Medicaid supplemental payment programs in Tennessee and Washington, D.C. as well as a proposed funding increase to the existing program in Nevada. Although we cannot provide assurance that any or all of these programs or program changes will ultimately be approved by CMS or the timing of such approvals, which may not occur until 2025. If approved in their current forms, the Tennessee program, with estimated annual net benefit of $40 million to $56 million, would be effective July 1, 2024. The Washington, D.C. program would estimate an annual net benefit of approximately $85 million would be effective October 1, 2024, and the funding increase to the existing Nevada program, with estimated annual net incremental benefit of approximately $56 million, would be effective July 1, 2024. Our previously provided earning guidance for the full year of 2024, as revised on July 24, 2024, did not include the estimated incremental net benefit related to any of these programs. I'd be pleased to answer your questions at this time."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] One moment for our first question. And our first question is going to come from the line of Josh Raskin with Nephron Research. Your line is open. Please go ahead."
},
{
"speaker": "Marco Criscuolo",
"content": "Hey, good morning. This is actually Marco on for Josh. Appreciate you taking the question. I was just wondering if you could speak to any changes you may be seeing in the behavior of managed care plans during the quarter, including activity around patient denials or downgrades across both the acute and behavioral segments. And then it would also be helpful if you just give some color on what trends you're seeing between commercial and MA plans and whether this activity is focused around any specific areas like two-midnight. Thank you."
},
{
"speaker": "Steve Filton",
"content": "Sure. So I think if you go back and review some of our transcripts and other commentary from late in 2022 and early into 2023, we first began to note, I think more aggressive behavior on the part of our managed care payers, especially coming off of the initial years of the pandemic, 2020, 2021, 2022, where clearly we felt like payers had become less aggressive, I think in response to a large degree to the significant decreases in utilization during the early stages of the pandemic. So since then, since I would say late 2022, early 2023, again we've seen I think payer behavior become more aggressive as it relates to denials, as it relates to patient status changes, length of stay, management when patients are in the facility, etcetera. I don't believe that we saw a dramatic change in the current quarter. I think again the more aggressive behavior that we've been citing I think has been ongoing for more like a year or four or six quarters, but wouldn't necessarily suggest that we saw dramatic change in the current quarter. As far as whether and behavior is focused on any particular area. You specifically asked about the two-midnight rule. Again, I think we've made a comment that we've been focused on the two-midnight rule and the appropriate coding consistent with the two-midnight rule and appeals consistent with the two-midnight rule. For several years we've been using a third party firm to help us properly code admissions. We've been using that same firm to help us with denial appeals, etcetera. And so I don't think we've seen again some of the perhaps significant difference in how two-midnight coding claims are being handled with our claims as maybe some of our peers have really changed their behavior as a result of the recent clarifications that CMS issued in terms of two-midnight rules."
},
{
"speaker": "Marco Criscuolo",
"content": "Thanks, appreciate all the color on that. And then just to squeeze in one more quick one, I was wondering if you could just give a quick update on physician recruitment and turnover trends in the acute behavioral segments, especially as it relates to opening up additional capacity and then whether you're seeing any more incremental competition in that area. Thank you."
},
{
"speaker": "Steve Filton",
"content": "Yes, so I think there's been much discussion about physicians and especially as it related to hospital based physicians. Last year when there was a significant increase for almost all providers in the expense of hospital based physicians, in our case especially emergency room physicians and anesthesiologists, I think that increased expense was more a result of billing changes and I think specifically the no surprise billing act and the constraints that that put on those specialties, emergency room anesthesiology, in terms of their ability to bill for out of network patients. So I think the pressures on those expenses were driven more by those billing changes than they were by a lack of or scarcity of those sort of physicians. I don't think that there's a dearth of physicians, nor do I think there's a glut necessarily in every market. Different specialties, are more challenging, etcetera. But I don't think we would describe physician recruitment as particularly, difficult in the current period. I don't think it's changed much over the last several years."
},
{
"speaker": "Marco Criscuolo",
"content": "Great. Thank you for all the color."
},
{
"speaker": "Operator",
"content": "Thank you. And one moment for our next question. Our next question is going to come from the line of Ann Hynes with Mizuho. Your line is open. Please go ahead."
},
{
"speaker": "Ann Hynes",
"content": "Great, thank you. Heading into 2025, are there any maybe major headwinds and tailwinds you want to call out? And to that I know it sounds like you're getting incremental providers stuff in 2024. Is there anything we should be on the lookout for 2025? Thanks."
},
{
"speaker": "Steve Filton",
"content": "So I think for us, Ann, as I mentioned in my prepared remarks, we will have two new facilities open in 2025, our West Henderson facility in Las Vegas which will open late this year, and then a hospital in the District of Columbia which will open in the spring. I don't believe, and we'll be more precise about this when we give our detailed 2025 guidance in February, but I don't believe that either of those facilities will create a significant drag on EBITDA. There will be some opening expenses and some ramp up, but I think both are well positioned. So again, they should not create much of a drag. I think otherwise for the two businesses, we are expecting the continued margin recovery that again I alluded to in my opening comments. And then finally, the major tailwinds are the ones that I mentioned again in my remarks, the specific ones in terms of Tennessee, District of Columbia, Nevada. These are either new or additional supplemental programs that have been submitted to CMS for approval. There's been some reporting and some things have been written about programs, either new or expanded programs in California and Florida that could be effective next year. But those I think are in sort of earlier stages of development. So I think broadly there's some significant potential tailwinds in the Medicaid supplemental area, some of which we've disclosed in some detail, others which I think are a little bit more or not quite as precise at this point. But those to me seem to be the big puts and takes for 2025 at this point."
},
{
"speaker": "Ann Hynes",
"content": "Great, thanks."
},
{
"speaker": "Operator",
"content": "Thank you. And one moment for our next question. Our next question is going to come from the line of Andrew Mok with Barclays. Your line is open. Please go ahead."
},
{
"speaker": "Andrew Mok",
"content": "Hi, good morning. Wanted to focus on the acute volumes. Maybe if you just take a step back and comment on the volume progression in that business and now that we've established a more normal baseline for volumes like what's the outlook in the acute care segment for volume growth? Thanks."
},
{
"speaker": "Steve Filton",
"content": "Andrew, I think we've been pretty clear and consistent in our commentary in this regard. And that is, we've been saying for some time that we expected acute, broadly acute care growth to return to sort of more normal, I'll call them pre-COVID levels. So same sort of revenue growth in the 6% to 7% range. That would be split pretty evenly between price and volume. I think if you actually look at our year-to-date metrics in acute care, I think our adjusted admissions are up 3%. I think our pricing or revenue per adjusted admissions is up 5%. I think if you adjust that for the Nevada Medicaid supplemental, you're sort of in that range of 6% to 7% revenue growth split pretty evenly between price and volume. I think that's been our view for a while. I know that some of the commentary from our peers have been a little bit more bullish about what acute care volume may look like and suggesting that there have been some structural changes in the business that would result in elevated acute care volume growth for the foreseeable future. We haven't seen that yet and obviously I think if there are these structural changes, we would benefit from them as would the average acute care hospital. We just haven't seen really evidence of that just yet. The other issue which I kind of alluded to earlier is I think a number of acute care hospitals are anticipating a fairly significant benefit from the two-midnight rule change and a consequent change in the way they're coding these things, etcetera. As I've indicated, again, I think pretty clearly and consistently for a while now. We think we've been focused on that issue for several years now and as a consequence don't necessarily anticipate an incremental benefit from that. So again, I think we view acute care volumes or the future of acute care volume growth, and I think broadly acute care revenue growth is something that should be solid, etcetera, but that some of the really elevated acute care volume growth that we've seen over the last several years has been a result of the catch up in postponed and deferred procedures or procedures that had been postponed and deferred during the pandemic. And by definition I think those were sort of a onetime thing and I think we're largely past that at this point."
},
{
"speaker": "Andrew Mok",
"content": "Great. And then your corporate expenses tracked a bit higher than our estimates in the quarter. Can you help us understand any one time items there or other drivers of the increase in the corporate segment? Thanks."
},
{
"speaker": "Steve Filton",
"content": "Yes, we had a $5 million loss on the extinguishment of debt related to our refinancing that we did during the quarter. We probably had another 5 million settlements of miscellaneous smaller lawsuits that $10 million of corporate expense I would clearly characterize as non-recurring in the quarter."
},
{
"speaker": "Andrew Mok",
"content": "Great, thanks for the color."
},
{
"speaker": "Operator",
"content": "Thank you. One moment for our next question. And our next question is going to come from the line of Justin Lake with Wolfe Research. Your line is open. Please go ahead."
},
{
"speaker": "Unidentified Analyst",
"content": "Good morning, this is Dylan on for Justin. Thanks for the question. Just had a couple quick ones for you. Is there any color you can provide on the trajectory of volumes in the behavioral business in the quarter? And then second, behavioral pricing clearly remains a strength. Are you expecting to see similar opportunities heading into 2025 or do you expect that to moderate? Thank you."
},
{
"speaker": "Steve Filton",
"content": "So as far as the trajectory of behavioral volumes, again, I think for the last several quarters we've been talking about our sense that while we originally guided to 3% same store patient day growth for behavioral for the full year of 2024, that growth was occurring more slowly than we originally anticipated. And we sort of revised that view to we'd be able to exit the year at that sort of 3% level. We were able to exit the third quarter at that 3% level. And that's despite a little bit of drag from the hurricane impact in South Carolina and Georgia on some of our facilities at the very end of the quarter Hurricane Helene. So yes, I think we remain confident that we should be able to exit the fourth quarter at that at least 3% patient day growth rate and remain confident that we can do so. As far as behavioral pricing, behavioral pricing as people know, has been quite strong for several years now throughout most of the pandemic. We attribute that to some degree to our efforts to leverage better pricing from some of our lower paying payers, particularly managed Medicaid payers. And I think in an environment where there's not a great deal of excess capacity in the behavioral industry writ large. That's been an effective sort of strategy. We've been suggesting for some time that behavioral pricing is likely to moderate at some point, and we continue to believe that. But to be fair, it is hanging in there very robustly and very strongly at the current time. And obviously we're not doing anything to try and reduce that. But we do believe that behavioral pricing, which has been running at historically high levels, will moderate at some point, but still should track in sort of that 4% to 5% range for the foreseeable future."
},
{
"speaker": "Operator",
"content": "Thank you. And one moment for our next question. Our next question is going to come from the line of Sarah James with Cantor. Your line is open. Please go ahead."
},
{
"speaker": "Unidentified Analyst",
"content": "Hey guys, this is Gabion [ph] for Sarah. You had a nice beat on acute revenue permission. Could you just walk us through the drivers there? And was any of that related to the extra day in the quarter?"
},
{
"speaker": "Steve Filton",
"content": "Yes, I mean, the extra day, I think is a mechanical sort of thing. We tend not to really focus on that largely because I think in the end, obviously, the longer the period, if you look at the full year, all that comes out in the wash. I think more importantly, we had a difficult acute care comparison. I think our same store adjusted admissions in last year's third quarter were up close to 7%. But I think even more importantly, if you go back and you listen to our or read our commentary from last year's third quarter, we attribute a lot of that to again, this catch up in the deferred and postponed procedures, those procedures that have been postponed or deferred during the pandemic. And as a consequence, if you go back, while our volumes, both admissions and surgical volumes, were strong in the third quarter of last year, they tended to be skewed towards those lower acuity kind of more discretionary procedures that people had the ability to defer during the pandemic. And so when you're looking at now that comparison to 2024 to 2023, you see, volumes sort of look unfavorable. And they've come down some, but acuity's come up because so much of that activity last year's quarter was due to the lower acuity, lower revenue sorts of procedures."
},
{
"speaker": "Unidentified Analyst",
"content": "Okay, awesome. And then any color on the inpatient surgical trend?"
},
{
"speaker": "Steve Filton",
"content": "Yes, as I noted in my prepared remarks, surgeries were so often they were probably down slightly in the quarter. And again, I think it's a lot of the same dynamic that surgeries were quite strong in the third quarter of last year, but that was skewed towards a lot of what I'll describe as sort of catch up, lower acuity, more discretionary, more elective sorts of procedures."
},
{
"speaker": "Unidentified Analyst",
"content": "Okay, great. Thank you, guys."
},
{
"speaker": "Operator",
"content": "Thank you. And one moment for our next question. Our next question is going to come from the line of A.J. Rice with UBS. Your line is open. Please go ahead."
},
{
"speaker": "A.J. Rice",
"content": "Hi, everybody. Maybe just to ask about the labor, you commented that your use of premium pay was down to 60 million, 12% down year-to-year. Any more broad comments on what you're seeing in both business lines and labor? Are we sort of at a stable point at this point, and if you can sort of hold your SWB ratio as a percent of revenues going forward, or do you think there's still further opportunities?"
},
{
"speaker": "Steve Filton",
"content": "Yes. What I think has happened, A.J., is that, again, we're in sort of now this post pandemic environment in which wage inflation, I think, has stabilized. It is clearly lower than it was at the height of the pandemic. Obviously, our use of premium pay has diminished dramatically, although it is also, I think, starting to stabilize and sort of flatten out. And I think that should continue that's benefiting us obviously, in an environment where the revenue growth in both businesses has been quite robust. It's contributing to the margin recovery that salaries are somewhat stable. And I will say people have noted to me that, on the behavioral side, salaries as a percentage of revenue did sequentially increase from Q2 to Q3. And I've asked about whether that's kind of emerging trend. And I would say not. I think that that's a function probably of the impact of the hurricane that we saw at the very end of the quarter where a number of our facilities, particularly in the Georgia, South Carolina market, saw diminished volumes but also it's a double whammy because we see diminished volumes, but we're also paying overtime, etcetera, to keep people in the facility and make sure it's properly staffed. But I think outside of that, I would say that labor trends have stabilized substantially in both business segments."
},
{
"speaker": "A.J. Rice",
"content": "Okay. And maybe just thinking about growth, development capital deployment, etcetera. Any comment on the behavior side, the JV pipeline, you paid some new bed additions as you start to think about 2025 and then obviously, to the extent there is free cash flow beyond any of that, whether there's M&A opportunities? Or should we think that most of that cash flow is going to go to stock buybacks from the year?"
},
{
"speaker": "Steve Filton",
"content": "Yes. I mean we continue with a pretty aggressive and robust capital expenditure program. I talked about some of the big spends in my prepared remarks, but we've started or maybe more properly, I would say we restarted to add that to our behavioral business. We've been doing that pretty consistently prior to the pandemic -- during the pandemic, we paused many of those expansion activities with the sort of logic being, we were struggling to staff the existing beds we had there was no point in building new beds. But now that, again, the labor market has stabilized, we're looking in those markets where there is an opportunity to increase volumes by adding beds. Now to be fair, our overall occupancy in behavioral stands on the low 70s. So there are plenty of facilities where we should have the potential for upside volume without having to add any new beds, but there are some facilities that are running at higher occupancies than that. And in those facilities, we are, again, either resurrecting or entertaining new programs to build beds and we'll continue to do that. As far as opportunities for M&A, I think we often comment that we are presented with opportunities reasonably regularly. We have found if you look at the last five, seven years, not a great deal of those opportunities to be very compelling, although we will continue to look at them. And so my guess, because this is M&A, I think can be hard to predict. But my guess is that as you think about it, our capital deployment will remain focused probably on capital expenditures and on share repurchase, much as it has been for the last five to seven years."
},
{
"speaker": "A.J. Rice",
"content": "Okay, thanks a lot."
},
{
"speaker": "Operator",
"content": "Thank you. One moment for our next question. Our next question is going to come from the line of Pito Chickering with Deutsche Bank. Your line is open. Please go ahead."
},
{
"speaker": "Pito Chickering",
"content": "Good morning guys. Looking at same store occupancy here, that's a fun metric because it probably underestimates the busier days of Monday through Wednesday for neglected procedures. So my question is what is the max occupancy for the portfolio before it impacts same-store mission growth? And as you think about hospital occupancy, if you can't sort of expand beds fast enough, does this create a more aggressive conversations with your lowest yielding MA payers like you did a few years ago when you're at max capacity in behavioral?"
},
{
"speaker": "Steve Filton",
"content": "Yes. So Pito, I'm not sure if your question was specific to one or both of the segments, so I'll try and answer for both. I think on the acute side, occupancy over the years has become a somewhat less relevant metric. Obviously it measures your occupied inpatient beds, but my experience is I've been in a hospital any number of times that maybe at 2/3 occupancy from an inpatient bed perspective, but you walk through the emergency room and there are stretchers in the hallway or you walk through the OR and you've got a real busy schedule or the Cath lab, that sort of thing. So I think that acute care inpatient occupancy is not as relevant as sort of a metric as it used to be, or at one time it was. There are, I think, a number of other equally important variables in measuring sort of the efficiency and the output of an acute care hospital. I think in terms of the broader question, I don't know that we have too many OR hospitals that we're really at max capacity in any of those areas. We're certainly not there in terms of inpatient beds, but I don't think we're necessarily there in terms of emergency room capacity or Cath labs or ORs, etcetera. And to the degree that we are, I think we're responding to that with capital improvement and expansion programs that address that. On the behavioral side, I do think that inpatient occupancy or an inpatient bed occupancy number is more relevant. There are sort of fewer ancillary sorts of procedures in a behavioral hospital that account for that. Although obviously outpatient activity needs to be measured as well. But the same thing. I mean, as I said, for the most part, I don't think we have physical capacity constraints in our behavioral business, but there certainly are facilities and geographies where that is an issue. And those are the places where we're doing debt expansions or at least contemplating debt expansions."
},
{
"speaker": "Pito Chickering",
"content": "Great. And then a follow-up here is on physician expenses. Like you talked about sort of that being stable at like 70% of revenue. Are there other areas like radiology and NICU which have not been pressure points in the past, which could be asking for subsidies going forward or pretty much across portfolio across all different groups of physicians at stable? Thank you very much."
},
{
"speaker": "Steve Filton",
"content": "Yes. So the answer is yes. And I would say in the portfolio I can find examples in almost every specialty where we've had requests for greater subsidies or increased expense, etcetera. As I noted in comments earlier, I think for us the biggest pressure, by far the most expansive, has been in the emergency room and anesthesia areas. But yes, we have, I think, one off situations where we've seen pressure from hospitalists or laborists or radiologists, as you asked about. But they clearly, I think, have accounted for much less pressure than ER and anesthesiology. And I think broadly, while we continue to sort of deal with those issues every day, I think that situation, which was such a headwind in 2023, has largely stabilized."
},
{
"speaker": "Pito Chickering",
"content": "Great. Thanks so much, guys."
},
{
"speaker": "Operator",
"content": "Thank you. And one moment as we move on to our next question. Our next question is going to come from the line of Joanna Gajuk with BofA Securities. Your line is open. Please go ahead."
},
{
"speaker": "Joanna Gajuk",
"content": "Hi, good morning. Thanks so much for taking the question. So I guess first to clarify the commentary around the outlook for psych business into next year. So you sort of alluded to the idea of, maybe pricing excluding supplemental, growing 4.5 and, and I guess you still expect to exit at 3% volume growth. So is that sort of the trajectory to expect next year in terms of growth for that segment?"
},
{
"speaker": "Steve Filton",
"content": "Yes. So Joanna, I mean we're not, we're going to give sort of precise 2025 guidance on this call. We don't do that until our fourth quarter call in February. But I think we have broadly described our expected sort of trajectory of growth in the behavioral business is same. So revenue growth in the kind of mid-to-upper single digits, 6%, 7%, 8% probably skewed a little bit more to pricing. So 4% to 5% pricing, 3% to 3.5% volume. But I'm not suggesting that that's going to be our precise guidance for next year. But I think in terms of thinking about next year, that's I think how we start. And then obviously to the degree that there's any significant Medicaid supplemental programs, etcetera that would be sort of incremental to that."
},
{
"speaker": "Joanna Gajuk",
"content": "Right. And I guess on site in terms of volumes, so this quarter maybe wasn't very close to 3%, but I guess you still expect to kind of exit that year. But as we think about all these different tailwinds, so can you kind of walk us through what you're seeing out there in the market? So obviously there's the mental health parity with a deal that has, I guess more teeth requiring, to actually execute on this mental health parity and also sounds like states are adding more benefits. So are you seeing higher demand and I guess, are you able to meet that demand? I guess is there something to be said about increased rates to be able to then, staff for that volume?"
},
{
"speaker": "Steve Filton",
"content": "Yes. So Joanna, I apologize because I'm having a little trouble hearing you, but I think I got the crux of your question. I'll say this. We as I indicated in some earlier comments, I think our volume recovery in behavioral has, I think we've been candid about saying it's taken a little bit longer than we expected. We've cited a number of issues that have been challenges, labor scarcity issues in specific pockets and specific geographies has been one. We had a handful of residential facilities that struggled with some very sort of unique issues that they've been recovering from. And I think over the last year or so we've talked about the impact of Medicaid disenrollments and the sort of challenges that that's created even for those patients who have been able to re-enroll or enroll in commercial exchange products. While that I think tends to be a benefit on the acute side, I don't think it tends to be as much of a benefit on the behavioral side because the large co pays and deductibles that generally come with those commercial plans have sort of been challenging. But I think for the most part the recovery in our behavioral volumes and our optimism about being able to sustain that recovery in the fourth quarter is really about the improvement of all these issues. We continue to be able to hire more staff and have more adequate staff to allow us to take more patients. The residential facilities that have struggled are continuing to improve and the Medicaid disenrollment impact continues to dissipate as either patients are able to re-enroll in Medicaid or get commercial exchange coverage and they exhaust their copays and deductibles. So I think it's the improvement in those areas that's really contributing to the behavioral improvement. I think you specifically asked about whether we're seeing or anticipating a significant benefit from the Biden administration's sort of tightening of rules on mental health parity. Mental health parity, which was implemented any number of years ago, sort of to great fanfare and I think expectation that we would really benefit from that. I think we've benefited to some degree, but I think the payers and the payer community broadly has been challenging in terms of really getting them to comply with I think both the spirit and the actual intent of mental health parity. I do think that the strengthened government regulations are helpful, but I don't know that they're likely to really create a landscape change. I think where they're helpful is as we appeal these things, as we appeal denials and that sort of thing, strengthened government regulations are often helpful in that regard. But I don't think that's going to drive a huge increase in behavioral volumes."
},
{
"speaker": "Joanna Gajuk",
"content": "Thank you. And some excuse. Very last I guess clarification question, I'll comment on the 2024 guidance or assuming no change so you put up $20 million, I guess, good guide in the quarter from supplemental that wasn't in there, but then there was a $10 million back, I guess, for debt and debt cost and -- I guess settlement, so roughly no change to your 2024 guidance? I just want to confirm that? Thank you."
},
{
"speaker": "Steve Filton",
"content": "Yes, there is no change to our revised 2024 guidance."
},
{
"speaker": "Operator",
"content": "Thank you. And one moment as we move on to our next question. Our next question is going to come from the line of Jamie Perse with Goldman Sachs. Your line is open. Please go ahead."
},
{
"speaker": "Jamie Perse",
"content": "Hey, thank you. Good morning Steve. I just wanted to go back to acute care volumes in the quarter at 1.5%. I appreciate you've been expecting some normalization but that was just weaker than expected. And want to get a sense of if you saw any change across the quarter, any callouts by payer class. If you can give us any detail on how some of the larger payer classes grew relative to that. And then as we think about normalization, is this what the new normal looks like or are there any dynamics in the third quarter that make this not representative of the go forward?"
},
{
"speaker": "Steve Filton",
"content": "Yes. So on this one Jamie, I think I'm just going to have to repeat comments that I've already made. I think that the most significant sort of dynamic in the quarter is the difficult comparison to last year which I will say we have clearly and consistently pointed out during the quarter and tried to manage people's expectations. But more importantly is that difficult comparison to last year I think was really related to the fact and I think if you go back and read or listen to our commentary from last year it was this sort of exhaustion of deferred and postponed procedures which we did view as kind of a one-time thing. What I also said earlier was I thought that if you looked at the year-to-date performance of the acute business 3% adjusted admission growth, 5% revenue per adjusted admission growth. And if you ex-d [ph] out the impact of the Nevada supplementals you start to get an acute care model that in my mind a was reflective or is reflective of our historical model but also our expectations for the future which is kind of mid-single digits 6% 7% same store revenue growth split pretty evenly between price and Volume."
},
{
"speaker": "Jamie Perse",
"content": "Okay, that's helpful. And then maybe just a bit of a longer term question. We've been in a pretty unique environment really for the last five years or so. A number of structural dynamics have either emerged or maybe intensified over that period. ASC utilization, aggressive payer tactics that probably impacts administrative burden, growth in MA and HICS. I guess, just as you think about the next five years, can you level set us on strategy and in particular internal investment priorities going forward?"
},
{
"speaker": "Steve Filton",
"content": "Yes, I mean, it's a pretty broad question and one that I'm sure we could speak for an extended period of time about all the dynamics that you mentioned. I think broadly the way I would answer the question, which seems to be an acute care centered question, is we have a view that the care continuum has clearly been expanded and payers are looking to ensure that patients can be treated in the most cost effective settings of care, which has resulted in a growth of ambulatory surgery facilities and freestanding imaging facilities and much greater access points. We've had great success with our penetration of freestanding emergency departments as an example. But broadly, I think we are trying to participate in the investment in that broader continuum. Whether it's again, ASCs, freestanding imaging, freestanding EDs, etcetera. That's certainly one component of it. The other, I think is a continued alignment with our physicians, whether that's through accountable care organizations. We have at least one of those in every single market in which we operate, whether it's employed physicians, which we have in virtually all of our markets, etcetera. But I think we view that as we sort of continue into a pretty challenging environment and where utilization is going to be viewed carefully by payers and by the government. We think being properly aligned with our physicians is most important dynamic. So to me, I would cite those two issues, the continued emphasis on physician alignment in a bunch of different ways and the continued expansion of the care continuum as two of our major focuses as we think about the next five years."
},
{
"speaker": "Jamie Perse",
"content": "All right, appreciate it. Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. And one moment for our next question. Our next question is going to come from the line of Ryan Langston with TD Cowen. Your line is open. Please go ahead."
},
{
"speaker": "Ryan Langston",
"content": "Hey, Steve. Thank you. Quick one and then maybe a more broad one first. Does the SDP program benefit you called out for DC. Does that include the new facility that you're opening?"
},
{
"speaker": "Steve Filton",
"content": "Yes, it does. Although I think for the most part it's been difficult to predict what the impact on the new facility is because obviously we have no track record of utilization, etcetera. So the number that we've given is largely based on the historic performance of our acute care hospital in the district as well as we do have a behavioral hospital in the district that would have a smaller benefit from this program. But the new hospital will participate in any new Medicaid supplemental program that's approved."
},
{
"speaker": "Ryan Langston",
"content": "So that would just be some upside potentially to what you've ranged already. I guess maybe modest."
},
{
"speaker": "Steve Filton",
"content": "Correct. Okay."
},
{
"speaker": "Ryan Langston",
"content": "And then maybe just more broadly, we've seen some, I guess, increase in frequency and legal headlines both on behavioral and the acute side. So just curious on your thoughts on is that just sort of the avalanche of you see one and now you're going to get three more. And if you think that might subside, I mean, it just seems like these are much higher, at least frequency than pre-COVID. So just any kind of high level thoughts on some of the legal news flow would be great. Thanks."
},
{
"speaker": "Steve Filton",
"content": "Yes, I mean, certainly there have been some kind of headline grabbing verdicts in I think, particularly in the behavioral space in the last year. I think, as we've indicated, we believe that the two verdicts that we have disclosed are both subject to appealable issues. At least one of the verdicts has been substantially reduced just at the trial judge level. But again, I think there's a great deal more appeal activity to go on both of those cases. I think it's hard to say whether those cases really reflect a significant, change in the landscape. I think they're both, they were both extraordinary verdicts in terms of any sort of history, in terms of the facts of the case or the jurisdictions or whatever. As I mentioned in my prepared remarks, we are increasing our reserves for malpractice expense to recognize. I think just more broadly an increase not so much in the frequency of cases, but in the severity of cases and the severity of settlements and verdicts, etcetera, but not necessarily really driven by the two cases that we've been disclosing, because I do think those are sort of extraordinary and are both likely to be significantly reduced."
},
{
"speaker": "Ryan Langston",
"content": "Got it. Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. And one moment for our next question. Our next question is going to come from the line of Matthew Gillmor with KBCM. Your line is open. Please go ahead."
},
{
"speaker": "Matthew Gillmor",
"content": "Hey, Steve, So the outlook for the Medicaid supplemental payments. I think we've heard you talk about Tennessee and DC in the past. I think today you mentioned some additional funding for Nevada of $56 million. Did that be understood to be something new that's developed, or was that already sort of baked in and understood previously?"
},
{
"speaker": "Steve Filton",
"content": "No, I think what gives rise to that incremental benefit is the state increasing the size of their Medicaid supplemental pool as a result of updating their Medicaid utilization statistics and data and submitting that to CMS. So that is something that was sort of incrementally newsworthy to us and obviously we're disclosing it now. But I think it's triggered by the increase in Medicaid utilization that the state is experiencing and as a consequence is increasing their pool of these Medicaid supplemental payments available."
},
{
"speaker": "Matthew Gillmor",
"content": "Got it. And then, Steve, I wanted to see if you would be able to provide any comments on the hurricane dynamics. I think you mentioned some impacts around the edges with behavioral volumes, but any way to think about sort of any EBITDA impact or is it just small enough that it doesn't matter that much?"
},
{
"speaker": "Steve Filton",
"content": "Yes, I mean, I would say that we thought that probably in the behavioral side of the business, patient day volume would have been maybe 25, 30 basis points higher had it not been for the impacts of the hurricane. I mentioned that, I think there was a bit of a, creep up in salary expense during the quarter as a result. I think broadly we had the view that trying to quantify the impact of the hurricane in both of the segments, it was just not material enough to sort of call out as a discrete item. It certainly was, a bit of a drag during the quarter. But I think, I think our point of view was it wasn't significant enough to call out as a discrete item."
},
{
"speaker": "Matthew Gillmor",
"content": "Got it. Thank you."
},
{
"speaker": "Operator",
"content": "One moment for our next question. Our next question is going to come from the line of Whit Mayo with Leerink Partners. Your line is open. Please go ahead."
},
{
"speaker": "Whit Mayo",
"content": "Thanks. I'll just keep it to one question. Steve was just looking for an update on some of the EMR investments you guys have been making within the behavioral segment. How many facilities now, any benefits that you're seeing on labor or other efficiencies, and then just maybe any new strategic initiatives within that segment that we should be mindful of as we enter 2025. Thanks."
},
{
"speaker": "Steve Filton",
"content": "Yes, I don't necessarily have the precise data in front of me with, but I think, by early next year, we'll probably have 25 or 30 facilities live on the EMR and that implementation and installation process will continue. I think, we feel like it's generally been successful, and I think it tends to lend itself to greater efficiencies when you don't necessarily have a paper record. But also, higher quality of care, different clinicians are able to view the record more, more easily, etcetera. And that improves, I think the quality of the patient care that you can provide. I think the other technological development that we've talked about before in behavioral has to do with what we describe as patient observation or patient rounding. Having eyes on behavioral patients very, very frequently is a significant part of keeping patients safe and well. And to date, that's been a physical exercise that literally someone is laying eyes on every patient every 15 minutes or so. But to the degree that we can enhance that process technologically, have a patient wear what looks like an apple watch and have our clinicians carry what looks like a tablet around and be able to know where patients are and whether they've been observed and keep track of them more effectively that way, I think that's going to be a significant development that will help in the behavioral business in a great many ways in terms of quality of patient care and risk management, etcetera, in the next few years."
},
{
"speaker": "Whit Mayo",
"content": "Okay, thanks."
},
{
"speaker": "Operator",
"content": "Thank you. And one moment for our next question. Our next question is going to come from the line of Michael Ha with Baird. Your line is open. Please go ahead."
},
{
"speaker": "Michael Ha",
"content": "Thank you. Steve, I think last quarter you mentioned a lot of cost management in your acute care business in preparation for that sort of eventual return to pre pandemic volume. And then basically the aim of being able to continue EBITDA and margin expansion even when things moderate. So now that volumes appear to be moderating and acuity seems to be picking up, it feels like it might be materializing faster than most expected. So I wanted to revisit this topic, ask about those cost management efforts, how it's been tracking, how has it been tracking. And at this point in time, if volumes do continue to moderate, what's your confidence level that you're right now in the right position to drive that EBITDA and margin expansion in the queue?"
},
{
"speaker": "Steve Filton",
"content": "Yes, I mean, I think the point that I tried to make last quarter, maybe in the last couple of quarters is this sort of idea that some of the traditional kind of blocking and tackling that we have done from a productivity standpoint was, if not suspended, maybe paused temporarily during the pandemic. We were so challenged in finding an adequate workforce and keeping an adequate workforce during the pandemic. There were, we definitely sort of, there was a reluctance to manage to what we would sort of consider peak efficiency. I think as we emerge from the pandemic more willing to do the sort of things that I think we've always historically done, including adjusting to volumes as they moved up and down. And I think you saw that last quarter and I think you saw that this quarter as well, where salaries as a percentage of revenues has been coming down and coming down pretty steadily, and I think is really one of the main contributors to that margin recovery. I think that's continuing. And I think the point being I don't exactly know where acute care volumes will move, and I don't think anybody really knows for certain. But I think we're in a position where we're much more, flexible about reacting to that and reacting to that in an efficient way than, we were at the height of the pandemic when we face so many more staffing challenges."
},
{
"speaker": "Michael Ha",
"content": "Thank you. And then follow up, California and New Mexico supplemental payments for 2025. We're hearing it could be potentially 70 million to 80 million for California, 30 for New Mexico. To UHS was wondering if you've any sort of additional clarity on sizing. And then with all the recent discussion around state proposals and the CMS raising those payments to average commercial rates for next year, I was wondering if you could talk more about those proposals. The potential tailwind, not just California and Florida, which everyone's been focused on, but across all your states, I guess. How real of a potential tailwind is this? Thank you."
},
{
"speaker": "Steve Filton",
"content": "Yes, so just responding to the specific questions you asked, New Mexico, I don't think is a significant, again, upside for us. We have one small behavioral facility in New Mexico, California, we obviously have a much bigger presence, both for acute and behavioral. And I think the challenge in terms of sizing the potential benefit in California is that the state has not created a formal plan or an allocation methodology, etcetera. So even though we understand that the potential benefit in total could be quite significant, we really have no way of knowing exactly how that would impact specific hospitals, how it would be allocated among specific hospitals until the state issues a more specific plan, which at least we understand is not likely to happen until sometime maybe next year, early next year. Your broader question about are more states likely to increase their programs or develop new programs, increase their funding to average commercial rates? It really varies by. And you know, we've sort of had this practice of we really only disclose them when the states have a formal plan, that they submit it to CMS and are awaiting approval. But we certainly, like others, are aware that other states are contemplating this in earlier stages, etcetera. And so we continue to believe that the potential benefit could be significant beyond just the ones that we disclosed, which are significant, I think, in and of themselves, but difficult to size that opportunity in any sort of precise way until the states develop their plans and Submit them to CMS."
},
{
"speaker": "Operator",
"content": "Thank you. And one moment for our next question. Our next question is going to come from the line of Ben Hendrix with RBC Capital Markets. Your line is open. Please go ahead."
},
{
"speaker": "Ben Hendrix",
"content": "Great. Thank you very much. Just a quick follow up on some of the psychiatric questions, especially in residential psych. And I think I've asked this question, but just wanted to get any update or any updated thoughts on your strategic initiatives around psych. I know you mentioned, the higher liability reserves and some very specific issues at some of your facilities. Is there any thoughts on kind of changing strategic direction or evolving strategy there? And could we potentially, amid this heightened security, could there be consolidation opportunities in residential? Thanks."
},
{
"speaker": "Steve Filton",
"content": "Yes, I mean, I was asked kind of a more strategic question earlier. Well, that focus was on acute care. But then I think in some ways the, my answer on behavioral and my outlook is similar in the sense that we see an expanding continuum in which outpatient care is likely to play a greater role and there'll be more demand for access to outpatient care. And we're expanding our outpatient footprint in response to that. I think we continue to expand our services to military members because that seems to be a growing and significant part of the business. The SUD [ph] or addiction business continues to grow and demand is increasing there. And I think we're increasing our exposure there. Yes, I don't know that it's particularly an acute residential sort of issue of paying attention or focusing on one more than the other as much as it is these other service lines, which we think are growing. And I would add to sort of the outpatient dynamic, continuing expansion of telehealth capabilities as well."
},
{
"speaker": "Ben Hendrix",
"content": "Thank you very much."
},
{
"speaker": "Operator",
"content": "Thank you. And I'm showing no further questions at this time. And I would like to hand the conference back over to Steve Filton for any closing remarks."
},
{
"speaker": "Steve Filton",
"content": "Yes, we'd just like to thank everybody for their time and look forward to speaking with people at the end of next quarter. Thank you."
},
{
"speaker": "Operator",
"content": "This concludes today's conference call. Thank you for participating. You may now disconnect, everyone. Have a great day."
}
] |
uhs | 2,024 | 2 | [
{
"speaker": "Operator",
"content": "Good day, and thank you for standing by. Welcome to the Q2 2024 Universal Health Services Earnings Conference Call. At this time, all participants are in a listen-only mode. After the speaker's presentation, there will be question-and-answer session. [Operator Instructions] Please be advised that today's conference is being recorded. I would now like to hand the conference over to your speaker today, Steve Filton, Executive Vice President and CFO. Please go ahead."
},
{
"speaker": "Steve Filton",
"content": "Good morning. Marc Miller is also joining us this morning. We welcome you to this review of Universal Health Services results for the second quarter ended June 30, 2024. During the conference call, we'll be using words such as believes, expects, anticipates, estimates and similar words that represent forecasts, projections and forward-looking statements. For anyone not familiar with the risks and uncertainties inherent in these forward-looking statements, I recommend a careful reading of the section on Risk Factors and forward-looking statements and Risk Factors in our Form 10-K for the year ended December 31, 2023, and our Form 10-Q for the quarter ended March 31, 2024. We'd like to highlight just a couple of developments and business trends before opening the call up to questions. As discussed in our press release last night, the company reported net income attributable to UHS per diluted share of $4.26 for the second quarter of 2024. After adjusting for the impact of the items reflected on the supplemental schedule, as included with the press release, our adjusted net income attributable to UHS per diluted share was $4.31 for the quarter ended June 30, 2024. Our acute hospitals experienced a moderation of the demand for their services in the second quarter with adjusted admissions increasing 3.4% year-over-year and surgical growth flattening out. Overall, revenue growth was still a solid 6.6%. Meanwhile, expenses were well controlled. Specifically, the amount of premium pay in the second quarter was $61 million, reflecting a 15% to 20% decline from the prior year quarter. On a same facility basis, EBITDA at our acute care hospitals increased 37% during the second quarter of 2024 as compared to the comparable prior year quarter. And the increase was 20% if you exclude the impact of the incremental Medicaid supplemental payments in Nevada. During the second quarter, same facility revenues in our behavioral health hospitals increased by 11%, primarily driven by a 9.3% increase in revenue per adjusted patient day. Even after adjusting for Medicaid supplemental payments not included in our original 2024 guidance, same facility revenues increased by 7.2% and same facility EBITDA for our behavioral health hospitals increased 13% in the second quarter as compared to the comparable prior year period. Our cash generated from operating activities increased by $422 million to $1.1 billion during the first six months of 2024 and as compared to $654 million during the same period in 2023. In the first half of 2024, we spent $450 million on capital expenditures and acquired 1.1 million of our own shares at a total cost of approximately $195 million. Since 2019, we have repurchased approximately 30% of the company's outstanding shares. As of June 30, 2024, we had $1 billion of aggregate available borrowing capacity pursuant to our $1.2 billion revolving credit facility. In our acute care segment, we continue to develop additional inpatient and ambulatory care capacity. We currently have 27 operational freestanding emergency departments as well as 12 more, which have been approved and are in various stages of development. Also, construction continues on our de novo acute care hospitals consisting of the 150-bed West Henderson Hospital in Las Vegas, Nevada, which is expected to open late this year. The 136 bed Cedar Hill Regional Medical Center in Washington, D.C. which is expected to open in the spring of 2025, and the 150-bed Alan B. Miller Medical Center in Palm Beach Gardens, Florida, which is expected to open in the spring of 2026. In our behavioral health segment, we recently opened the 128-bed River Vista Behavioral Hospital in Madera, California, and we are developing the 96 beds Southridge Behavioral Hospital in West Michigan a joint venture with Trinity Health Michigan, which is expected to open later this year. I'll now turn the call over to Marc Miller, President and CEO, for closing comments."
},
{
"speaker": "Marc Miller",
"content": "Thanks, Steve. We're pleased with our second quarter results as both our business segments continued to make operational improvements. As we anticipated, acute care volumes have moderated somewhat and are gradually be going to resemble the patterns we experienced prior to pandemic. The increase in operating income in comparison to last year's second quarter for acute care hospitals is a further step towards a more extended margin recovery, we hope to sustain for the next several periods. In our acute segment, physician expense, which is a significant headwind in 2023, has stabilized at approximately 7.5% of revenues. Based on the generally favorable operating trends in the first half of the year, we are increasing the midpoint of our 2024 EPS guidance by 17% to $15.80 per diluted share from $13.50 per diluted share previously. New supplemental programs being developed in Tennessee and Washington D.C. which are not yet fully approved are not included in our revised guidance. Lastly, as announced in yesterday's earnings release, our Board of Directors has authorized a $1 billion increase to our stock repurchase program, thereby increasing the current aggregate purchase -- repurchase authorization to $1.228 billion. We're happy to answer questions at this time."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] One moment for our first question which comes from Ann Hynes of Mizuho Securities. Your line is open."
},
{
"speaker": "Ann Hynes",
"content": "Great. Thanks. I just want to focus my question on the supplemental payments. I'm just trying to figure out what inning you are in both the acute care and behavioral for maybe new programs. Like so you mentioned D.C. that sounds like it might be a new program in acute care. And on the behavioral side going forward that would be great. Thanks."
},
{
"speaker": "Steve Filton",
"content": "Yes, Ann, so I think we had mentioned before that I think from our perspective while we may understand that individual states are contemplating either new programs or expansion of existing programs, we tend to really not discuss them until there is some formal submission of a program to CMS and sort of pending approvals with -- from CMS within the state and both the Tennessee and Washington D.C. programs sort of fall into that category. As you suggest, Tennessee is a state in which we have exclusively behavioral business. Washington D.C. is a geography where we have both acute and behavioral business although the Medicaid supplemental program would be primarily beneficial to the acute business. Both programs we have been told that the expectation from state of the district is that the programs are likely to be approved either later this year or early next year. Both programs would be retroactive. We believe Tennessee would be retroactive most likely to July of 2024 and that D.C. would be retroactive to October of 2024 this year. And again, none of these things are guaranteed and they all depend on CMS approval. Those are the two I'll call them incremental or additional programs we would disclose. But we certainly are aware of other states and where expansion of programs or new programs are at least being considered."
},
{
"speaker": "Ann Hynes",
"content": "Great. And just one follow-up. I know that you provided the potential benefit for Tennessee, but have you -- can you provide what you think D.C. would be? Thanks."
},
{
"speaker": "Steve Filton",
"content": "Yes. So, we've disclosed in our 10-Q that we think the potential benefit of our prior 10-Q the potential benefit in Tennessee would be between $42 million and $56 million annually. The potential benefit in Washington D.C. is probably in the $80 million to $90 million range annually."
},
{
"speaker": "Ann Hynes",
"content": "Great. Thank you."
},
{
"speaker": "Operator",
"content": "And one moment for our next question. And our next question will be coming from Stephen Baxter of Wells Fargo. Your line is open, Stephen."
},
{
"speaker": "Stephen Baxter",
"content": "Hi. Thanks. I was hoping you could elaborate a little bit on behavioral volume performance in the quarter. I think you had expectations maybe the last earnings call just going to improve a little bit in the second quarter. So just wondering if you could talk about some of the drivers of performance in the quarter. And then also, how you're thinking about behavioral demand growth in the back end of the year. Thank you."
},
{
"speaker": "Steve Filton",
"content": "Yes. I think that the dynamics surrounding behavioral volumes have remained pretty much the same. You are correct in your description. We -- behavioral patient days on a same-store adjusted basis were up I think about 2% in Q1. We expect it be to equal and maybe better than slightly in Q2. We did not. I think the issues are very familiar to what we've been talking about for some time, while we've made I think a lot of progress on filling our labor vacancies around the country. We still find in very specific markets and geographies that certain labor positions sometimes nurses, sometimes therapists and counselors, sometimes nonprofessionals and mental health technicians are difficult to place and can sometimes limit capacity or our ability to admit patients. I think we've discussed in the last few quarters the fact that Medicaid disenrollments, particularly in the Southern states, Texas and Mississippi, Louisiana, Arkansas have had more of an impact on our business as people have gotten disenrolled from Medicaid and it's taken them some time to get either reenrolled in Medicaid or into a commercial exchange program, if they get into a commercial exchange program they often have the high co-pays and deductibles which make them meeting their financial requirements difficult behavioral hospitals. And finally, we have a handful of behavioral facilities that struggled with very specific issues in 2023, I believe they've all improved but are doing so at a somewhat slower pace than we originally imagined they would. I think ultimately we still believe that that 3% patient day growth target that we embedded in our original 2024 guidance is an achievable target, probably not in terms of full year growth. But I think we believe that by the end of 2024, we should be growing at that rate and we view that as a sustainable rate of growth going forward."
},
{
"speaker": "Operator",
"content": "And one moment for our next question. And our next question will be coming from Ben Hendrix of RBC Capital Markets. Your line is open."
},
{
"speaker": "Ben Hendrix",
"content": "Thank you very much. Just wanted to see if you could elaborate a little bit on the moderation in acute demand and your surgeries flattening out with trending towards pre-COVID levels. Any trends you can call specifically in specific categories and any payer mix implications there, and how you're seeing that develop? Thank you."
},
{
"speaker": "Steve Filton",
"content": "Yeah. I mean, so one comment that I'd make about the 3.4% adjusted admission growth in acute care is that that comparable number in the second quarter of last year was 7.7% and surgical growth in the second quarter of last year was in the 5% to 6% range. So those were both very difficult comparisons. I think we had a view that 3.4% adjusted admission growth a relatively flat. Surgical growth was relatively close to our expectations given the very difficult comparison. We've been talking I think for some time about the expectation that acute care volumes both overall admissions and surgical growth would return to pre-pandemic patterns. I don't know that that's absolutely where we are right today. But certainly I think we've been preparing for that. And I think a lot of the cost management that you saw during the quarter was an expectation and preparing for that, so that as we return to some of those pre-pandemic levels of revenue and volume growth, we could generate the increased EBITDA and margin expansion and remain on that trajectory for at least several more periods."
},
{
"speaker": "Ben Hendrix",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "One moment for our next question. And our next question will be coming from A.J. Rice of UBS. Your line is open."
},
{
"speaker": "A.J. Rice",
"content": "Hi, everybody. Maybe just first question and then I have a follow-up. First question on the updated guidance, I know you didn't raise the full year guidance after the first quarter and there was some outperformance, and then you've had some outperformance in the second quarter. And then there's also the supplemental payments maybe that weren't in the original guidance. Can you just parse out how much is just capturing year-to-date trends? How much is an adjustment for supplemental payment information? And then have you made any adjustment to your second half expectations in this updated guidance?"
},
{
"speaker": "Steve Filton",
"content": "Yeah. So A.J. from a high-level perspective the approach that we took to the revised guidance was, obviously, to increase the guidance by the amount of the first half beat, which was substantial to include in the revised guidance for the back half of the year. Any supplemental programs and payments that we knew would continue and be present in the second half. We did not as Marc indicated in his comments include anything for Tennessee or Washington D.C. And then we included some of the cost management improvements that we've made, which we believe are certainly sustainable. But for the most part particularly from I think a revenue and a volume perspective just generally retained our original guidance for the second half of the year."
},
{
"speaker": "A.J. Rice",
"content": "Okay. There's been a lot of discussion this quarter about impact of two-midnight rule Medicaid redeterminations and so forth. Can you just maybe make some comments about what you're seeing there and how -- I know two-midnight rule wouldn't affect the behavioral business, but the redeterminations maybe it had some impact on both sides. Any updated thoughts on what you're seeing in those two areas?"
},
{
"speaker": "Steve Filton",
"content": "Yeah. I mean as far as two-midnight goes and we've commented on this before and I acknowledge that our comments may be a little bit different than what some of our peers have said. But we've been unable to validate, or I think precisely identify any real benefit that we're getting from the two-midnight rule change. We don't see any dramatic change in metrics like amount of denials or patient status changes, et cetera. Nor anecdotally do we hear from our personnel who deal with this issue on a daily basis that they've seen real behavior changes on the part of payers. Again I know some of our peers have suggested otherwise, but we're just unable to really parse out any significant impact from the change of the two-midnight rule. Medicaid redeterminations, I think on the acute side have resulted in an increase in commercial exchange patients. Again I think compared to some of our peers probably not as big an increase. We've gone -- we had commercial exchange patients as a percentage of our overall adjusted admissions. Pre the end of the PAT was about 4%. I think that number has climbed to about 5% currently. I know some of our peers have suggested that number has climbed to 6% or 7%. We haven't gotten that high. On the behavioral side, I alluded to this in an earlier response. I do think we're being affected by the Medicaid redeterminations, particularly in the adolescent population. We definitely have seen some weakness in that population in the last, I'm going to say, two three quarters. And it's -- I think, it's been a slow process for those adolescents to either reenroll in Medicaid or to get on to a commercial exchange program. And if they get on to a commercial exchange program, to exhaust a bit or sometimes large copays and deductibles that those plans have. So, I think Medicaid redeterminations to probably had a bigger negative impact on the behavioral business, the shift to commercial exchanges on the acute side, has probably been a slight net positive."
},
{
"speaker": "A.J. Rice",
"content": "Okay. Thanks a lot."
},
{
"speaker": "Operator",
"content": "One moment for our next question. And our next question will be coming from Justin Lake of Wolfe Research. Your line is open."
},
{
"speaker": "Q – Justin Lake",
"content": "Thanks. Good morning. Steve, first on the guidance, in terms of just kind of isolating that DPP bucket, I think you started the year at about $810 million in the 10-K that you expected to get this year. You updated it to $860 million, with the ones with the 10-Q. Just curious, what that number is right now that you expect to get this year. So let's just do that in my first question. Then, I've got one for Marc. Thanks."
},
{
"speaker": "Steve Filton",
"content": "Yes. So we're still working on that disclosure, which we'll have in our 10-K in eight or 10 days. But I think there'll be a significant step up from the $860 million obviously, including the Washington I know numbers that we included in the press release, et cetera. But there'll be a more precise picture that we file our Q in a week or so."
},
{
"speaker": "Q – Justin Lake",
"content": "Okay. Do you have a round number, you could share with us? Like does it go to -- do you think it goes much higher than $900 million? Or if I add those two numbers in there?"
},
{
"speaker": "Steve Filton",
"content": "Yes, I think it will go into the low to mid-900s."
},
{
"speaker": "Q – Justin Lake",
"content": "Okay. So, if we look at your guidance raise of $215 million, you started the year at around 810. If it goes to low to mid-900s, is it maybe fair to say that, maybe half give or take of that guidance raise is coming from these supplemental payments? That a reasonable way to think about the rest [indiscernible]?"
},
{
"speaker": "Steve Filton",
"content": "I think that's fair."
},
{
"speaker": "Q – Justin Lake",
"content": "Okay. And then Marc, you talked about the improvement in the hospital business in terms of the margins. Curious, if the -- there's still a potential way to go to get back to pre-COVID levels. What do you think a reasonable target is when you sit down with your hospital operators? And do you have a trajectory or a plan, at which you kind of time line is probably the best way to put it in terms of when you expect to get there? Maybe you could share a couple of the steps, you expect to take to get that. Thanks."
},
{
"speaker": "Marc Miller",
"content": "Yes. I mean, we have a lot of plans and there's a lot of discussions on how we're going to continue to incrementally improve. I'm not going to give you a number or a time period right now. But every market is a little bit different, obviously. We've been very pleased, with the work that the operators have done especially, in the last 12 months. In addressing not only the volume issues, but really getting a better handle on expenses. And I think if we just continue with that trajectory, we'll get to where we need to be fairly soon, but we still have a little ways to go."
},
{
"speaker": "Q – Justin Lake",
"content": "Great. Thanks."
},
{
"speaker": "Operator",
"content": "And one moment for our next question. And our next question will be coming from Jason Cassorla of Citi. Your line is open, Jason."
},
{
"speaker": "Q – Jason Cassorla",
"content": "Great. Thanks. Good morning. Maybe just to ask on the acute pricing and mix in the quarter up 3.5% or so, but kind of normalizing for the supplemental payment dollars this year maybe only up kind of slightly year-over-year. Is that just simply a function of that lower acuity volume continue to return? I know you made comments around surgical volume dynamic in the quarter? Or just maybe anything you can give on acuity and payer mix trends within a Q kind of outside of the supplemental payment programs would be helpful."
},
{
"speaker": "Q – Justin Lake",
"content": "Yes. I think it's a variety of things, Jason. Again, I think we had a pretty difficult comparison. We were comparing to something close to 10%, revenue growth last quarter high surgical and less years quarter, rather high surgical growth, et cetera. I think we're seeing some settling down, some exhaustion of some of those postponed and deferred procedures that have been postponing deferred, during the pandemic. I think that even exclusive of the supplemental payments our expectation in the acute business is, we'll get to as we have historically a same-store revenue growth sort of trajectory of 5% 6% split pretty evenly between price and volume. And again, I think with our with the progress that we've made as both Marc and I have alluded to on the cost management side, that should allow us continued EBITDA growth and margin expansion until we get either completely back to or something close to pre-pandemic margin levels in that segment."
},
{
"speaker": "Q – Jason Cassorla",
"content": "Okay. Great. Thanks. And then maybe just a follow-up. With the $1 billion increase to the share repo program, I know you accelerated a little bit in terms of share repo activity in the quarter maybe with the Illinois lawsuit kind of dynamics going on. But with the increase there in the repo program, is the expectation that you're still aiming to spend around $500 million $600 million on share repo for this year? Or how should we think about the share repurchase dynamics? Thanks."
},
{
"speaker": "Steve Filton",
"content": "Yes. So, I think your suggestion is largely on point. Our original guidance suggested that we would spend the bulk of our free cash flow, which would be $500 million or $600 million on share repurchase. And I think that is still our intent. And I think frankly the main point of including that announcement in this quarter's release was to just reinforce that idea. We believe we're still on track and obviously we needed the reauthorization to be able to accomplish that."
},
{
"speaker": "Q – Jason Cassorla",
"content": "Great. Thank you."
},
{
"speaker": "Operator",
"content": "Our next question will be coming from Sarah James of Cantor Fitzgerald. Your line is open."
},
{
"speaker": "Sarah James",
"content": "Thank you. I was hoping you could talk a little bit about the embedded adjusted admissions growth baked into your guidance for the second half. Are you assuming that first half levels stay flat or decelerate? And could you talk a little bit about what the drivers are for that assumption?"
},
{
"speaker": "Steve Filton",
"content": "Yes. So, our volume assumptions I think in the back half of the year are not terribly different than our original guidance. On the acute side, I think it's adjusted admission growth in the 3% to 4% range just sort of continuing kind of how we're exiting the in the second quarter. I think on the behavioral side, practically, it will be a tall order to get to 3% patient day growth for the full year. But I do think that we still believe that we'll get to that 3% by the end of the year and that that will be a sustainable level or a level of growth that we can sustain for the foreseeable future after that."
},
{
"speaker": "Sarah James",
"content": "Got it. And on the behavioral side, do you think about getting to that 3% as mostly capacity driven? And do you have any updates on how you're hiring practices are going? Thanks."
},
{
"speaker": "Steve Filton",
"content": "Yes, I mean I think it's a combination of things. I ticked off I think the things that have been progressing a little more slowly than we expected. I think we believe that will accelerate. We believe we'll continue to have more success in hiring particularly in pockets that have been somewhat troublesome. I think that the impact of the Medicaid disenrollment, which I do think is weighed down our volume in the last three or four quarters will get better as more of these people get either reenrolled in Medicaid or in commercial exchange products and the copays and deductibles. And I believe the progress on the handful of residential facilities that have been a drag which have been progressing but at a somewhat slower rate than we expect will continue and all that will help and allow us to get back to the 3%, which I think again was our original plan it's just happening a little bit more slowly than we had originally anticipated."
},
{
"speaker": "Sarah James",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "And our next question will be coming from Andrew Mok of Barclays. Andrew, your line is open."
},
{
"speaker": "Andrew Mok",
"content": "Hi, good morning. Just wanted to follow up on the Medicaid supplemental payment programs. First can you give us a sense where these programs stand relative to average commercial rates? And second how does the higher Medicaid reimbursement change the relative attractiveness of patients in that payer class? Is this a category that you would lean into from a referral and service line perspective? Thanks."
},
{
"speaker": "Steve Filton",
"content": "Yes. So, -- and I think at least one of my acute care company peers made this point that even though there have been these substantial increases in Medicaid supplemental payments around the country that for the most part. And I think this is particularly true on the acute side our Medicaid reimbursement remains well below commercial rates mostly well below Medicare rates. And quite frankly in most cases still below our cost. So, we've made the point before and I'll reinforce it again because it's an important one that these Medicaid increases are really intended to I think make up for the inadequate reimbursement of the last several years, particularly the cost pressures that accelerated during the pandemic just broadly inflation pressures, but also the particular wage pressures that were exacerbated during the pandemic. I think on the behavioral side, at least in some of the states the Medicaid supplemental payments do in some cases approach Medicare reimbursement in some cases sort of probably between Medicare and commercial. I think in those states and in those facilities it does sort of change our approach and it I think encourages us to focus on those referral sources and those community resources that tend to produce Medicaid patients. And I think we it does inform our approach in those markets. And we are I think the phrase you used was leaning into that. I think on the acute side the vast majority of our Medicaid business comes to our emergency room. So, there's not a whole lot of proactive actions that we take to seek that business out we get the business we get and we're just being reimbursed for that a more adequate rate. But yes, on the behavioral side, I do think that we're in those space where these programs increase the Medicaid reimbursement to a level that makes it more attractive. We are using upraise leaning into that business and trying to work with referral sources to get more of it."
},
{
"speaker": "Andrew Mok",
"content": "Great. Thank you."
},
{
"speaker": "Operator",
"content": "And one moment for our next question. And our next question will be coming from Pito Chickering of Deutsche Bank. Your line is open, Pito."
},
{
"speaker": "Pito Chickering",
"content": "Hey. Good morning guys. So, on the acute labor side, can you talk about where turnover is today where hiring is and how to think about those in the back half of the year as well as contract labor? And also as length of stay comes down due to better staffing, how does length of stay reductions help your EBITDA growth?"
},
{
"speaker": "Steve Filton",
"content": "Yeah. So as far as acute care turnover Tito, I think that we're down into the low-and-mid-20s which is kind of where we were in sort of the pre-pandemic period. Obviously we still view that turnover rate as high. But to be fair that's -- the hospital and acute care industry has had turnover rates in the high-20s and low-30s and nationally for a long time. And while we view those as still very inefficient and not necessarily ideal and we continue to work to lower them. Part of that is it's just the nature of the business. But obviously, as I indicated in my prepared comments our ability to reduce premium pay which has been reduced almost probably by two-thirds from its height at the -- the very height of the pandemic indicates more success in hiring and filling these permanent positions. I think you also see it in our -- in just our deceleration or a reduction, in the rate of acceleration, in wage inflation, in the acute business, the reduction in incentive payments, recruitment incentive payments et cetera, all indicate I think a settling out of the labor supply demand dynamic and just greater success on our part in filling our open vacancies. As far as the length of stay dynamic, because the vast majority of our payments are made on a per discharge basis the lower our rate to stay, the more efficient we are in being able to treat patients and fully treat them and discharge them to the appropriate setting whether that's home or to some sort of subacute facility to the degree that we reduce length of stay. We're really reducing our cost per discharge or cost per admission. And then, again, I think that we've lowered our length of stay dramatically from the height of the pandemic, but even continue to do so incrementally. And again I think that's partly reflected in our very successful cost management and cost reduction initiatives that you can see on our income statement."
},
{
"speaker": "Pito Chickering",
"content": "Okay. There's been some negative press recently including the Senate Finance Committee on results of care. Are you seeing that impact to your referrals at all?"
},
{
"speaker": "Steve Filton",
"content": "Yeah. Honestly, Pito, we really have seen virtually no impact from the Senate hearing and report. I think the greatest impact we would expect perhaps to have seen would be from referral sources. But I think what we kind of believe is the lesson from this is that referral sources understand the business very well. They understand this is a very difficult patient population. They understand that our hospitals, I think do overall a very admirable job. And I think the outcomes and the patient satisfaction results suggest that patients are generally satisfied and highly satisfied with their care in these facilities. And I think referral sources recognized that. So no we've really seen no impact on our volumes no impact from referral sources not necessarily any additional incremental regulatory oversight. So we're pleased with that."
},
{
"speaker": "Pito Chickering",
"content": "Perfect. Great. Thanks so much, guys."
},
{
"speaker": "Operator",
"content": "And one moment for our next question. And our next question will be coming from Michael Ha of Baird. Your line is open."
},
{
"speaker": "Michael Ha",
"content": "Thank you. So on behavioral volumes still yet to slowly rebound pricing remains powerful. I was wondering if you could help us break out roughly how much of the volume headwind is Medicaid redeterminations versus labor-related constraints? Is it 50-50 maybe more of redetermination related? And would it be fair to say that redetermination impact tails off into the back half of this year that it creates a positive backdrop? And against easier second half volume comps that should help the bounce back naturally in behavioral volumes. And then, if you could discuss the source of behavioral pricing strength I think you said 7.2% as the supplemental payments. So if you could just test some of the dynamics there is it what's happening in par pricing that would be helpful. Thank you."
},
{
"speaker": "Steve Filton",
"content": "Yeah. I mean, again, I would just make the point that the shortfall from where our behavioral volumes are the 1.4% patient day growth in the quarter versus where we thought we would be which would be continuation of Q1 at around 2% or maybe a little bit higher than that. It's not an enormous shortfall. And its 60, 70, 80 basis points and therefore it's like to parse with great precision between the issues that I elaborated on the staffing, the Medicaid redeterminations the handful of residential facilities. So that's difficult to do. I think broadly as your question suggests we do believe redeterminations get -- or the impact from redeterminations get better in the back half of the year as we do believe these other issues the staffing and the residential facilities will get better in the back half of the year and allow us to reach that 3% target."
},
{
"speaker": "Operator",
"content": "And one moment for our next question. Our next question will be coming from Kevin Fischbeck of Bank of America. Your line is open."
},
{
"speaker": "Kevin Fischbeck",
"content": "Okay. Just a follow- on that comment there about the site volume improvement. I guess two questions. First one is, is there any sign, I guess, maybe outside of the Medicaid population that demand in any way shape or form is being impacted? Or is this really just about kind of capacity and then redeterminations? And then second, when you think about that labor dynamic to get back to 3% by the end of the year and to consistently be growing 3%. I mean, you're going to have to be adding staff at that pace. Are you currently adding staff at that pace generally that would support that? It sounds like you're not quite there yet. So just trying to understand what you're doing between now and year-end that should be getting you to kind of sustainably add that type of capacity? Thanks."
},
{
"speaker": "Steve Filton",
"content": "Yes, Kevin. So I think -- and part of the reason that I think we have been confident that behavioral volumes should and could increase to sort of more historically normative levels is that we believe the underlying demand is strong and we measure that in a couple of different ways. We measure it sort of from a macro basis, there's a lot of sources of incidence of behavioral illness and the need for treatment in a whole variety of diagnoses, including opioid illness and many others. And again, we believe that virtually across the board demand for behavioral treatment continues to increase. And so this really becomes an issue of can we -- what do we have to do to satisfy that demand and that sort of plays into the labor dynamic? Yes, we are. We continue to have net hires. I would say, our -- we have had positive net hires for between the last 18 and 24 months. Again, it's been incremental and a little slower than we thought, but we continue to add that. I think one of the major areas of focus more recently is we had a question earlier, I think, for Pito about acute care turnover. Behavioral turnover tends to be probably twice what acute care is. And that creates a lot of inefficiency. So even though we're hiring a lot of people they're leaving. And again, I think, this is not just a UHS issue. I think it's an industry-wide issue. But we are very focused on the things that we can do and want to do to reduce that turnover rate, which includes mentorship programs and educational opportunities and career development opportunities so that when we hire people they really have an incentive to want to stay with the organization to stay with the facility. And I do believe that we can reduce our turnover rate, which I think is a practical objective. That will be one way in which we'll be able to satisfy some of that outstanding behavioral demand that we've really been unable to satisfy as much as we'd like to in recent periods."
},
{
"speaker": "Kevin Fischbeck",
"content": "All right. Great. Is there an actual physical capacity dynamic too that you need to be adding beds? Or is there enough bed capacity it's really just the labor that's the constraint?"
},
{
"speaker": "Steve Filton",
"content": "Yes. So I think it's sort of a catch 22. I think we dramatically reduced the pace at which we were adding beds during the pandemic, because we had a view that well what's the point of adding new beds if we can't staff the beds that we already have. I think as we make more and more progress, and again, this is an individual facility individual market kind of calculation in each phase, but as we increase our ability to fill those vacancies et cetera and sort of see a path and a ramp to being able to fill those vacancies, I think, we're going to be more willing to resume the pace of bed additions that we were running at before the pandemic."
},
{
"speaker": "Kevin Fischbeck",
"content": "Thanks."
},
{
"speaker": "Operator",
"content": "And one moment for our next question. And our next question will be coming from Whit Mayo of Leerink Partners. Whit, your line is open."
},
{
"speaker": "Whit Mayo",
"content": "Hey, Steve I have one more labor dynamic question. What's interesting is this is fourth consecutive quarter where your SWB per patient day has moderated. And I'm just really trying to square this against the comments on the challenges in filling positions. You said you're hiring maybe a little bit slower than you thought, but it's not pressuring the salary line at all. And I guess, I would have thought intuitively the opposite would happen, but maybe there's something optical with the mix of RTC versus acute or something. How do I make sense of this?"
},
{
"speaker": "Steve Filton",
"content": "Yes. I mean, I think what you saw during the pandemic was people leaving subacute industries and that obviously included behavioral, but it included, I think, lots of other sub-acute industries like nursing homes and skilled nursing facilities and home health. And they were leaving those industries to work in acute care settings where they were able to make a significant premium to their existing salaries. And I think there's always been for sure a gap and that acute care compensation rates were always higher than sub-acute care compensation rate, but that gap widened dramatically during the pandemic. I do think it has since narrowed. And so really -- and that's I'm trying to answer your question in the sense of. So it really got to be an issue. It didn't matter when a nurse told us -- a behavioral nurse told us that she was leaving to make three times for salary in an acute care setting. Raising her salary by $2 an hour et cetera was not going to have any impact which is why I don't think you saw dramatic pressure on our behavioral rates during the pandemic and which is why as you're suggesting I think you're seeing moderation actually in our salaries and wages per patient day. Because the way we're solving this problem is not necessarily through higher premium payments and incentive payments. Although, we certainly did that during the pandemic and we do it in markets where we still think it's necessary. But I think our real focus is on how do we make people feel that working in a behavioral setting is rewarding is creating career opportunities for them is a place that they're going to be valued et cetera. And I think that's our focus. Look certainly and particularly with the availability of some of these Medicaid supplemental payments et cetera in some markets, if we believe that paying higher compensation and -- could be an answer we'll pursue that. But again I'm going to suggest that I think in most cases this is not a problem of throwing money at it just automatically solves it. But we'll invest more money where we think it makes sense."
},
{
"speaker": "Whit Mayo",
"content": "Okay. And my follow-up I haven't heard you talk about the health plan business in some time. Wondering how that's performing versus expectations? And how you guys think of that as a core business for UHS? Or do you think differently at all about it? Thanks."
},
{
"speaker": "Steve Filton",
"content": "I mean we've talked about the health plans and time to time. I think like any provider-sponsored health plan and this is really an acute care dynamic. We only operate the health plan in markets in which we have acute care hospitals. And it is a way for us to create narrow networks in which our hospitals participate. It's a way for us to create further alignment with Medicare physicians particularly in plants that are focused on Medicare Advantage patients. And we think ultimately even though the plan operates largely at a breakeven level currently that it's still less expensive and greater, sort of, return investment than some other options like physician employment or other similar options although we certainly do those things as well. And so, yes, the health plan continues to do that. It continues to provide us again I think a narrower network and a funnel of patients in certain markets and we'll continue to operate it with that aim."
},
{
"speaker": "Whit Mayo",
"content": "Thanks."
},
{
"speaker": "Operator",
"content": "Our last question will be coming from Joshua Raskin of Nephron Research. Joshua, your line is open."
},
{
"speaker": "Joshua Raskin",
"content": "Hi. Thanks, Just one more Steve. I guess, I heard the 5% of patients are coming with exchange-based insurance. But what percentage of revenue is coming from those individual exchange patients? I'll be curious across both segments. And if you could comment on the margins of those patients relative to your other segments? And then why do you think that 5% is lower than peers? Is that network strategy and contracting? Or do you think that's geographic based?"
},
{
"speaker": "Steve Filton",
"content": "As far as the second question I don't really know the answer to that Josh. As far as the first one goes because I think commercial exchange reimbursement tends to be somewhere between Medicare and commercial probably a little closer to Medicare I would say I don't have this data right in front of me, but my guesstimate would be the 5% of admissions would be something pretty close to what percentage of revenue would be because I would think that sort of midpoint between commercial and Medicare is probably about the midpoint of our reimbursement."
},
{
"speaker": "Joshua Raskin",
"content": "Okay. And margins you think similar to somewhere between Medicare and commercial then?"
},
{
"speaker": "Steve Filton",
"content": "Yes. Yes. I'm sorry, but yes."
},
{
"speaker": "Joshua Raskin",
"content": "Okay. Thanks."
},
{
"speaker": "Operator",
"content": "We did get an additional question from Ryan Langston and that's Ryan Langston of TD Cowen. Your line is open, Ryan."
},
{
"speaker": "Ryan Langston",
"content": "Thanks. Good morning. Thanks for squeezing me in. Just real quick on the new facilities that are coming online both I guess in the acute and behavioral can you just remind us generally how long it takes those facilities to get to breakeven? And do the geographies or any other dynamics in those markets have any changes to that maybe faster or slower? Thanks."
},
{
"speaker": "Steve Filton",
"content": "Yes. I would say generally the ramp of the facility to breakeven is probably in the 6-month to 12-month range and then to what I would consider to be divisional averages probably the 18-month to 24-month range. In markets like Las Vegas that time frame tends to be compressed. Again I think there's little impact this year in 2024 because the facility that we're opening in Las Vegas will be very late in the year. So I don't think it's going to have much of an impact on earnings this year. And we'll get more precise feedback on the impact of both West Henderson and the Washington D.C. facility when we give our 2025 guidance early next year."
},
{
"speaker": "Ryan Langston",
"content": "Thanks."
},
{
"speaker": "Operator",
"content": "Okay. And I'm showing no further questions. I would now like to turn the conference back to Steve Filton for closing remarks."
},
{
"speaker": "Steve Filton",
"content": "We would just like to thank everybody for their time this morning and look forward to speaking with everybody again next quarter. Thank you."
},
{
"speaker": "Operator",
"content": "And this concludes today's conference call. Thank you for your participation. You may now disconnect."
}
] |
uhs | 2,024 | 1 | [
{
"speaker": "Operator",
"content": "Good day, and thank you for standing by. Welcome to the Universal Health Services First Quarter 2024 Earnings Conference Call. [Operator Instructions]"
},
{
"speaker": "",
"content": "Please be advised that today's conference is being recorded. I'd now like to hand the conference over to your first speaker today, Steve Filton, Executive Vice President and Chief Financial Officer. Please go ahead."
},
{
"speaker": "Steve Filton",
"content": "Thank you, and good morning. Marc Miller is also joining us this morning. We welcome you to this review of Universal Health Services results for the first quarter ended March 31, 2024. During this conference call, we will be using words such as believes, expects, anticipates, estimates and similar words that represent forecasts, projections and forward-looking statements. For anyone not familiar with the risks and uncertainties inherent in these forward-looking statements, I recommend a careful reading of the section on Risk Factors and forward-looking statements and risk factors in our Form 10-K for the year ended December 31, 2023. We'd like to highlight just a couple of developments and business trends before opening the call up to questions."
},
{
"speaker": "",
"content": "As discussed in our press release last night, the company reported net income attributable to UHS per diluted share of $3.82 for the first quarter of 2024. After adjusting for the impact of the items reflected on the supplemental schedule, as included with the press release, our adjusted net income attributable to UHS per diluted share was $3.70 for the quarter ended March 31, 2024."
},
{
"speaker": "",
"content": "Our acute hospitals continue to experience strong demand for their services in the first quarter with adjusted admissions increasing 4.5% year-over-year on a same facility basis. When combined with the net revenue per adjusted admission increase of 4.6%, our acute care services net revenues increased by 9.6% during the first quarter of 2024, as compared to the first quarter of 2023. Despite these increases, we believe that both volumes and acuity in March were adversely impacted by the timing of Easter and spring break which occurred in March of this year compared to April of last year."
},
{
"speaker": "",
"content": "In connection with the previously disclosed newly implemented Medicaid supplemental reimbursement program in Nevada, our acute care hospitals located in the state recorded approximately $38 million of aggregate incremental income during the first quarter of 2024."
},
{
"speaker": "",
"content": "Meanwhile, premium pay in the quarter was $68 million as compared to $86 million in the first quarter of 2023. During the first quarter of 2024, same-facility net revenues in our Behavioral Health Hospitals increased by 10.4%, driven primarily by an 8.2% increase in revenue per adjusted day. Adjusted patient day growth in the quarter was 2.0% over the prior year quarter. We believe the patient day volume was muted somewhat by the aforementioned calendar timing issues."
},
{
"speaker": "",
"content": "Our cash generated from operating activities increased by $106 million to $396 million during the first quarter of 2024 as compared to $291 million during the same quarter in 2023. In the first quarter of 2024, we spent $209 million on capital expenditures and acquired 700,000 of our own shares at a cost of approximately $125 million. Since January 1, 2019, we have repurchased almost 27 million shares, representing 30% of our shares outstanding as of that date."
},
{
"speaker": "",
"content": "As of March 31, 2024, we had $733 million of aggregate available borrowing capacity pursuant to our $1.2 billion revolving credit facility. I will now turn the call over to Marc Miller, President and CEO, for closing comments."
},
{
"speaker": "Marc Miller",
"content": "Thanks, Steve. In our year-end conference call, we said we envisioned 2024 as a year of continued strength in both of our business segments. And during the first quarter of 2024, both segments increased their operating margins when compared to the comparable quarter of 2023. We anticipated that acute care volumes would likely moderate to a degree, but remain robust compared to historical levels. We also believe the acuity trends will continue their recovery trajectory."
},
{
"speaker": "",
"content": "In our Behavioral Health segment, we anticipated that patient day volumes would gradually improve over the course of the year, returning to a more historically normal level of growth in the 3% range. We noted that both of our business segments have experienced a significant increase in Medicaid supplemental payments which are helping to compensate for several years of inadequate reimbursement levels that have failed to keep up with the costs we had to incur to properly care for our patients. Overall, we're pleased with first quarter results. We are now happy to answer questions at this time."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Our first question comes from the line of Justin Lake of Wolfe Research."
},
{
"speaker": "Justin Lake",
"content": "First question on your acute care volumes in the quarter. Just to your point, Steve, I think it's pretty clear the calendar had some impacts, January, February stronger, March weaker. So I'm curious if you can maybe share with us what you were seeing monthly or maybe kind of Jan, Feb versus March. And then how does April kind of starting to look versus March? Are you seeing it kind of back to January, February levels or somewhere in between?"
},
{
"speaker": "",
"content": "And then secondly, we know you've got a bunch of Medicaid dollars in Nevada, curious what ran through the behavioral business in the quarter. For instance, Mississippi, I think, had at a program that was put in, can you give us some color on the impact of those Medicaid provider tax dollars and behavioral? That would be helpful as well."
},
{
"speaker": "Steve Filton",
"content": "Okay, I'll try and tackle a bunch of different issues there. Yes, so definitely acute care volumes and behavioral volumes softened in March, I think, as a result of the Easter spring break timing. We're seeing some recovery in April, I would say April is probably volume-wise somewhere in between the January, February run rate and the March run rates. And I think that's what we would expect. I mean, the shortfall in admission and elective activity and surgical activity that we saw in March, I think we would largely expect to make up not necessarily completely in April, but mostly through the second quarter. And it seems like we're on track to do that."
},
{
"speaker": "",
"content": "As far as the Medicaid dollars, the one thing I would point out is we probably had in the quarter on the behavioral side, maybe $10 million to $15 million of out-of-period behavioral dollars that is we're catching up, mostly from 2023 as programs sort of refine their calculations, et cetera. So I think that's the major point in terms of the activity. Obviously, we disclosed in our at 10-Ks and 10-Q a great deal of detail about these Medicaid supplemental payments. And we'll update that disclosure in the 10-Q that we'll file in a week or so. Operator, we can get the next question."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Ann Hynes of Mizuho Securities."
},
{
"speaker": "Ann Hynes",
"content": "So obviously, you beat consensus EPS and EBITDA meaningfully. Can you tell us what you beat versus your internal expectations? Is my first question."
},
{
"speaker": "",
"content": "And my second question is, inpatient grew higher than outpatient in the quarter. Could you let us know how much is from the 2-Midnight Rule?"
},
{
"speaker": "Steve Filton",
"content": "Thanks, Ann. Yes, I mean, our internal budget for the quarter was not far off from consensus. I think maybe it was a little bit higher than consensus, so maybe 2 or 3 percentage points higher than consensus. But obviously, it was a successful quarter, both in terms of the third-party expectations as well as our own. As far as the 2-Midnight Rule and the impact on inpatient acute volumes, as best as we can tell, it did not have -- and I think the question is, is there a change in payer behavior that's resulting in a measurably increased amount of inpatient activity versus observation and our own data as well as we use a third party to help us adjudicate a lot of these [Indiscernible] call them claims that are on the bubble of being inpatient or observation. We use a third party to help us with that."
},
{
"speaker": "",
"content": "And I think both our internal resources and our third-party consultants tell us that they're not seeing a significant or measurable change in the behavior of our payers that's really impacting our inpatient activity. So I would say that in our minds, most of the growth in acute care volumes in the quarter is exclusive of any change in payer behavior."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Stephen Baxter of Wells Fargo."
},
{
"speaker": "Stephen Baxter",
"content": "Two kind of quick ones, I guess. So first, the behavioral patient day, volume growth improvement that you're expecting throughout the year, I guess, just give us a little bit of color on leading indicators or potentially capacity opening up, I guess, like what is giving you the confidence to kind of point to that from here."
},
{
"speaker": "",
"content": "And then secondarily, you obviously had this disclosure of a jury award during the quarter. I know that you discussed some measure of potential protection from insurance related to this. First, could you update us on where you stand from an insurance perspective related to that specific award? And any general comments you might offer about the litigation environment."
},
{
"speaker": "Steve Filton",
"content": "So in terms of your first question about behavioral patient days and behavioral patient day growth, I think as you alluded to in your question, it improved slightly from the pace of the last few quarters, our expectation is that it will continue to improve during the year. Incrementally, I think Marc mentioned that our underlying guidance for the year assumes we'll get to like a 3% patient day growth level. What gives us that confidence is simply that, as we've said, many times over the last several years as we believe the underlying demand is there."
},
{
"speaker": "",
"content": "That's evident in the amount and volume of inbound inquiries we get on the Internet and our 800 numbers, et cetera. And it's really about our ability to staff sufficiently to be able to treat that volume. We've mentioned a few other I think dynamics that have muted that volume a little bit in the last few quarters, including some specific residential treatment facilities that we believe continue to improve including the impact of Medicaid disenrollment, which I think we think is stabilizing, et cetera. So I think it's all those factors together that give us the confidence that behavioral volume will continue to grow incrementally throughout the year."
},
{
"speaker": "",
"content": "Your second question was around the verdict in a malpractice case in Illinois that we disclosed in an 8-K a few weeks ago. That verdict was as we noted in the 8-K, unprecedented, it was unprecedented, both in terms of our own history and cases with similar fact patterns, it was unprecedented in terms of verdicts in that specific jurisdiction, et cetera. And so we think there still is a great deal of uncertainty around how that specific verdict will be ultimately adjudicated and as a result, other than the disclosure that we had in the 8-K and in the press release, we'll have in our 10-Q, we haven't really had any measurable impact on our financial statements until there is some level of greater certainty around what the ultimate outcome will be."
},
{
"speaker": "",
"content": "From an insurance perspective, we disclosed in our Qs and Ks, our insurance coverage by year. This is a 2020 incident, we disclosed that we had $250 million of commercial insurance for that year. The bulk of that insurance around $225 million is still available for coverage."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Pito Chickering of Deutsche Bank."
},
{
"speaker": "Pito Chickering",
"content": "Can you talk about the acute OpEx changes that you saw in this quarter? How much did [Indiscernible] increased year-over-year? And is this the right level going forward and any other pressure points [Indiscernible] should be thinking about?"
},
{
"speaker": "Steve Filton",
"content": "Yes. So I think, Pito, especially on the acute side, the increase in other operating costs are primarily driven by physician expense which we said for the year would increase by about 5% or 6%, and we believe that will still be the case. But because physician expense continue to increase every quarter last year, and we believe will be relatively flat this year, meaning flat quarter-to-quarter, the increase over last year will diminish as we get to the end of the year."
},
{
"speaker": "",
"content": "And again, I think we're on target to get to that sort of 5% or 6% growth over the prior year. But in Q1, that growth was more like 12% or 13%. And then the other, I think, driver of OpEx increase, particularly in the acute division was increased claims having to do with our insurance subsidiary and that's mostly having to do with increased premiums, the insurance subsidiary, was that sort of a breakeven level for the quarter, which is where we had it budgeted. So nothing unexpected there for our point of view."
},
{
"speaker": "Pito Chickering",
"content": "Okay. And then on -- a follow-up to Justin's question on supplemental payments. I guess for $10 million to $15 million from prior two periods. But looking out into '24 or '25, what states do you think could be expanding or adding sort of new payments that could impact your behavioral throughout the year?"
},
{
"speaker": "Steve Filton",
"content": "Yes. So what I would say is we've often pointed out, and I think there are a couple of analysts on this call who will routinely point out that over the last several years, especially our original forecast of supplemental payments have tended to only increase as the year has gone on as states either implement new programs or refine their existing programs and calculations and I think that's our expectation for this year as well."
},
{
"speaker": "",
"content": "One of the tricky parts about this is I think we tend not to disclose what states they are or what expectations might be until the state really goes public or gets the approvals they required or goes public with their calculations. So we do believe, I think as we said on the last call, and I'll reiterate today, I think we do expect a number of states to implement either new programs or expand existing programs by the end of the year, but we'll give that detail as it becomes more certain in our public filings."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of A.J. Rice of UBS."
},
{
"speaker": "Albert Rice",
"content": "Obviously, with the strong revenue number, that gives you leverage down the income statement. But I wondered if you look at labor, both permanent and your premium labor. Can you give us a little sense of what the underlying trends are year-to-year wage increases, how it's working out with your premium labor outlay and then similarly, I'll ask on the first second question. Pricing was strong in the quarter. Obviously, that was helped on the acute side by the supplemental payments, any updated thoughts on where commercial rate increases are coming out and the extent to which you think exchange-related coverage as people maybe pick up exchange coverage versus Medicaid is impacting what you're seeing there?"
},
{
"speaker": "Steve Filton",
"content": "Yes. So again, a few different issues here. I'll try and address them discretely. Yes, I mean I think clearly, what the income statement reflects as you alluded to, A.J., is more operating leverage and efficiency on the labor line. I think it's a result of a few different things, premium and pay."
},
{
"speaker": "",
"content": "As I said in my opening comments, is down roughly $20 million from the same quarter last year. I think we're seeing wage rate inflation decelerate from the peak levels that it was running at the height of the pandemic. I think that's helping. I also think we've made a number of productivity adjustments in both business segments over the course of the last 6 months. As we came out of the pandemic, I think we reevaluated our productivity in both segments, particularly in our nonclinical areas, some of which I think maybe grew ahead of the actual need for those resources during the pandemic."
},
{
"speaker": "",
"content": "As far as pricing goes, we continue to get, I think, reasonable price increases in our contractual rates. I think the bigger issue, quite frankly, on the acute side, especially, is more this issue of as the managed care companies see their margins under pressure, we have tended in the past to see greater levels of denial activity, patient status changes, et cetera. We saw a lot of that in 2023. I think that activity has stabilized some in the fourth quarter and in the first quarter of this year, but it's something that we're watching very carefully. We are seeing, I think, as a result of Medicaid disenrollments, more patients moving to exchange coverage. I think that tends to be a net positive on the acute side because I think exchange coverage reimbursement tends to be slightly better than Medicaid or in some cases measurably better."
},
{
"speaker": "",
"content": "On the behavioral side, I think it's a bit of a toss-up because a lot of these exchange coverages have pretty significant co-pays and deductibles. And given the fact that behavioral care on an absolute basis tends to have a much smaller bill. I think we find that patients who have exchange coverage often will not be able to cover their or the bill will not cover their co-pays and deductibles."
},
{
"speaker": "",
"content": "So sometimes, that switch from Medicaid to an exchange coverage is not a favorable development on the on the behavioral side, and May, I think, contribute a little bit to the slower growth in patient pay volumes on the behavioral side."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Ben Hendrix of RBC Capital Markets."
},
{
"speaker": "Benjamin Hendrix",
"content": "Just a quick follow-up on the Illinois litigation. I appreciate that this is unprecedented and different, in fact, and jurisdiction from Acadia settlement, but that was also kind of equally unprecedented. I was just wondering if this is changing at all your approach to the RTC business, your strategy, capital allocation and how you expect to kind of grow in your approach to behavioral health over the long term?"
},
{
"speaker": "Steve Filton",
"content": "No, I think it would be premature, then. Again, as I commented earlier, I think that there still is a great deal of uncertainty surrounding this particular case and verdict that we had. I'm certainly not an expert and wouldn't comment in any great detail on the case that Acadia had other than to comment that it was a different state, it was the case with multiple plaintiffs. There were multiple cases. Our case was in a different jurisdiction, a single [Indiscernible] of a single incident, et cetera."
},
{
"speaker": "",
"content": "So yes, I think broadly in response to your question, no, I don't think our approach to the business is being changed at the moment as a result of this verdict. We are very focused on the things we need to do to work through this verdict and to challenge it and appeal it if necessary, at several different levels of the judicial system. But at the moment, I don't think it's having an impact on the way we think about the business."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Kevin Fischbeck of Bank of America."
},
{
"speaker": "Kevin Fischbeck",
"content": "I was wondering if you can talk a little bit about margins. I guess both segments saw some nice margin improvement in the quarter. You've talked about a significant margin opportunity in both segments of time. Just want to get a little more color update about how you think about build to an opportunity for margins, the pace of that margin improvement? And it does feel like -- and I don't know if this was in your original assumption, but it does feel like the supplemental payments are coming in maybe better than one might have thought a year or 2 ago. So I want to get your thoughts about how that might impact your view on where margins ultimately can be?"
},
{
"speaker": "",
"content": "And then I guess if you think about where we are versus where it could be, what are the main levers in each segment to kind of get from here to there."
},
{
"speaker": "Steve Filton",
"content": "Yes. So Kevin, we have said for some time that we felt like the margin deterioration that we saw during the pandemic could and would largely be recovered in both business segments as we return to sort of more normal levels of growth, and I think you specifically have pointed out that acute care volumes broadly, not just ours, still haven't necessarily returned to prepandemic levels. So we still think there is a decent amount of runway there for continued acute care volume growth as well as behavioral volume growth, which I addressed in a previous question."
},
{
"speaker": "",
"content": "I think the benefit there is that we continue to have this strong revenue performance. I do think expenses are being better controlled, both by us in terms of our own in actions and things that we control, productivity, et cetera, but I also think broadly, wage inflation is becoming more manageable. Physician expense, which was a huge drag of the increase in physician expense in '23, I think it's not going to be a drag for the full year of '24. And so I think that's -- all those are opportunities for margin improvement."
},
{
"speaker": "",
"content": "Obviously, as your question suggests, the increase in Medicaid supplemental payments are a significant opportunity as well. I think as Marc's comments reflected in our prepared remarks, we largely feel that those increased Medicaid reimbursements are making up for an adequate reimbursement over the last several years, but if you put it in the context of margin improvement, they should be very helpful because at least at the current moment, there's not new or incremental expense associated with most of those Medicaid supplemental payments. So it's a big help in recovering those margins that deteriorated over the past few years because they were inadequately reimbursing us for our cost increases."
},
{
"speaker": "",
"content": "We'll see, I mean, obviously, the first quarter was a significant improvement, as I alluded to in an earlier question, over our expectations. We'll see how the rest of the year plays out. But hopefully, we'll recover more of that margin deterioration than we originally anticipated in our guidance, but we'll see how the rest of the year plays out before making that judgment."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Jason Cassorla of Citi."
},
{
"speaker": "Jason Cassorla",
"content": "I wanted to follow up on the supplemental payments and the acceleration there. Clearly, you guys are benefiting. But I guess your local market competitors [Indiscernible] benefiting as well. So I guess I'm just curious if you're seeing any changes from a competitive standpoint either competitors accelerating build-out of the outpatient or anything along those lines?"
},
{
"speaker": "",
"content": "And then if I could follow up quickly just on the Illinois litigation. I know there's a number of unknowns there on how that could play out. But does that change how you're thinking from a share repo argument or capital deployment in the near term as you wait to see how that all evolves. Any help there would be great."
},
{
"speaker": "Steve Filton",
"content": "Yes. So in terms of your first question, Jason, I don't know that in any of our markets, we've detected or recognized a significant change in our competitive behavior as a result of the increase in supplemental payments. I'll make the point that, obviously, the supplemental payments tend to benefit as they're intended to providers who are providing more service to Medicaid patients have higher Medicaid utilization. I think that's why we struggled a little bit more during the pandemic. I think we tend to have a slightly higher Medicaid utilization than some of our public peers. So I think we're benefiting from that now. But in terms of our local market now, I don't know that, again, the Medicaid supplemental payments are specifically affecting competitive behavior."
},
{
"speaker": "",
"content": "Just like I don't know that it's specifically affecting our strategic sort of moves or actions in a specific market. As far as the Illinois impact on capital deployment or specifically share repurchase, I'll sort of reiterate the same comment that I made before. I think it's too early for us to really make any sort of -- or have any sort of specific reaction until we see a further diminution of the uncertainty surrounding how this verdict and case will ultimately be adjudicated. At some point, it could have an impact but I think at the moment, we're waiting at a minimum until we at least see the outcome from post-trial motions at the trial judge and trial court level. And so at a minimum, I think we'll wait and see what happens there before deciding what our next steps are."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Whit Mayo of Leerink Partners."
},
{
"speaker": "Benjamin Mayo",
"content": "Steve, maybe just comment on the Medicaid rule that was released this week on state-based programs. Maybe too early to have much insight, but it seems like some positives and some less positive things. Just curious how your team and legal advisers are looking at this."
},
{
"speaker": "Steve Filton",
"content": "Yes. So I mean we were encouraged with the fact that in this rule, Medicaid did not place a cap on these supplemental programs. Instead, they focused -- as they have in the past, I don't think this was a new focus there, but they focused on these hold harmless agreements, which they have historically objected to. I'm certainly not an expert -- a legal expert in this regard. But I do know that we've certainly used legal experts and consultants and are aware of consultants who will adamantly argue that CMS just is wrong on this particular issue and on the legality of these hold harmless arrangements."
},
{
"speaker": "",
"content": "But regardless of -- so I think there's a chance that CMS' objection to these hold harmless agreements might be successfully challenged legally over the course of the next several years. In any event, I think it was encouraging that CMS said that they were not going to essentially go after or enforce any actions against these hold harmless agreements until 2028, which I think means that if states are convinced that these arrangements are not going to withstand sort of legal scrutiny, they have time to change them. So I would make the point, we did a quick analysis and think that maybe about 1/3 of the supplemental payments we currently receive are under these hold harmless agreements that CMS has objected to. But 2/3 are not. And we think, again, that CMS has left the stage plenty of time to restructure their arrangements if they're convinced of these hold harmless agreements will not hold up under legal scrutiny. So I think generally, we found that all to be pretty encouraging in terms of the flexibility the states will have and the time they'll have to respond to this new rule."
},
{
"speaker": "Benjamin Mayo",
"content": "That's helpful. And just one other quick one. Just thinking about the opening of West Henderson later this year. Is that still a good timetable and maybe the P&L consideration, start-up losses, and I'm kind of curious how you think about how the volume may get redistributed in the market once that hospital opens."
},
{
"speaker": "Steve Filton",
"content": "So West Henderson is scheduled to open late in the year, maybe in late November, December. So it shouldn't have much of an impact, there will be some level of preopening costs and then a month or 2 of probably operating losses as it opens. I think we didn't really highlight that in our call a couple of months ago, in part because I think we have a view that continued improvement of our hospital in the [renal market] will largely offset that. And as a consequence, neither was likely to have a material impact on this year's results."
},
{
"speaker": "",
"content": "There's some amount of cannibalization that will take place, meaning we'll take some patients probably from our existing Henderson Hospital. But the real play for West Henderson is significant population growth in that area that we think will allow the hospital to have a very successful opening. Quite frankly, the opening of Henderson at this point, I think, 5 years ago was very successful for the same reasons. And I think we're looking for West Henderson to have a very similar experience when it opens late this year."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Sarah James of Cantor Fitzgerald."
},
{
"speaker": "Sarah James",
"content": "Can you clarify the $5 million sequential uptick in premium pay, was that related to the acute volume strength? Then does your $50 million a quarter of premium pay goal assume a version to normal acute volumes? And how do you think about strategy and time line to get to that $50 million?"
},
{
"speaker": "Steve Filton",
"content": "Yes. So I actually think, Sarah, that the $68 million in premium pay in Q1 is pretty similar to what we've been running the last few quarters. You're right, we have talked kind of about a goal of getting into sort of the mid-50s. But I think what's prevented us from doing that is these really robust acute care volumes. And I'll make the point that the 4.5% adjusted admission increase in Q1 of this year is compared to, I think, in excess of a 10% increase in adjusted admissions last year's first quarter. So you're really talking about, I think, some pretty historically high acute care volume numbers."
},
{
"speaker": "",
"content": "And yes, I think we acknowledge that it will be difficult to get much below the premium pay levels we're currently running at unless acute care volumes moderate. And quite frankly, we'd be perfectly happy if they don't. I think at these levels of acute care -- at this level of acute care volumes, we're relatively satisfied with having to run this level of premium pay."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Joshua Raskin of Nephron Research."
},
{
"speaker": "Joshua Raskin",
"content": "I was wondering if you could give a broader update on CapEx spending and maybe capacity increases in specific areas of focus and then just a quick follow-up on Las Vegas and West Henderson opening. I'm curious if Las Vegas on the acute care side, volumes or demand there running above company average? And maybe just a little bit more color on sort of shorter-term trends there."
},
{
"speaker": "Steve Filton",
"content": "Sure. So I think from a CapEx perspective, Josh, I think we continue to invest on the acute side in those areas where I think acute invasion hospitals really differentiate themselves, meaning emergency room services, emergency room capacity, surgical services, both in and outpatient, and again, for the higher acuity, higher-end services that we don't have as much competition in. But we also continue to invest in outpatient. We have a very successful freestanding emergency department initiative that has been underway for a number of years. I think we'll finish this year with probably 30 freestanding EDs around the country, whereas 5 years ago, I think we didn't have any, and we can also continue to invest in some freestanding surgical services facilities, freestanding imaging centers, et cetera."
},
{
"speaker": "",
"content": "On the behavioral side, it's mostly building more inpatient capacity now that we are at least in many markets and many facilities, more fully staffed, but also in that business, investing in freestanding outpatient developments, telemedicine, addiction treatment, et cetera. So I think, again, in both business segments, the CapEx really runs the gamut of the sort of full service continuum at our facilities and our integrated providers tend to provide in their markets."
},
{
"speaker": "",
"content": "As far as the specific questions about Las Vegas, look, I think one of the comments that we've made over the last several years is that one of the reasons why I think we've been slower to recover those margins that we talked about in the previous question than some of our peers is that some of the geographies around the country that have recovered more quickly from the pandemic, Texas and Florida, most specifically, while we have a presence in those geographies, we tend to have a bigger footprint in places like Nevada, California, the addition of Columbia that have tended to recover more slowly from the pandemic just from a broader economic perspective. But I think in the last couple of quarters, the recovery trajectory in Nevada has definitely accelerated and separate and apart from the Medicaid supplemental program, which obviously is quite helpful in that market or that state. We've seen, I think, fundamental business metrics improve pretty dramatically in the last couple of quarters."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Our next question comes from the line of Andrew Mok of Barclays."
},
{
"speaker": "Andrew Mok",
"content": "I think you commented that the quarter was above your internal expectations. You're expecting behavioral volumes to improve from here, and there's potential upside to initial forecast for supplemental payments. So just putting all those together, any updated thoughts on where you think you sit within the unchanged guidance for the year."
},
{
"speaker": "Steve Filton",
"content": "Sure, Andrew. I mean, clearly, just from a mathematical perspective, the amount that we exceeded our own internal budget and consensus numbers for the first quarter would already put us on the trajectory [indiscernible] towards the high end of our guidance. I think most people know, but I'll just repeat for everybody's sake. We had never revised guidance after the first quarter. It's just something that we don't generally think is a kind of a prudent thing to do. I think if the trends continue, however in Q2, that's certainly a possibility, guidance revision at the end of Q2 if these trends continue. Again, I think the trends that I would specifically highlight were better than we expected in Q1 of our acute care volumes, which I think we thought might moderate a little bit more than they actually did and behavioral pricing, which I think we thought might moderate a little bit more than they did. Obviously, we're pleased that neither did, we're focused on keeping both of those metrics as high as they can be."
},
{
"speaker": "",
"content": "But to me, that's where we'll watch most closely in Q2. If those metrics remain strong and steady in Q2, I think it's much more likely that we'd have a guidance revision at that point in time."
},
{
"speaker": "Andrew Mok",
"content": "Great. And then just a follow-up. I think you commented on intra-quarter in April volumes in the acute segment. Just hoping you could do the same thing in the behavioral segment and maybe comment on trends exiting the quarter to help support the higher growth outlook?"
},
{
"speaker": "Steve Filton",
"content": "Yes. I think I forget if the comments that I made were specifically about the acute segment. But I think the trends more similar in both. I think I commented in some conferences earlier this quarter that the behavioral business got off to a bit of a slow start with some bad weather -- in bad winter weather in states that don't necessarily usually expect bad winter weather in the south central part of the country. But [April volumes] recovered in late January and certainly in February, but I think have the same calendar issues as the acute segment did in March, softer volumes, et cetera, particularly in that child and adolescent population, which tends to really soften when school is out."
},
{
"speaker": "",
"content": "But yes, I mean I think I'd make the same comment. I think we would expect to recover that softness if not in April, but then over the course of the second quarter. And I think Marc alluded to in his prepared comments that our general expectation at the beginning of the year was that behavioral volumes would incrementally improve as the year went on, and that's still our expectation."
},
{
"speaker": "Operator",
"content": "I'm showing no further questions at this time. I would now like to turn it back to Steve Filton for closing remarks."
},
{
"speaker": "Steve Filton",
"content": "We'd just like to thank everybody for their time and look forward to speaking with everybody next quarter."
},
{
"speaker": "Operator",
"content": "Thank you for your participation in today's conference. This concludes the program. You may now disconnect."
}
] |
ulta | 2,024 | 3 | [
{
"speaker": "Operator",
"content": "Good afternoon, and welcome to Ulta Beauty's conference call to discuss results for the Ulta Beauty Third Quarter 2024 Earnings Results. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. We ask that you please limit yourself to one question and then re-enter the queue for any additional questions. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce Ms. Kiley Rawlins, Vice President of Investor Relations. Ms. Rawlins, you may proceed."
},
{
"speaker": "Kiley Rawlins",
"content": "Thank you, Julian. Good afternoon, everyone, and thank you for joining us for a discussion of Ulta Beauty's results for the third quarter of fiscal 2024. Hosting our call today are Dave Kimbell, Chief Executive Officer, and Paula Oyibo, Chief Financial Officer. Kecia Steelman, President and Chief Operating Officer, will join us for the Q&A session. Before we begin, I'd like to remind you of the company's safe harbor language. Many of our remarks today will contain forward-looking statements which speak only as of today, December 5th, 2024. We refer you to our earnings release and SEC filings where you will find a number of factors which could cause actual results to differ materially from these forward-looking statements. We'll begin this afternoon with prepared remarks from Dave and Paula. Following our prepared comments, we'll open the call for questions. As always, the IR team will be available for any follow-up questions after the call. Now, I'd like to turn the call over to Dave. Dave?"
},
{
"speaker": "Dave Kimbell",
"content": "Thank you, Kiley, and good afternoon, everyone. We appreciate your interest in Ulta Beauty. Our team delivered improved performance for this quarter with better-than-expected sales and profitability. For the quarter, net sales increased 1.7% to $2.5 billion and comparable sales increased 0.6%. Diluted EPS increased 1.4% to $5.14 per share. As we shared on our last call, we are navigating a number of headwinds, including the normalization of the US beauty category, a dynamic consumer environment, and elevated competition, particularly in prestige beauty. We are starting to see benefit from actions we are taking to reinforce our market position and improve our performance. And while the headwinds have not abated, we are making progress. In the third quarter, our prestige market share trends improved, resulting in flat market share this quarter based on Circana data for the 13 weeks ended November 2, 2024. The trend was driven primarily by improvements in makeup and hair, and we continue to see strength in fragrance and skin care. Our share performance in Mass Beauty was consistent with the second quarter. Comp growth improved from the second quarter trend, driven by stronger transaction trends across both stores and e-commerce channels. We continued to expand our loyalty program, ending the quarter with 44.4 million active members, 5% more than last year. We continued to convert new members, we reactivated more lapsed members, and we improved existing member retention. Our marketing strategies to support our tent pole events and drive relevance and buzz deliver double digit growth in earned media value and stronger sentiment. And we made progress to optimize our new ERP system and help our teams adapt to new processes, balance inventories across the network, and deliver a better guest experience. Our teams are working hard to strengthen our market position, and I want to thank all of our associates for continuing to deliver great guest experiences while working collaboratively to drive improved performance in a dynamic operating environment. Turning to performance by category. Fragrance was our strongest category, delivering high single-digit comp growth, driven by men's fragrance, gender-neutral fragrances, and new products, including new fall and holiday gift sets. The growth of men's fragrance was fueled primarily by newness from ARMANI and YSL and the appeal of established franchises from Jean Paul Gaultier and Valentino. Consumer interest in gender neutral scents is increasing and our assortment including Billie Eilish and NOYZ, an exclusive fragrance LUSH that's launched this summer, is driving guest engagement. New women's brands Kylie Jenner and Orebella, both exclusive to Ulta Beauty and new women's fragrances from Valentino, YSL, and NEST also contributed to overall category growth. The skincare category delivered mid-single-digit comp growth this quarter, as strong growth in body care was partially offset by a decline in prestige skin care. Mass skin care was flat. The strong performance of body care was driven in large part by newer brand Sol de Janeiro, which continues to engage guests with exciting innovation and exclusivity and Touchland, which introduced compelling newness. In prestige skin care, newness from brands OLEHENRIKSEN, Sacheu, DIME Beauty, and others resonated with guests, while engagement from Naturium, Bubble, and La Roche-Posay delivered growth in the mass skin care category. Comp sales in the makeup category decreased in the low single-digit range driven primarily by softness in mass makeup. Strong growth from recently relaunched Ulta Beauty Collection was offset by certain brands lapping space expansion, strong innovation or social media engagement last year. Prestige makeup was flat. New prestige brands Charlotte Tilbury, ILIA Beauty and DIBS Beauty resonated with guests and compelling product newness combined with in-store investments delivered growth for established brands MAC and Clinique. Promotional events during the quarter including 21 Days of Beauty and Fall Haul performed well, driving growth for several makeup brands, while our engaging Wicked collaboration was well received, highlighted by exclusive brand r.e.m. beauty. Comp sales for the hair care category also decreased in the low single-digit range. Exciting newness from Matrix, [Way] (ph), Divi, and Odele delivered growth for the category, while Redken continued to drive healthy guest engagement with their Hero product lines. In hair tools, new products from Shark Beauty and Dyson resonated with guests. This growth was offset by softness in key brands with expanded distribution and limited newness this year. Our services business delivered low single-digit comp growth, primarily driven by engagement in core services, including color, styling, and hair treatments. Ear piercing and makeup services also performed well. And our salon backbar takeovers, which get stylists an opportunity to introduce brands to guests, continued to drive product attachment, and new guest acquisition for participating brands. We are seeing improvements in our business, and we are focused on strengthening our market position and performance further. In October, we shared our refreshed strategic framework designed to lean into our existing strengths while also driving innovation to meet the evolving needs of beauty enthusiasts. As the beauty destination of a lifetime, we intend to drive profitable growth and market share leadership in beauty and wellness over the longer term through curating the best of all things beauty and wellness for all beauty enthusiasts, fostering authentic empowering human connections that inspire, delight and engage at every touch point, engaging our guests wherever they want to shop by expanding our reach through seamless and immersive omnichannel experiences, and building lifelong loyalty and brand love through member growth and personalization. We are confident our focus on these foundational areas will drive stronger revenue and earnings growth over the long term. And the near term, we are addressing key areas to reinforce our competitive position. Let me share some highlights of the progress made this quarter, starting with our efforts to strengthen our assortment. We are enhancing our brand portfolio to drive category growth. During the third quarter, we launched new makeup brands ILIA Beauty, DIBS Beauty, and RMS Beauty, as well as emerging skincare brand Oak Essentials. Additionally, we expanded our wellness offerings with emerging brands, The Honey Pot and Joylux. Looking ahead, we have an exciting pipeline of brand launches planned for the fourth quarter, including the recently announced prestige skincare brand, TATCHA, celebrated for balancing timeless Japanese botanicals with proven clinical ingredients, XO KHLOE, an exclusive fragrance brand created by Khloe Kardashian, and Apothekary, an emerging wellness brand. In addition to new brands, we launched two exciting exclusive collaborations this quarter. First, as the exclusive beauty retail partner with NBCUniversal Pictures for the movie Wicked, we worked with key brands to develop a limited edition collection of products across multiple price points and categories. The Wicked inspired collection features products from leading brands including r.e.m. beauty by Ariana Grande and Beekman 1802, both of which are exclusive to Ulta Beauty, as well as OPI and Scunci among others. With immersive in-store experiences and engaging displays, Wicked came to life in Ulta Beauty stores through our digital channels and through Ulta Beauty at Target. Second, we launched an exclusive and a disruptive beauty offering of the beloved Mini Brands, which offers miniature versions of popular consumer brands. This first ever Beauty Mini Brands collection includes 68 tiny replicas of best selling products from 13 brands, including e.l.f., NYX, Drybar, and Supergoop!. Both of these unique collaborations are driving strong sales, awareness, traffic, and engagement, especially with Gen Z millennial members. As we discussed at our recent Investor Day, engaging guest experiences drive differentiation, loyalty, and meaningful business value, and we are focused on creating authentic, personalized experiences across all our channels. In Q3 we hosted more than 13,000 in-store events including unique celebrity and brand founder events, multi-branded events, and skin care focused events. We also expanded our salon event, The Workshop, to more stores and invited guests to learn how to create salon-worthy blowouts while receiving customized coaching and personalized recommendations from our talented in-store stylists. We are enhancing our digital experiences to drive traffic and sales. During the quarter, key online activations drove guest engagement, and our expanded sampling program delivered double-digit sales growth. Our digital merchandising strategies, including enhanced search, guided navigation, and enriched product pages drove conversion, and our site optimization efforts are improving the guest experience and delivering stronger conversion trends. Importantly, we continued to drive increased app adoption. In the third quarter, we saw double-digit growth in member engagement with the app, which accounted for about two-thirds of our e-commerce sales in Q3, up about 600 basis points from last year. We continued to introduce new digital experiences and resources to drive discovery and trial. This quarter we enhanced our suite of virtual try-on and AI enabled skin and hair analysis experiences with the launch of GLAMlab 2.0 which includes a new 3D engine to enhance precision and stability, shoppable makeup looks, and a new user interface that includes sharing capabilities. We also launched new digital buying guides that amplify search engine optimization while providing guests with educational content, beauty tips, and product recommendations. To deepen the meaningful connection we have with beauty enthusiasts, we launched UB Community, a welcoming, inclusive, digital forum for guests to connect, learn, empower, and engage learn, empower, and engage in the immersive world of beauty to foster authentic connections. Launched in October, our community amplifies the intersection of beauty, wellness and joy, and our user count is already three times our initial target, confirming the meaningful role Ulta Beauty plays in our members' lives. With more than 44 million active members, Ulta Beauty Rewards is an unmatched strategic asset that provides us with unique consumer insights to drive sales. In Q3, we expanded personalization across digital channels with enhanced product recommendations, replenishment reminders, site experiences and retargeted and social channels. Leaning into targeted life cycle campaigns in both owned and paid channels, we reactivated members with greater efficiency. Additionally, we grew our platinum and diamond member base, leveraging unique incentives like exclusive and early access to key events and brand launches, gifting and personalized offers that drive engagement. Platinum and diamond members shop more frequently and spend more each visit and continue to retain at best-in-class rates. Increasingly, social relevance drives authentic customer connection and brand advocacy, especially in beauty, and we're evolving to position social at the center of our marketing strategies to accelerate browse and earned media value growth. During the third quarter, we leveraged our marketing and social capabilities to lean into emerging trends, amplify key growth brands and activate new trend-focused events. We also engage talent from our UB Collective, our affiliate program, and Ulta Beauties, our new associate ambassador program as well as key brand founders to support key brand launches, exclusive collaborations and tent pole events in new and innovative ways across social channels to drive guest buzz and engagement. Efforts delivered accelerated EMV growth, increased impression and expanded key brand health metrics. We continue to enhance our product capabilities to grow our retail media network, UB Media. We recently partnered with e-commerce tech company, Rocket, to introduce AI non-endemic ads for products and services outside the beauty category, and we are partnering with Roblox, the ultimate virtual universe to create innovative advertising opportunities for our partners. Over the years, our Ultaverse has grown into one of the largest beauty games on Roblox, attracting over 11 million visits. With growing interest from beauty brands to participate in our Ultaverse, we're unlocking new possibilities at the intersection of gaming, innovation and media to bring those brands to life in exciting new ways through our UB Media capabilities. Now leveraging lessons in the second quarter, we continue to evolve and tailor our promotional strategies to reiterate our value offering and drive sales and traffic. We began the quarter with a new hair event showcasing the glossy hair trend, replacing last year's fall Gorgeous Hair event, this event featured a strong promo offer, new and exclusive items from Dyson and a spotlight on gloss and shine products. Especially strong in stores, the new event exceeded our expectations and drove strong results for participating brands. At the end of August, we brought back our beloved 21 Days of Beauty event. New beauty steals, member-only events and bonus offers, combined with robust marketing and social support, 21 Days of Beauty delivered strong growth versus last year's event. We wrapped up the quarter with a successful Fall Haul event, which drove mass engagement and new member acquisition with compelling offers that surprised and delighted guests. In addition to strengthening and evolving our merchandising tent pole events, we optimized our loyalty offers, proactively planning the timing, type and target audience of these offers. As a result, our promotional effectiveness improved from the first half trend. Shifting now to our plans and expectations for holiday. The formal holiday season is in full flight. And while we're encouraged by our performance through Cyber Monday, we have several significant holiday sales weeks still ahead. While consumers continue to spend, our insights suggest that economic concerns are driving a greater focus on value. With our diverse assortment of products and price points, compelling offers and convenient omnichannel touch points, we are well positioned to support our guests as they celebrate the season and our teams are excited, engaged and ready to help them deliver a joyful holiday. Our holiday campaign this year is Find Joy in the Present, a reminder of the joy that comes not only from gifts of beauty, but from the big and small moments that drive authentic emotional connection. With the goal of driving deeper emotional engagement, our campaign is supported with robust integrated activation across media, member marketing, PR and social channels as well as festive experiences in stores and on our digital platforms. We have strategies in place to fortify our competitive positioning and manage through the compressed holiday selling season. We are transforming our channels into a concierge for all things holiday, providing greater value to consumers with real-time beauty solutions, gift guides and tips tailored to our guests' needs and creating fun experiences that drive awareness and make Ulta Beauty the go-to destination for the holidays. Our merchandising team has created an exciting holiday assortment, with a strong focus on newness and exclusives balanced with value-driven holiday kits and core items that make great gifts. Whether guests wants to gift others or treat themselves, we have thoughtfully curated options across every category and budget. Our corporate and supply chain teams have been working hard all year to ensure Ulta Beauty is ready to bring our guests joy this holiday season. And our store teams are ready to bring the holiday to life for our guests, with new in-store events and demonstrations to build guest connection and drive sales and traffic. And with BOPIS, same-day delivery options and new for this holiday, our participation in DoorDash and soon-to-be launched Instacart marketplaces, it's never been easier or more convenient to shop at Ulta Beauty. With our engaging holiday messaging, incredible holiday assortment, knowledgeable associates ready to provide guidance and recommendations, new innovative digital tools and multiple ways to shop, I am confident we are well positioned to deliver another successful holiday season. In summary, I am encouraged by the improving trends we are seeing in the business and optimistic about our holiday plans. We believe the beauty category will remain resilient, and we are confident the actions we are taking to deliver stronger performance combined with our outstanding associates who are committed to offering guests authentic inclusive experiences across all of our touch points will enable us to reinforce our market position and drive long-term profitable growth. Now, before Paula discusses our financial results, I want to share that Monica Arnaudo, Chief Merchandising Officer, has announced her plan to retire from Ulta Beauty in the spring of 2025. Since joining Ulta Beauty in 2017, Monica has built an outstanding team and elevated our assortment in ways that have helped us deliver remarkable sales and market share growth, while furthering our mission to be our guests’ most loved beauty destination. I want to thank Monica for everything she has contributed as a member of our executive team and for the impact she has had on our organization. While we work to identify Monica’s successor, she is fully committed to supporting her team and Ulta Beauty with a successful transition. And now, I will turn the call over to Paula for a discussion of the financial results. Paula?"
},
{
"speaker": "Paula Oyibo",
"content": "Thanks, Dave, and good afternoon, everyone. I want to echo Dave's sentiments and congratulate Monica. Monica has been a trusted leader and steadfast ambassador of our brands, and we are so grateful for all of her contributions. Now turning to our financials. I'll begin with a discussion of our third quarter financial results and then provide more color on our fourth quarter and full year expectations. For the third quarter, we delivered better-than-expected performance across the P&L, reflecting stronger top line growth, continued financial discipline and expense management and favorable shrink trends. Net sales for the quarter increased 1.7%, sales contribution from new stores and a 0.6% increase in comp sales was partially offset by lower other revenue. During the quarter, we opened 28 new stores, closed two stores and remodeled 27 stores. The comp sales increase was driven by a 0.5% increase in transactions and a 0.1% increase in average ticket. Other revenue declined $5 million to $48 million, primarily due to an increase in deferred revenue related to our loyalty program, driven by the expansion of our member engagement efforts, which were partially offset an increase in income from our credit card program. Looking at the cadence of sales throughout the quarter. Comp sales in August decreased slightly primarily due to a shift in timing of our semiannual 21 Days of Beauty event, which resulted in stronger comp performance in September. October trends were positive but softened compared to the previous period. From a channel perspective, our e-commerce channel delivered mid-single-digit sales growth. The sales trend in comp stores improved from the second quarter, decreasing modestly compared to last year. For the quarter, gross margin decreased 20 basis points to 39.7% compared to 39.9% last year. The decline was primarily due to deleverage of fixed costs and lower other revenue, which was partially offset by favorable channel mix due to lower e-commerce shipping costs and lower shrink. Lower revenue growth resulted in deleverage of store and supply chain fixed costs. Additionally, more new store openings and the expansion of our supply chain network pressured these areas. As a percentage of sales, inventory shrink was lower than last year. Our investments in secure fragrance fixtures combined with new inventory management processes and enhanced training for our field teams are helping us control inventory shrink. Year-to-date, shrink as a percentage of sales is roughly flat with last year, and we continue to expect shrink will be flat for the full year. Merchandise margin was flat with lower inventory reserves primarily related to the relaunch of Ulta Beauty Collection, offset by unfavorable brand mix. Moving to expenses. SG&A increased 3.2% to $682 million. Overall, SG&A spend was better than planned again this quarter, primarily due to focused expense management. As a percentage of sales, SG&A increased 40 basis points to 27% compared to 26.6% last year, reflecting lower top line growth, most expenses deleveraged this quarter. In addition, SG&A deleveraged primarily due to higher store payroll and benefits, primarily due to higher average wage rates and higher corporate overhead, primarily due to strategic investments. These pressures were partially offset by lower incentive compensation, reflecting operational performance that was below our internal targets. Depreciation was $67 million for the quarter compared to $61 million last year, primarily due to new store and supply chain investments. Operating profit decreased 2.7% to $318.5 million. As a percentage of sales, operating margin was 12.6% of sales compared to 13.1% of sales last year, and diluted GAAP earnings per share increased 1.4% to $5.14 compared to $5.07 last year. Moving to the balance sheet and our capital allocation priorities. We ended the quarter with $178 million in cash and cash equivalents and $200 million in short-term debt. Similar to third quarter last year, we drew on our revolving credit facility during the quarter to support working capital needs and ongoing capital allocation priorities, including share repurchases and capital expenditures. Total inventory increased 1.9% to $2.4 billion compared to $2.3 billion last year. The increase was primarily due to the impact of 63 net new stores. Year-to-date, through the third quarter, we generated $302 million in operating cash flow. Capital expenditures were $114 million for the quarter, primarily reflecting investments in new and existing stores, IT investments and merchandise fixtures. In the third quarter, we returned $267 million of capital to our shareholders through the repurchase of 731,000 shares. At the end of the quarter, we had $2.9 billion remaining under our $3 billion share repurchase program we announced at our investor meeting in October. Now turning to our outlook. We have refined our sales and EPS guidance for the fiscal -- for fiscal 2024 to reflect our third quarter results, while continuing to take a cautious view of the consumer and operating environment. We expect net sales for the year will be between $11.1 billion and $11.2 billion, with comp sales growth between negative 1% and flat. For the year, we continue to plan to open approximately 60 to 65 net new stores and remodel or relocate 40 to 45 stores. We expect operating margin will be between 12.9% and 13.1% of net sales, with deleverage to come from both gross margin and SG&A, reflecting our top line expectations. Reflecting these assumptions, we now expect diluted EPS for the year will be between $23.20 and $23.75. With one quarter left in the year, I want to share how we are thinking about Q4. While we are encouraged by our third quarter results and our performance quarter-to-date, we also acknowledge that the fourth quarter will likely be impacted by a compressed holiday season, a dynamic operating environment and continued uncertainty around underlying consumer demand. For Q4 modeling purposes, we expect comp sales will decline in the low single-digit range and operating margin will be between 11.6% and 12.4%. One final update. We have updated our capital expenditure expectations for the full year and now expect to spend between $400 million and $425 million in CapEx in fiscal 2024, including approximately $230 million for new stores, remodels and merchandise fixtures, $130 million for supply chain and IT, and about $50 million for store maintenance and others. In closing, we know it will take time to see the full benefits from our efforts, but we remain confident that our go-to-market strategies and investments along with continued operational and financial discipline will enable us to drive stronger sales and value creation over the long term. And now, I'll turn the call back over to our operator to moderate the Q&A session."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Our first question comes from Simeon Siegel, BMO Capital Markets."
},
{
"speaker": "Simeon Siegel",
"content": "Thanks. Hey, everyone. Nice job, and if I forget later, I hope you and your families all have a nice holiday season. Dave, any further color you can share on how you're thinking about the broader competitive and promotional landscape over holiday? And then just Paula, could you quantify any of those gross margin pressure points this quarter, how you're thinking about the next quarter and beyond? And then just does any of today's progress in the full year guide lift impact your initial margin views you had given us in October? Thank you."
},
{
"speaker": "Dave Kimbell",
"content": "Great. Thanks, Simeon, and happy holidays to you as well. I'll start with just the broader competitive and promotional landscape. And Paula, you can pick up on some of the margin specific areas. So for the third quarter, what -- as we -- as I mentioned in the remarks, we continue to see this is an intensely competitive time frame. And we've been managing and discussing that throughout the year. We feel like our actions, the adjustments we made in the third quarter helped us improve our performance, strengthen our performance, but we also recognize we have more work ahead of us. The dynamics in the marketplace continue, particularly in the prestige space, but we're seeing progress. And our unique proposition, the aspects that only Ulta delivers through our assortment, our loyalty program, our points of presence, the experience we deliver have always been key to our business and continue to be core drivers. Promotionally, what we experienced in the third quarter was continued normalization after some reduced promotion coming right out of COVID. So we anticipated that coming into Q3 -- coming into this year. We saw that in Q3. Our promotional rates in Q3 were lower than Q2, but still somewhat higher than last year. But as I mentioned in the remarks, our efforts to adjust our promotional strategy to lean in and amplify our tent-pole events, made our overall efforts more effective leveraging our CRM program and our personalization efforts are driving the business. As we look into the holiday, it is obviously a very promotional time frame, the most promotional time frame. That's certainly true this year. And as we navigate through and share our fourth quarter results, we'll have reflections on the overall dynamics, but we're anticipating continued promotional intensity, but not significantly outside of what we would expect so far this holiday. Paula, do you want to talk about that?"
},
{
"speaker": "Paula Oyibo",
"content": "Sure. Good afternoon, Simeon. Yeah, so we raised our full year operating margin and EPS, reflecting Q3 performance and also ongoing expense discipline. What I would say as we think about kind of Q4, generally for the full year, we continue to expect gross margin deleverage, and when we think about Q4, reflecting the top line expectations in a competitive environment. Gross margin will continue to de-leverage. And really, the trends we've seen all year will continue. So, headwinds are the deleverage we expect to see from a fixed cost perspective, merchandise margin pressure will continue given promotions and category mix. And then our tailwinds, lower transportation costs, which we've been speaking about all year, we'll continue to provide some offsets to that. I would say from an SG&A perspective, we're expecting growth from a full year in the mid-single-digit range. But Q4, expecting that to be in the low single-digit growth range. We still expect or most of our expenses to deleverage on the lower sales. But we'll continue to maintain financial discipline as we have in Q3."
},
{
"speaker": "Simeon Siegel",
"content": "Great. Thanks…"
},
{
"speaker": "Paula Oyibo",
"content": "And I think the second -- okay. Thank you."
},
{
"speaker": "Simeon Siegel",
"content": "No, sorry. Didn’t mean to cut you off."
},
{
"speaker": "Paula Oyibo",
"content": "No, all good. Thank you, Simeon."
},
{
"speaker": "Simeon Siegel",
"content": "Thanks, guys."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Kelly Crago, Citi."
},
{
"speaker": "Kelly Crago",
"content": "Hi, thanks for taking my question. I just wanted to see if you could provide a little bit more context on the prestige makeup line that was flat in the quarter. How was it for the industry overall? And if you could just talk about the innovation pipeline in prestige -- I'm sorry if I said prestige beauty before, I'm talking about prestige makeup. If you could talk about the innovation pipeline there. And then just secondly, any way to kind of quantify the drag you've seen from the competitive pressures specifically with those new points of distribution and sort of where we're at in the timeline for when you expect those headwinds to abate further? Thanks."
},
{
"speaker": "Dave Kimbell",
"content": "Great. Well, thanks, Kelly. Yeah, let's see, starting with prestige makeup, obviously, an important category, our largest category. And I'd start with saying, overall, we're pleased in the third quarter that prestige makeup was flat for the quarter for us, which was improvement from some of the trends. The drivers behind that are our innovation that we continue to launch brands like ILIA coming into our portfolio, strong execution across our key programs like 21 Days of Beauty, which is focused on prestige and make up, of course, is the highlight of that, and real emphasis on some of our core brands like the Clinique and MAC and other strong performing brands that we've been working closely with to ensure we're delivering for our guests and our guests respond well to them. And so we're really -- we've been focused on this category for a long time to strengthen its performance and we're really pleased that it was able -- that we were able to do that. Overall, in the category, we saw the category, the total prestige makeup category a bit more than us in low single-digits. So we saw pressure share, although our share performance, while still pressured, improved from the second quarter. So we're making headway, and we're pleased with that. Overall, on the competitive environment, you asked about competitive openings. As we've been talking about throughout the year, that's certainly a meaningful dynamic as there's been more than 1,000 new points of distribution in prestige beauty that over the last couple of years. And that has been a pressure. I shared in previous discussions that 80% of our stores have experienced at least one competitive opening and more than half have had multiple competitive openings, and that continues to be a dynamic that's going on in the marketplace. Having said that, we're confident in the actions that we're taking. We know we've seen historically new store openings. We're able to absorb the shorter-term hit, but then turn our stores back into positive contributors to our business over the long term. This is a different dynamic given the scale, just the sheer number of new stores opening in a short period of time. But we're confident in our ability to do that. We did see improvements in Q3 that contributed to the stronger performance we had in Q3 in total versus Q2. So we feel like we saw some headway in that. But we're not -- but it's we're still in the midst of it. And so by no means are we claiming that we're through it. We've got more work to do. We're working through the dynamics. And our focus there is continue to do what we do best, lean into our strengths in our stores and online and all of our experiences that activity, those things that I highlighted on earlier are what helped us make progress this quarter and other things that are going to drive us into 2025 as we continue to strengthen our business."
},
{
"speaker": "Kelly Crago",
"content": "Thanks. Best of luck and happy holidays."
},
{
"speaker": "Dave Kimbell",
"content": "Happy holidays."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Korinne Wolfmeyer, Piper Sandler."
},
{
"speaker": "Korinne Wolfmeyer",
"content": "Hey, good afternoon. Thanks for taking the question and congrats on the quarter. I'd like to touch a little bit on the competitiveness on the mass piece of business. I feel like we talked a lot about prestige, but I do want to understand mass, a lot of the broader mass -- larger mass retailers have been talking a little bit more positively about beauty. You've got dollar stores expanding more in beauty. So, how is this impacting the competitive landscape would you say for that piece of the business? And how are you thinking about the mass piece going forward and heading into 2025? Thank you."
},
{
"speaker": "Dave Kimbell",
"content": "Well, yes. Thanks, Korinne. The -- I'll start with saying that beauty is a very attractive category. And so we've talked many times about the fact that anybody in beauty, whether in the mass side, prestige side, luxury is emphasizing the category, investing in the category and that's been going on across all of our competitors. In the mass specific business, yeah, that -- the total mass business continues to perform in that mid-single-digit range for the quarter in total mass. And it's an important category for us. As you know, one of the key differentiators of our business is strength in mass and [mass] (ph) and prestige and luxury. And so we continue to be focused on our mass business and the important role that it plays. So that we're well aware of the dynamics. We have seen mass makeup as a category -- cost of category decelerate. Certainly, there's brands that are stronger, but the total category has been more pressured, but we're seeing strength -- continued strength in mass skin, which is an important business for us. So we're focused on continuing to drive our mass business and make sure we're delivering the assortment that we know our guests love the ability to engage with us across all price points and continue to be confident in our ability to excite them and engage them in our mass business."
},
{
"speaker": "Operator",
"content": "Okay. Thank you. And our next question comes from Anthony Chukumba, Loop Capital Markets."
},
{
"speaker": "Anthony Chukumba",
"content": "Thank you so much for taking my question. Hopefully, you can hear me okay. And I'll just keep it to one question. Obviously, you had a very impressive sequential improvement in your performance. And you've touched on a few different things, but if you had to sort of almost like kind of stack rank what you thought drove the better performance, would it be the more effective promotions? Would it be some of the merchandising changes? Would it be some of the partnerships you talked about, like, with Wicked and I guess, the Mini Brands or whatever. Yeah, if you could just give us -- help us to understand what, from a sequential perspective led to the improvement in performance. Thank you."
},
{
"speaker": "Dave Kimbell",
"content": "Great. Thanks, Anthony. Yeah, I mean, I wouldn't point to one thing. There was not one thing that ever really drives our business. And we talked about coming out of the second quarter. While we're pleased with some aspects of our business, we were clear on areas that we needed to address, and we leaned into several of the key factors. Assortment is always critical. Bringing in newness, some of the brands I highlighted like ILIA into the quarter played an important role. The collaborations that you mentioned also drove excitement and enthusiasm. Assortment is always a key driver and certainly was in the third quarter. Our promotional effectiveness, we had some learnings in the second quarter as we were faced with more pressure sales, how we adapted our promotional environment. We had learnings there that we built from into the third quarter. Leaning in, strengthening our core tent pole events that our guests value from Ulta Beauty, 21 Days of Beauty, our hair brand and Fall Haul as well as smart, purposeful targeted and effective complementary promotions throughout the quarter in a very personalized. So that drove a strong effectiveness. We worked hard throughout the quarter. Our teams across the organization, store teams, for sure supply chain, our IT teams, our digital teams to make sure we were delivering a great experience to improve conversion, and we're pleased that we were able to do that both in store and strong performance online. And that took a holistic effort with making sure we have strong engagement from our store associates and strong execution online. And we also -- the last thing I'd mention is we highlighted in the second quarter, some disruption from some system changes and we made improvements in that space to make sure our products were where they needed to be. So multiple elements contributed. It was a really holistic effort across the organization, and we're pleased. Having said that, we know we've got more work to do. We're -- while we're pleased with the sequential improvement, we are focused on stronger improvement over time as we move both through the holiday period and into 2025 and beyond. So we'll continue to lean into all of those things and the broader strategies that we went through in a lot of detail at our Investor Day in October."
},
{
"speaker": "Anthony Chukumba",
"content": "Very helpful. Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. And our next question comes from Christopher Horvers, JPMorgan Chase & Company."
},
{
"speaker": "Christopher Horvers",
"content": "Thanks, good evening. So I'll throw a quick two-parter in there as well. So the first part is, are you positive quarter-to-date? You mentioned encourage -- and how are you thinking about the balance between the five fewer days but at the same time, have a very substantial gift card business and five fewer days would suggest a strong January follow-through. And then following up on an earlier question, any further thoughts on how you think about '25. You talked about a floor of 11% long-term 12% plus, how did this quarter change that point of view, if at all? Thanks."
},
{
"speaker": "Paula Oyibo",
"content": "Hi, Chris, thanks for the question. What I would say is we won’t necessarily get into the details of specifically comp quarter-to-date. But what I will say is that, our holiday season is off to a solid start and our teams are executing well. We are encouraged by what we're seeing, but we also recognize that we have several important weeks ahead of us in the holiday season, even an operating environment is dynamic. And so that is why we shared that we're expecting Q4 comp sales to decline in the low single-digit range. So that's what we're thinking from a quarter perspective. And I would say, yeah, there is a component of the dynamic environment that is related to how consumers the fewer shopping days and things of that sort that we are obviously contemplating as we think about our expectations for Q4. As we think about 2025, again, still several important weeks left ahead of us, and we're focused on closing -- getting to a holiday strong and closing out the fiscal year strong. And we will provide additional color on 2025 when we provide our guidance in March, consistent with what we typically do. Now that being said, I would say directional color that we provided at our Investor Day remains the same. We expect 2024 and 2025 to be transitional period as we invest to reaccelerate our growth, and we continue to expect to make investments in 2025 that will position us for a stronger long term. but we will make decisions to enable -- to ensure that we're delivering operating margin at least above 11%."
},
{
"speaker": "Christopher Horvers",
"content": "That’s great. Thanks very much."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Kate McShane, Goldman Sachs."
},
{
"speaker": "Emily Ghosh",
"content": "Hi, this is Emily Ghosh, on for Kate. We were wondering on UB Media, how big of a competitive moat do you think it could be, especially considering what it does to help your relationship with vendor partners? And how much is UB Media contributing to the long-term operating margin outlook that you provided at the Investor Day?"
},
{
"speaker": "Dave Kimbell",
"content": "Great. Thanks, Emily. Yes, the -- we think we're very optimistic and excited about the role that UB Media is and will play on our business going forward. As you suggest, we have a real competitive opportunity because of the scale and the breadth of our business, the data that we have, the understanding of beauty engagement and transactions across really all beauty enthusiasts of all ages and all geographies is really unmatched. And so we've worked hard to deliver an experience for our brand partners that adds value and most importantly, adds strong ROI in their media investments and the growth that we've seen in that business reinforces that we're able to do that. We're -- as we did talk about at our Investor Day, continued investment and capabilities. I highlighted a couple of those capabilities on the call earlier today related to roadblocks and other ways that we can further give our brands opportunities. But because of the brand relationships that we have and the role that we play in the category, we are confident that our opportunity to grow this business, continue to grow this business over time will be will be a positive impact on the business. Paula, do you want to talk about the financial impact?"
},
{
"speaker": "Paula Oyibo",
"content": "Sure. What I would say is UB Media, Emily, is contributing positively to gross margin in a way to think about it over time is that it plays in for role for us, and it will help offset some of the merchandise margin pressure. We currently see we have shared as we make certain investments in brand building and other things in 2025 and beyond that would serve to help offset some of those pressures."
},
{
"speaker": "Emily Ghosh",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "And our next question comes from Oliver Chen, TD Cowen."
},
{
"speaker": "Oliver Chen",
"content": "Hi, thanks, David and Kecia. On your thinking longer term, what will it take positive comp in terms of what categories perhaps you see as the biggest opportunities? And was the commentary on October being a bit softer. Was that surprising to you? It sounds like you may continue to expect to see a fair bit of volatility. And Kecia, online half store sales, is it a mid-single-digit leverage occupancy. Anything we should know about that in terms of achieving fixed cost leverage based on the comp? Thank you."
},
{
"speaker": "Dave Kimbell",
"content": "Thank you. Oliver, let's see. So first on long-term growth, what's going to deliver positive comps. I guess I would go back to what we talked about in detail at our Investor Day. We really see a combination of leaning in and reinforcing our established strengths as well as innovating across our entire ecosystem as key contributors to our performance. We talked about four key pillars or platforms assortment, having the best assortment across beauty and wellness experience, delighting our guests in every touch point that we have access, continuing to expand our availability, both with stores, accelerated new store openings as well as strong online expressions and then, of course, loyalty and building brand love. We're really focused on driving innovation across each of those and making sure that we're ready to do that. And what we -- what I talked about in an earlier question, that contributed to the third quarter improvement versus the second quarter. It's the foundation. It's the fundamentals. It's the core things, Oliver, you know about our business having tracked us for a long time. When assortment is stronger and experience is right and our loyalty is working and our touch points are driving both in-store and online, those are the things that will come together. So much -- really all of it, we just shared a couple of months ago, those are the aspects that will drive our business going forward."
},
{
"speaker": "Paula Oyibo",
"content": "Yeah. And, Oliver, this is Paula. Given you asked a question about October and whether or not we were surprised. What I would say is now -- and we thought, Dave mentioned and we talked about the timing and some of our tent pole event. And so that had a role to play in kind of the by period performance in Q3. And then I think you had a question about leverage points, and we don't specifically disclose a specific point, and we've shared in the past one way to think about things is from a rent perspective, expense is around 4%. And so as you think about comp and total growth, maybe think about it in that perspective."
},
{
"speaker": "Oliver Chen",
"content": "Happy holidays. Thanks."
},
{
"speaker": "Dave Kimbell",
"content": "Thanks, Oliver."
},
{
"speaker": "Operator",
"content": "And our next question comes from Krisztina Katai, Deutsche Bank."
},
{
"speaker": "Krisztina Katai",
"content": "Hi, good afternoon. Congrats on a nice quarter. So I just wanted to follow up on your early learnings from your market share reinforcing strategy. It obviously enabled you to maintain flat market share in the third quarter, at least in prestige. Where are you seeing some of the biggest gains in member engagement? I think, Dave, you talked about both platinum and diamond members are up in the program year-over-year. And then just as the competitive opening pressures abate, is it fair to say that maybe the worst is behind us? And is there a timeline for when you think maybe you could return to market share gains? Thank you."
},
{
"speaker": "Dave Kimbell",
"content": "Well, let's see. So, on the -- where we've seen engagement, yeah, you highlighted an important part of our business, which is what we call our lead guest, our Platinum and our Diamond members. And we're pleased that we continue to see strong performance from them, high engagement, high spend, they are obviously our best guest. But we're seeing that across the board, and it's something we've been focused on to continue to grow our business. Our loyalty program in total was up 5% for the quarter, and that was a combination of attracting new members as one of the things we talked about in October was even though we've had a lot of growth in that -- in our loyalty program over time, we still see a lot of opportunity ahead, and we're continuing to attract new members and bring them into our business. And that, of course, is important fuel for future growth. We also had success reactivating lapsed members, a lapsed member is somebody that has a -- is part of the program but hasn't purchased with us for the at least once in the last 12 months. And we have a very focused CRM personalized program going after that group, and we continue to see success with that. And then our retention is strong. There is an intense competitive environment, but our guests continue to demonstrate that they like what Ulta is offering. And so retention remains healthy. And so those things come together. We're seeing it across all ages, all geographies, strength across all types of beauty enthusiasts, which is an important part of our business. Competitively, you asked about the dynamics there. And I continue to say something that we've shared in the past is, it's difficult for us to exactly predict or lay out when we would see us completely moving through this because we've never experienced the scale of this in such a concentrated period of time. Having said that, I'll reiterate something I mentioned earlier, which is we have confidence. We've seen it in the data before new store openings. Our stores are able to recover and return to strong contributors. The data that we see now, stores that have not been impacted by competitive opening continue to perform better and positively, and we saw improved performance in Q3. But I would not take that fully as a, okay, we're through 100% through it, and it's totally behind us. This is a meaningful disruption in the category. We're learning every period. What -- how the dynamics are evolving, but we did make progress in Q3, and it's our focus to continue to do that as we move into 2025."
},
{
"speaker": "Dave Kimbell",
"content": "All right. So with that, thank you all. I will wrap up. Thank you for joining us today. So, I want to close out by thanking our more than 55,000 Ulta Beauty associates working together in our stores, in our distribution centers and across our entire corporate team. I sincerely appreciate their continued focus and commitment to delivering unique and memorable guest experiences across all our channels. So, as we close, I want to wish you all a happy and healthy holiday season. There's still time to get out and shop at Ulta Beauty. So make sure you put that into your holiday shopping plans, and we look forward to speaking to you again when we report results for fiscal 2024 on March 13. Have a great evening. Thank you all."
},
{
"speaker": "Operator",
"content": "Thank you. That does conclude today's teleconference. You may disconnect your lines at this time."
}
] |
ulta | 2,024 | 2 | [
{
"speaker": "Operator",
"content": "Good afternoon, and welcome to Ulta's Beauty's Conference Call to discuss results for the Ulta Beauty Second Quarter 2024 Earnings Results. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce you to Ms. Kiley Rawlins, Vice President of Investor Relations. Ms. Rawlins, please proceed."
},
{
"speaker": "Kiley Rawlins",
"content": "Thanks, Alicia. Good afternoon, everyone, and thank you for joining us for a discussion of Ulta Beauty's results for the second quarter of fiscal 2024. Hosting our call today are Dave Kimbell, Chief Executive Officer; and Paul Oyibo, Chief Financial Officer; Kecia Steelman, President and Chief Operating Officer will join us for the Q&A session. . Before we begin, I'd like to remind you of the company's safe harbor language. The statements contained in this conference call, which are not historical facts, may be deemed to constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Actual future results may differ materially from those projected in such statements due to a number of risks and uncertainties, all of which are described in the company's filings with the SEC. We caution you not to place undue reliance on these forward-looking statements, which speak only as of today, August 29, 2024. We have no obligation to update or revise our forward-looking statements, except as required by law, and you should not expect us to do so. We'll begin this afternoon with prepared remarks from Dave and Paula. Following our prepared comments, we'll open up the call for questions. [Operator Instructions] As always, the IR team will be available for any follow-up questions after the call. And now, I'd like to turn the call over to Dave. Dave?"
},
{
"speaker": "Dave Kimbell",
"content": "Thank you, Kylie, and good afternoon, everyone. We appreciate your interest in Ulta Beauty. For the quarter, net sales increased 0.9% to $2.6 billion and comparable sales decreased 1.2%. Operating profit was 12.9% of sales and diluted EPS was $5.30 per share. Although, we anticipated the headwinds experienced in the first quarter would continue, our results were short of our expectations, driven by a decrease in comp store sales, specifically comp store transactions. E-commerce sales increased as expected. We do not believe these results reflect the strong engagement with our brand, the strength of our operating model, or the performance I know we can deliver over the longer term. Importantly, we are clear about the factors that adversely impacted our store transaction growth in the second quarter, and we have actions underway to address the trends. We attribute the decline in comp store transactions to four factors. First, while the beauty category remains resilient, growth is normalizing after three years of unprecedented gains. Additionally, consumer behavior is starting to shift as consumers increasingly focus on value and become more cautious with their spending. Based on data from Circana, U.S. beauty growth slowed to approximately 3% through the first half of 2024, with prestige beauty experiencing high-single digit growth and mass beauty maintaining low-single digit growth. Second, competitive intensity in the beauty category remains high. As we have shared previously, the strength of the beauty category, combined with an attractive margin profile, has drawn substantial and diverse competition to the category. Today, there are significantly more places to buy beauty, especially prestige beauty, with more than 1,000 new points of distribution opened in the last three years. As a result, our market share continues to be challenged, particularly within prestige beauty. Based on Circana data for the 13 weeks ended August 3, 2024, we maintained our share in Mass Beauty, but lost share in the beauty -- prestige beauty, particularly driven by makeup and hair categories. We know beauty enthusiasts love to shop for beauty, and they love Ulta Beauty and the unique experiences we offer. But they also love engaging in new beauty offerings. As a result, we often see a short-term impact of new distribution points on an existing nearby store, whether it's a competitor opening or a new Ulta Beauty store. What is unique about the current environment is the scale and pace of change. More than 80% of our stores have been impacted by one or more competitive opening in recent years, with more than half impacted by multiple competitive openings. This significant portion of our store fleet is experiencing a prolonged sales impact. Notably, the positive signals we see in our broader business reinforce the appeal of our differentiated model and our confidence that we will mitigate these near-term competitive pressures. Our brand awareness and brand love continue to increase with strong gains across multiple demographics, demonstrating the broad appeal of our unique, All Things Beauty, All In One Place offering. We continue to attract new and lapsed members to our loyalty program, while maintaining strong retention of our existing members. At the end of the second quarter, we had 43.9 million active Ulta Beauty Rewards members, 5% more than last year. Importantly, we continue to experience healthy growth in our platinum and diamond members. Newness continues to resonate with guests and drive growth. Newer brands, including Sol de Janeiro, Charlotte Tilbury, and OLEHENRIKSEN are driving sales, new member acquisition and member reengagement while newness from a variety of existing brands, including Clinique, Way and PEACH & LILY are driving healthy comp growth. Guests continue to engage with our unique in-store services offering, which delivered mid-single digit growth in the quarter. And new stores continue to perform well. During the quarter, we opened 17 stores, including our 1,400 store and their performance was in line with our expectations. Now we've disrupted the beauty category for more than 30 years and we understand how to successfully manage competitive forces. To reinforce our competitive position and drive stronger performance, we are aggressively taking actions across five areas: strengthening our assortment, expanding our social relevance, enhancing our digital experience, leveraging our powerful loyalty program, and evolving our promotional levers. I will discuss each of these areas in detail shortly. Now in addition to these external factors, we experienced unanticipated operational disruption during the quarter, resulting from the completion of our ERP transformation. In March, we began updating key store systems through a thoughtful and controlled implementation plan. And in July, we finished the migration of all of our stores to our new ERP platform. We are pleased to have successfully completed this important phase, but we have experienced some unexpected operational challenges as our teams have adjusted to new capabilities, new processes, and new ways of working associated with the new systems. Specifically, through the transition, our teams were managing portions of our fleet on both the old and new systems, which led to some store inventory allocation disruption. With all of our stores and DCs now operating on the same core systems, we are shifting from implementation to system optimization and are working quickly to help our teams navigate these new ways of working in order to balance inventories across the network and deliver an optimized guest experience. To minimize future disruption, we have identified key legacy processes that are creating friction and implemented proactive monitoring as well as dedicated support to quickly address issues when they arise. I am confident that our new capabilities will support better, more agile decision-making in the future. And I'm grateful for our collective team's hard work and dedication to manage through this critical transformation. The fourth factor impacting our performance this quarter was the effect of incremental promotions, which did not deliver the expected sales lift. As the top line trends softened in late June and July, we executed incremental promotions to drive revenue. These offers drove strong sales and traffic across our digital platforms, but did not deliver the expected incrementality in stores. The increased frequency of offers, combined with the introduction of new offer structures, put pressure on average selling price without activating incremental purchases in stores. We understand why the incremental promotions did not deliver as expected and will apply these learnings as we manage promotional activity in the second half. Turning now to performance by category. Fragrance delivered double-digit growth, driven by strong guest engagement with Mother's Day and exciting newness. Newness from existing brands, including Valentino, YSL, and Burberry as well as new brands, NOYZ, Orebella and Kylie Jenner, all of which are exclusive to Ulta, contributed to the category's growth. Our exciting Mother's Day gift with purchase offers and gift sets fueled strong guest engagement and our unique assortment of gift sets for Father's Day and back-to-school also delivered growth for the category. The skin care category delivered mid-single digit comp growth this quarter driven by strong growth in Body Care. Sol de Janeiro continues to excite guests, and this quarter, we introduced an exclusive body mist, which is resonating well. Reflecting the appeal of dermatologist recommended brands and favorite La Roche-Posay and new brands, PanOxyl and VANICREAM delivered strong growth. And relevant mass brands, including Bubble and BIOMA continued to engage guests. Overall, prestige skincare was pressured as engaging newness from PEACH & LILY and OLEHENRIKSEN was offset by softness from certain brands impacted by increased distribution or the lapping of strong social media engagement last year. Comp sales in the makeup category decreased mid-single digit range. Among new brands, Charlotte Tilbury, Polite Society, and WYN BEAUTY as well as exclusive newness from Clinique delivered strong growth. This growth was more than offset by sales decreases from existing brands that had newness that did not meet expectations or have experienced increased points of distribution in the market. In Mass makeup, e.l.f., about-face, and Milani delivered strong growth, but this growth was mitigated by planned softness in Ulta Beauty Collection as we prepared for the brand relaunch. Comp sales for the hair care category decreased in the high-single digit range, driven primarily by planned promotional shift. As we shared previously, we incorporated prestige hair care offers in our first quarter semi-annual beauty sale and eliminated our Gorgeous Hair event, which took place in May of last year. In addition, the impact of exciting newness from Wahl, Divi and Odele and strong engagement with Redken was offset by pressure from key brands lapping strong newness last year. As I mentioned at the outset, we are focused on five key areas to reinforce our competitive position. And we are pleased with the progress we've made in many areas and have identified further opportunities to shift our momentum. Starting with our efforts to strengthen our assortment. During the quarter, we continued to enhance our brand portfolio with new engaging brands, including Orebella, Naturium and Naked Sundays while also launching several emerging exclusive prints through our Spark program, including Door, a clean French beauty inspired skincare brand; Magic Molecule, a skincare healing brand; and NOYZ of premium gender-neutral fragrance. We also expanded the key growth driving brands like Sol de Janeiro, MAC, and Kiehl's into additional stores. Looking ahead, we have an exciting pipeline of brand launches planned for the balance of the year, including the recently announced ILIA Beauty, a clean skin centric prestige makeup brand; and DIBS Beauty, a multipurpose easy-to-use makeup brand. In addition to enhancing our assortment with compelling newness, we are focused on building greater awareness and engagement with key exclusive brands, including PEACH & LILY, Polite Society, WYN BEAUTY, and LolaVie, while also collaborating closely with strategic legacy brands to drive stronger growth and profitability. I'm excited to share that we have relaunched Ulta Beauty Collection to inspire beauty discovery, celebrate self-expression, and create a deeper emotional connection with guests. With simplified and good-for-you formulas, the new collection includes refreshed fan favorites as well as new innovations that reflect modern trends across skin care, body care, bath, suncare and cosmetics. Certified with clean ingredients and cruelty free products across the entire assortment, the reimagined collection is positioned at a masstige price point and is designed to make beauty discovery purposeful and accessible for beauty enthusiasts of all ages. While the new assortment has only been available for a few weeks and is still ramping up as we roll out additional SKUs, we are pleased with our early results. Social relevance powers customer connection and loyalty. To accelerate our social relevance and enhance our brand awareness, we have scaled our creator and influencer networks, and we are expanding our culture forward activations to ensure we are at the heart of the social and cultural conversation for beauty. As a result, this quarter, we delivered meaningful growth and earned media value and social sentiment and drove more than 250 million social impressions. During the quarter, we doubled the size of our influencer network to include a double -- a diverse range of influencers across key audience segments to reflect our inclusive audience targeting strategy. We also launched Ulta Beauties, our new associated ambassador program to harness the superpowers of our team and highlight the expertise and passion of our talented associates. As a group, these talented creators developed compelling content in support of our big summer Beauty sale, back-to-school, and the Joy project, which increased our EMV by more than 10% this quarter. Additionally, we launched a new affiliate program, UB Creates to drive traffic and conversion. Last year, we launched the Joy project, a multiyear initiative to make Beauty and the world a more joyful place. In celebration of National Day of Joy, we kicked off the second chapter of our Joy project with the launch of a social movement to spark positivity in the beauty space, partnering with brands, celebrities and creators as well as our own UB collective and UB beauties, our viral complement chain reached more than 260 million people and generated meaningful growth in EMV. To continue to expand our social relevance, we plan to deploy amplification and content strategies in the second half, leading into trend in cultural moments, leveraging our expanded creator network and enhancing brand partner activations. Leveraging new capabilities, we are enhancing our digital experiences to drive traffic and sales. During the quarter, we enhanced search and filtering functionality and make it easier for guests to find what they want quickly. And we streamlined the path to purchase with a new quick add-to-bag feature, making it more convenient for guests to add products to their cart. And to facilitate greater basket building, we introduced new personalized product recommendations and additional upsell placements along the guest purchasing journey. Importantly, we continue to drive increased app adoption through associate engagement, targeted communications, and app-only offers. In the second quarter, member engagement with our app increased 16%. And now our app accounts for about two-thirds of our e-commerce sales, 600 basis points higher than last year. While the app is a vital tool to drive e-commerce sales, the majority of our spend from app users actually incurs in store, making the app another key engagement tool to drive sales per member. As we look forward, we will continue to create and apply new digital features and functionality to give our guests new and more convenient ways to discover, transact and engage with Ulta Beauty. With more than 44 million active members, our loyalty program is a strategic asset that provides us with unique insights across categories, price points and channels and enables us to drive traffic and spend per member. To drive deeper connection and greater awareness, we are amplifying the value of our rewards program through member-only events, social engagement, and marketing activations. In May, we launched Member Love, a member only event of enticing category focused points offers, which delivered healthy member engagement and higher spend per member. And in July, we launched our first member tiered offer to drive traffic, new member acquisition, and member reactivations. In addition to targeted events and communications, we have integrated our rewards program into our digital experience, MAGs and tentpole events to drive engagement and reinforce the value of the program. Looking ahead, we are focused on attracting customer segments to drive new member growth, driving differentiated engagement early in the life cycle to enhance retention, and leveraging our extensive member data to accelerate traffic. Finally, we continue to evolve our promotional strategies to drive traffic and sales. Supported by a robust media strategy, in-store amplification, and engaging social content, we enhanced our big summer Beauty sale event with compelling offers across categories and price points. In addition to driving strong sales, the event delivered growth in new members and member reactivation as well as increased penetration of existing members. And always a fan favorite, we're excited to kick off 21 Days of Beauty with a new look, new beauty steals and unique events for our best members. As the competitive and promotional environment evolves, we will apply the learnings I mentioned earlier and leverage our member insights to execute productive, targeted offers while eliminating less effective promotions and applying new capabilities to create engaging events for our guests. In closing, Ulta Beauty remains a key beauty destination with strong consumer awareness and brand love. And our exceptional teams are committed to offering guests unique inclusive beauty experiences across all of our touch points. We are confident we have identified the factors that impacted our performance in the second quarter and are focused on the right actions to deliver stronger performance. As we turn to the second half of the year, our teams are focused on driving stronger sales and traffic, executing with excellence for our guests, exercising financial discipline as we adapt to a more challenging operating environment, and protecting and cultivating our unique culture, driven by our talented and passionate associates. While it will take time to shift the top line trend, I remain extremely confident in our model and in our ability to execute and win in an increasingly competitive category. And now, I will turn the call over to Paula for a discussion of the financial results and outlook. Paula?"
},
{
"speaker": "Paula Oyibo",
"content": "Thanks, Dave, and good afternoon, everyone. I'll begin with a discussion of our second quarter financial results and then provide more color on our updated outlook. We faced greater-than-expected challenges in the second quarter, resulting in overall financial performance that were below our expectations. Sales growth from comp stores was softer than expected and gross margin was pressured by incremental promotional offers. However, our teams exercised financial discipline, and we took swift actions to mitigate impacts of the top line trend. Net sales for the quarter increased 0.9%, solid new store performance from 49 net new stores and a 12% increase in other revenue, primarily due to an increase in credit card income and growth in royalty income from our target partnership was partially offset by a 1.2% decline in comparable sales. During the quarter, we opened 17 new stores, closed one store, remodeled nine stores and relocated one store. The comp sales decline was driven by a 1.8% decline in transactions, which was partially offset by a 0.6% increase in average ticket. The increase in average ticket reflects growth in average selling price per item, offset by lower average unit per transaction. Looking at the cadence of sales. Net sales trends decelerated as we moved through the quarter, with July being our most challenged period. Comp store sales climbed in the low-single digit rate, primarily driven by a decrease in store transactions. Average ticket also decreased. Our digital channel performance was stronger with e-commerce sales increasing in the low-single digit range. Across digital channels, the sales trends accelerated as we moved through the quarter, with incremental promotional activity driving stronger guest engagement particularly in July. For the quarter, gross margin decreased 100 basis points to 38.3% compared to 39.3% last year. The decline was primarily due to lower merchandise margin and deleverage of store fixed costs, which were partially offset by growth in other revenues and lower shrink. Merchandise margin declined primarily due to increased promotional activity, adverse impact from brand mix and the continued lapping of benefits from price increases last year. While the impact of promotional activity was higher than planned, it was well below 2019 levels. Store fixed costs also delevered driven by lower top line growth and more net new store openings. As a percentage of sales, inventory shrink was lower in the quarter. We completed the rollout of our new fragrance fixtures to all stores and introduced an additional fixture to protect our assortment of popular smaller rollerball fragrances. These investments are having a meaningful impact on fragrance test, and we expect the additional fixtures will support a continuation of the trend. In addition, we continue to increase our ORC focus and have deployed new tools, capabilities and training to our store and field loss prevention teams. Year-to-date, shrink as a percentage of sales is flat with last year, and we continue to expect shrink will be roughly flat for the full year. Moving to expenses. SG&A increased 7.3% to $645 million. Overall, SG&A spend was better than planned again this quarter, primarily due to focused expense management. As a percentage of sales, SG&A increased 160 basis points to 25.3% compared to 23.7% last year. Reflecting lower top line growth, most expenses deleveraged this quarter. In addition, we preserved sales driving expenses, including store labor and marketing, and completed key elements of our transformational agenda this quarter. These pressures were partially offset by lower incentive compensation, reflecting operational performance that was below our internal target. Operating margin was 12.9% of sales compared to 15.5% of sales last year. And diluted GAAP earnings per share was $5.30 compared to $6.02 last year. Moving to the balance sheet and capital allocation priorities. We ended the quarter with $414 million in cash and cash equivalents. Total inventory increased 10.1% to $2 billion compared to $1.8 billion last year. In addition to the impact of 49 net new stores, the increase was primarily due to inventory to support new brands and the opening of our new market fulfillment center in Greer, South Carolina, which opened in the third quarter last year. Year-to-date, through the second quarter, we generated $359 million in operating cash flow. Capital expenditures were $95 million for the quarter, primarily reflecting investments in new and existing stores, IT investments, and merchandise fixtures. Depreciated was $65 million compared to $62 million last year, primarily due to higher depreciation related to new stores and IT investments. In the second quarter, we returned $212 million of capital to our shareholders through the repurchase of 550,000 shares. At the end of the quarter, we had $1.6 billion remaining under our current $2 billion repurchase authorization. Now turning to our outlook. We have taken a more cautious view for the year. We now expect net sales for the year will be between $11 billion and $11.2 billion, with comp sales in the range of down 2% to flat. In addition to reflecting our first half performance, our updated outlook for sales assumes it will take more time for our actions to change the top line trajectory, and that stores impacted by multiple competitive openings will continue to be pressured more than the rest of the fleet. The operating environment remains dynamic, and the low end of our range implies incremental pressure on consumer spending. For the year, we expect operating margin will be between 12.7% and 13% of net sales. Most of the reduction in our expectation for operating margin compared to our previous view is due to the lower top line. But we have also included flexibility to respond to the evolving promotional environment. For the year, we expect gross margin will deleverage 70 basis points to 90 basis points as lower merchandise margin and deleverage of store fixed costs are partially offset by other revenue growth and lower transportation costs. For the year, we expect SG&A expense will increase in the mid-single digit range. We expect many of the trends we experienced in the first half will continue in the second half, with SG&A driving most of the operating margin deleverage. Reflecting these assumptions, we now anticipate diluted EPS will be in the range of $22.60 to $23.50 per share. We continue to expect to generate strong operating cash flow for the year, which will support our planned CapEx investments of $400 million to $450 million and share repurchases of $1 billion. In closing, we are focused on improving performance in the second half, and we believe our newness and go-to-market strategies, along with continued operational and financial discipline will enable us to navigate the dynamic environment and drive improved sales and profit momentum over time. And now, I'll turn the call over to our operator to moderate the Q&A section. Operator?"
},
{
"speaker": "Operator",
"content": "Thank you. We will now be conducting a question-and-answer session. [Operator Instructions] Thank you. Our first question comes from the line of Steven Forbes with Guggenheim Securities. Please proceed with your question."
},
{
"speaker": "Steven Forbes",
"content": "Good evening, Dave, Paula. Dave, I was hoping you could expand on the competitive pressures you noted in the prepared remarks. Any way to help us contextualize the size of this headwind such as year one cannibalization rates, and any early insights on the recovery path? Meaning, what does the recovery for those stores impacted look like? And maybe you can give us an example of some of those earlier stores that were impacted, any time frame to sort of get back to those prior levels pre cannibalization? Thank you."
},
{
"speaker": "Dave Kimbell",
"content": "Great. Thanks for the question, Steve. And yeah, let me just start with saying, we -- of course, we're no strangers to competition. We know how to compete effectively. And this is, as I said in the remarks, a very attractive category that continues to increase in the competitive environment. As it relates to increased points of pressure, what we've shared before is that we have historically seen a short-term impact on new distribution points on our existing store when a competitor opens near one of our stores. What's unique about this time in this environment is the scale and the pace of change, which is it made it difficult for us to fully forecast the cumulative impact. 88% (ph) of our stores have been impacted by one -- at least one store. And as I said in the remarks, more than half of our stores have been impacted by multiple competitive openings, which to give you context of what that means is, if you take a single Ulta Beauty store, two or more competitive stores have opened within that store's trade area, which is unusual for us historically and something that we're navigating through. What we saw during this quarter is that stores that have had multiple competitive openings, which again could happen over the -- at different times over the three years that we've been navigating, as those stores with multiple competitive openings are underperforming those stores with no or limited competitive impact. Stores that have -- the segment of stores that have not had a direct in-market trade area competitive impact delivered positive comps for the quarter, which is another reason that we feel confident in our model, in our business, in our guest engagement. Stores that have just one competitive opening that occurred early in the expansion cycle are performing in line with historical trends, another data point that gives us confidence as we look forward. But we know we're still in the midst of this. Stores have opened aggressively over the last couple of years. These competitive pressures will likely continue into the near term. But the positive signals I highlighted in our broader business, the guest engagement, the impact of newness, the impact of our new stores, the success of our salon business, the loyalty growth, all of those factors suggest to us and give us a lot of confidence that our business continues to have underlying strength in health and we're navigating through this short term. We know it will take time, but we are not sitting still and we're aggressively taking actions across all the things that I highlighted in the prepared remarks."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Mark Altschwager with Baird. Please proceed with your question."
},
{
"speaker": "Amy Teske",
"content": "Hi. Good afternoon. This is Amy Teske on for Mark. With the demand backdrop continuing to be pressured, can you talk more about the actions you were taking within SG&A to limit the amount of deleverage you're seeing in the model? Thank you."
},
{
"speaker": "Kecia Steelman",
"content": "Sure. Thank you. Thank you, Amy. As I mentioned in our prepared remarks, we did deliver better than planned SG&A due to focused and disciplined cost management as we navigated our top line pressures. As we think about the second half, we've planned SG&A expenses to increase in the mid-single digit range for the year, reflecting a more moderated growth in the second half. We continue to exercise financial discipline as we navigate these near-term pressures, while still making sure that we're investing and ensure we're well positioned for success over the long term. But as we look ahead, we're expecting that moderation in SG&A growth because we are completing our transformation, many of our transformational investments are completing. And we will continue to, like I said, exercise financial discipline as we navigate."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Michael Lasser with UBS. Please proceed with your question."
},
{
"speaker": "Michael Lasser",
"content": "Good evening. Thank you so much for taking my question. Given the competitive overlap with all these new points of distribution is not going to go away anytime soon, how long do you expect that it will take to restore the business to positive comps? And since it seems that hitting the promotional lever is not having the intended impact, what is the backup plan or what is the alternative if the actions you are taking don't work to restore positive comps? Thank you."
},
{
"speaker": "Dave Kimbell",
"content": "Thanks, Michael. Yes, it is, as we've discussed, a dynamic and competitive environment that we're navigating through, and I gave you some of those dynamics in my prepared remarks. We are -- and as I said, we remain confident and bullish in the long-term outlook for this business because of all the positives that I've highlighted. We're executing across a number of efforts to drive our business. Here's what I know about our business right now. We are seeing many positive signals that are gaining traction, and we're addressing areas that maybe are not working as well as we had hoped. Assortment is always key. So when we look at key levers, assortment is critical. Newness is working and resonating with our guests, brands like So de Janeiro, Charlotte, OLEHENRIKSEN are driving sales. Our new -- our exclusive brands are playing an important role, and we continue to add brands, Naturium in Q2. And tomorrow, we launch ILIA, an important makeup brand that we're excited to add to our assortment. So continued innovation is a key lever for us that's working, and we'll continue to drive that. I talked about the importance of marketing and social relevance and connecting, deepening brand love. We're pleased with the progress, all-time high of brand love and brand awareness. And we'll continue to drive that because we know that drives connection and awareness and reinforces the role that we play in our guests' lives. Our digital business is critical. And I shared that our digital sales were on expectation, and we're focused on delivering across all of the experiences, you know that we've invested heavily in our digital capabilities over the last couple of years. Earlier this year, we completed our new digital store platform, and that's giving us new ways to delight our guests. And that's working, and we'll be focused on driving that. Loyalty is core to our long-term success. We're pleased with the 5% year-over-year growth, high level of retention, high level of engagement from a best guest, our platinum and diamond guests and a critical part of that business going forward. Services and experience is also driving positive. Promo is an important piece of our business, and I'm glad you highlighted it. As I mentioned in the prepared remarks, some of the incremental offers that we added as our performance decelerated in the second half of the quarter did not have the intended effect in -- particularly in our store channel. Promos, generally though, our tent pole events, I mentioned our big summer Beauty sale. Tomorrow, we launch 21 Days of Beauty. Our big promotional events are working, are attracting new guests, are demonstrating the behaviors. And we continue to amplify and elevate those, and you'll see that come to market with our next one, again, starting tomorrow with 21 Days of Beauty. But we'll take our learnings and promotional impact that we had in the second quarter as we navigate this challenging competitive environment through the second half of the year and continue to focus on the highest return, highest impact promos. So promos are working but we did have some experiences that -- and last thing, I'd just say, if you just step back, Michael, and just think about our business, we feel very confident that we're well positioned to recover. We've got a differentiated business model. And while some elements have been pressured, our model continues to be connected to our guests. And the experiences we offer are unique, enduring. Nobody does what Ulta Beauty does, our guest value, the assortment, the loyalty, the unique services offer, our omnichannel offerings. And I'd say most importantly, the unique experience we deliver to our guests in our stores and online. We allow our guests to discover beauty on their own terms, and we continue to deliver that every day in our stores, and I'm very proud of what our teams are doing. So we're sharpening our differentiated model. We're focused on leaning in on what's working, addressing the dynamics that -- where we have opportunity. And while, as I said, it's going to take a little time to turn back to our custom position of being a share gainer, we are confident we'll get there and our actions are designed to do just that."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Rupesh Parikh with Oppenheimer. Please proceed with your question."
},
{
"speaker": "Rupesh Parikh",
"content": "Good afternoon. Thanks for taking my question. So just going back to unit growth and also target rollout. Just given the more difficult environment right now, like any thoughts on salon unit growth? And as you look at Target, I believe that continues to roll out. Just curious how that's playing out in the current backdrop."
},
{
"speaker": "Dave Kimbell",
"content": "Yes. We -- as far as our own stores, we're pleased with our new store openings. As I mentioned in my prepared remarks, our new stores, despite some of the other dynamics going on, continue to perform well. And we are -- we have opportunities across the country in a variety of different types of markets to continue to fill in, to reach new markets, to reach new consumers. I've shared before in previous calls, the work we're doing with our small format store, that's performing well. So we're going to lean in more there. And so we're confident that again, we will work through these competitive pressures, and we want to make sure we're reaching as many beauty enthusiast in all parts of the country as possible with our new stores. And then our Target partnership is working. I'll let Kecia give a little bit of color, but we're pleased with that partnership, the strategic role that it plays in our member engagement program is still very strong. And we're positive and optimistic about that path."
},
{
"speaker": "Kecia Steelman",
"content": "Yes. In the last quarter, we opened four Ulta Beauty at Target stores. We have 541 total locations through the quarter. We're still on track to hit our 800 stores through our commitment. It's about deepening that guest engagement. It's about driving growth of the new member and the conversion and the reengagement of lapsed members, and we're seeing that. And then I think it's also really key that nearly 4 million guests have linked their Ulta Beauty and their Target circle loyalty programs together. We do see this as another way to just continue to connect with that guest and engage them back into the Ulta Beauty home store."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Kelly Crago with Citi. Please proceed with your question."
},
{
"speaker": "Kelly Crago",
"content": "Hi. Thanks for taking our question. I just wanted to follow up on the promotional levels that you're kind of assuming this year. What gives you the confidence that promo levels can sustain at this lower rate relative to pre-COVID just given the category slowing, the consumers seeking value? And there's been a big step up in the competitive environment. And then just secondly, just curious your thoughts on just the makeup of the product assortment. Any rethinking of how maybe big you are in some of these brands that are distributed -- not over distributed, but have seen the distribution points increase quite a bit, some of these more established brands. Just any thoughts on how you see the brand assortment evolving over the next couple of years. Thanks."
},
{
"speaker": "Dave Kimbell",
"content": "Thanks, Kelly. Yes. On the promotional levers, when we look out over the -- well, when we look through this year and what's ahead of us, promotional activity has increased, as I highlighted. And that does reflect both the normalization of the category and increased competition. And as I shared, we were more promotional in the first half of the year. As we turn to the second half, promotion will play an important role. The second half, driven by holiday is always a more promotional period. Holiday is a different dynamic and is intensely promotional to begin with, has been for years, regardless of the competitive environment. As we're competing not just in beauty, but we're competing for gifting occasions across consumers' baskets. And so we're prepared for that. And we'll -- we continue to take our learnings. As we look back pre-COVID, we continue to believe that the environment, while intense, will remain rational. Our guidance assumes that while higher than last year, we will be below 2019 levels for the year, driven by smart execution, CRM capabilities that we have built aggressively over the years, driving efficiency, leaning into our tent pole events and maximizing those. And so while promotional has played a bigger role, we feel we've got it rightsized as we look into the second half of the year, knowing it's a higher promotional period. As far as assortment and what's ahead, Ulta Beauty has a very unique assortment. All price points across mass and prestige, strength in makeup, haircare, skincare, fragrance, bath, wellness services as well, and we're really proud of that. It's one of the things our guests continue to tell us that they really love about us. And the fact that we deliver that in an omnichannel way, in-store and online. So to your specific question around legacy brands, they play an important role. We're really pleased and proud of our partnership with some of the biggest brands in the world. And we're focused on driving growth with those brands. We have a very unique experience in store with many of these brands that brings education, entertainment, events to our guests. We drive exclusivity with our guests through some of these brands. An example is Black Honey with Clinique that we've launched that's in market right now. And so we'll continue to partner with these brands to bring in new experiences. These brands play an important role because of the trust and engagement that they have, the opportunity to bring new guests in and delight our existing guests. But at the same time, we are focused on finding what's new. It's one of the greatest things about this category is the level of entrepreneurship, newness, innovation, and we will continue to drive that. I've highlighted a few already, a few in the fragrance category, as an example, Orebella, Kylie, NOYZ, all new, all exclusive, all exciting, all performing well. Brands in makeup like WYN and Polite Society, both new, both exclusive and we have many others. So we'll lean into the broad mix. For us, it's all things beauty. And to do that, we need to be winning and leading across all types of brands, and that's what we're focused on going into the future."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Korinne Wolfmeyer with Piper Sandler. Please proceed with your question."
},
{
"speaker": "Korinne Wolfmeyer",
"content": "Hey, good afternoon. Thanks for taking the question. I'd like to hear a little bit more about the operational disruption you referenced with the ERP transition. Can you provide a little bit more color on what exactly happened, how the business was impacted? And what gives you confidence that the issue is cleared out going forward? Thank you."
},
{
"speaker": "Kecia Steelman",
"content": "Yes, Korinne. As Dave mentioned in his earlier comments that we executed by far the most complex element of our multiyear ERP implementation during this quarter, and that was the rollout to our stores. Our teams had to manage dual systems as we phase through the 1,400-plus stores that we have. So that just really added a lot of complexity. It created challenges to our purchasing, our store allocation and our planning processes and systems. And we do see this as a short-term headwind. The great news is that we've completed this challenging phase, so we're through it now. And what I would say what we're doing is that we're really fine-tuning and optimizing the system. And while there's still some investments for continued optimization, we've really built that already into an ERP budget plan, and it's reflected in the current guidance. A change of this magnitude when you're going through DCs and stores, it's really not easy. And adapting takes some time. But we're really grateful to our teams for embracing these transformative changes. And we feel like we're really making progress. And we're confident that we're positioned and ready to have a great holiday season."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Ike Boruchow with Wells Fargo. Please proceed with your question."
},
{
"speaker": "Juliana Duque",
"content": "Hi. Thank you for taking my question. This is Juliana on for Ike. As we head into your Analyst Day in a few weeks, I was just wondering if there's any preliminary update on the long-term algo or the long-term margin target that you can give us? Thank you."
},
{
"speaker": "Kecia Steelman",
"content": "Hi, Juliana. Thank you for the question. And I certainly understand and appreciate the reason for the question, but we are not providing an update on our long-term expectations on the call today. But as you mentioned, we do plan to do so at our Investor Day in October. And at that time, we are very much looking forward to sharing how we're thinking about our future growth, including kind of the growth opportunities ahead in the category, opportunities specifically for us, what investments, if any, it will take to support those. And how that translates into our long-term financial expectations. And so looking forward to that in just about a month or so."
},
{
"speaker": "Juliana Duque",
"content": "Thank you very much."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Michael Baker with D.A. Davidson. Please proceed with your question."
},
{
"speaker": "Michael Baker",
"content": "Okay. Hi. Thanks. I wanted to ask about the pace of the share losses in prestige. So your business seems to have gotten worse based on your comps, but some industry data and competitive data are also seeing a deceleration. So I wonder if you can give us any color on the gap between what you're seeing in your own business and competitors. Are you seeing the share losses actually get worse here, I guess, is the question. Thanks."
},
{
"speaker": "Dave Kimbell",
"content": "Yeah, Michael. Thanks for the question. As you said, yes, the category has, as I highlighted, moderated, really is anticipated through the year after multi-years of growth. As far as our performance, as I said, we maintained mass -- share in mass, but continue to be pressured in prestige. And that's driven in particular by hair and makeup, which are the categories that I've talked about in the past. No, we wouldn't say that it's getting any worse. The dynamics are as they've been for much of the year as it relates to share, it's a reflection of both the monitoring category, continued competitive pressures and then some of the other dynamics that we've highlighted and discussed here today are what contributed to the performance we delivered in the second quarter."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Ashley Helgans with Jefferies. Please proceed with your question."
},
{
"speaker": "Ashley Helgans",
"content": "Hey. Thanks for taking the question. So a question around kind of the increasing competitive environment. Has that changed the ability to get new brands at all? And then when you're adding new brands like ILIA, do you factor in where they're currently distributed? Thanks."
},
{
"speaker": "Dave Kimbell",
"content": "Yeah. No. Great question, Ashley, and thanks for sharing. I'd say big picture, no. I mean, our brand partners are so key to our success and something that I have been so proud of how our team manages our relationships and works as true partners to building our brands. Brands continue to see Ulta Beauty as a leading destination to expand their business, whether they're an existing brand like ILIA or a new brand that's just been created that's looking to reach $44 million of the best beauty enthusiasts across the country. And we're demonstrating that right now. Our brands continue to lean into us. So I've highlighted a few things, rolling established brands through innovation, exclusives on those brands, expansion of those brands and finding new ways. I mentioned expanding Kiehl's, a brand that we've had for a while and finding new ways to reach our guests, expanding that into stores. Brands are excited about that because they see growth. Launching big established brands like ILIA and discovering new and exclusive brands. So we are focused every day on creating an environment that our brands see value with us, and they do. 44 million members, 1,400 stores, a strong and dynamic digital environment and an experience that's unique. Despite the competitive environment nobody does what Ulta Beauty does. And our brands, probably understand that better than others. And that's why we've had such success creating deep relationships and continuing to attract both existing and brand-new to the world brands. And that's something that I see will continue to drive our business going forward."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from the line of Olivia Tong with Raymond James. Please proceed with your question."
},
{
"speaker": "Olivia Tong",
"content": "Great. Thank you. A few questions left. First, how much of the miss relative to your expectations this quarter do you think was a function of the category decelerating versus your own share loss? And then second, why do you think the promos that you did this quarter didn't quite work? And then as you think about the rest of the year, is it you have to deploy more promo or different promo because it looks like from your full year outlook revision that you expect comps to potentially fall another 100 basis points in the second half versus Q2. And just lastly, if you could talk about what you saw towards the end of the quarter into this quarter that influences your guidance. Thank you."
},
{
"speaker": "Dave Kimbell",
"content": "Great. Thanks, Olivia. Let's see. First, on the mix of the drivers. We highlighted four primary elements that we believe impacted our business in the second quarter. And we think each played a role in our sales performance with the competitive pressures continuing to be the largest driver. So as we've talked about here today, continue to focus on the competitive pressure, recognizing the category, while still healthy, has moderated some. So it requires us to continue to elevate our efforts and then addressing some of the internal dynamics around our operational efforts as well as promotional. So all contributed, and we're focused on driving them. For promo specifically, we -- as I've mentioned, what has not -- maybe what did not work as much was not our tent pole events, our core strategic elements, our loyalty events, the key connections that we have. But as I said, we -- our sales moderated throughout the quarter. And as we saw that, call it, in mid-June and into July, on top of some of the efforts we already had, like our big summer Beauty sale and other programs, we layered in incremental promotions. And historically, we've done some of that, and it's worked in different ways. But this time, what we saw was that layering helped in the e-com business, as we highlighted, and did drive traffic and sales on e-com. But added some complexity in store in how that came to life and did not resonate as well. And so when we saw our consumers engaging with them, we created an environment that was not as clear and crisp as we needed it to be. And so we're addressing that going forward. As far as our outlook into the rest of the year and the role of promo as well as other things, we have assessed the impact of the new and existing challenges that we've been talking about here today, and we evaluated a number of scenarios that anticipate a variety of macro consumer changes, competitive category performance, holiday shifts, and a more promotional environment. We've taken all that into account, and that's reflected in our outlook. But I'd say last thing I'd say to all that is, I hope it's clear, we're not standing still. I've highlighted many of the things that we're doing. We're taking action. We're building off successes with newness and other efforts that we have across the business. We do not anticipate having to lean only on promo. That's never what we've had to do. And all of the actions across loyalty, innovation, newness, services, guest experience, digital will come together to drive us and give us confidence in our comp guidance for the second half of the year."
},
{
"speaker": "Kiley Rawlins",
"content": "Operator, I think we have time for one more question."
},
{
"speaker": "Operator",
"content": "All right. Great. Our last question comes from the line of Susan Anderson with Canaccord Genuity. Please proceed with your question."
},
{
"speaker": "Susan Anderson",
"content": "Hi. Good evening. Thanks for fitting me in here. I guess, I was curious, it sounds like most of the competitive pressure is on the prestige side, and it did sound like you maintained that mass share. But are you also seeing any increased competition on the mass side maybe being some of the mass retailers getting more competitive from a promotional standpoint? And then also just really quick on the hair care, was that decline or change there primarily driven by prestige or did you see anything else on the mass side as well? Thanks."
},
{
"speaker": "Dave Kimbell",
"content": "Great. Yes. This is a very competitive category. And so while we're pleased that we maintained share of mass, we know there's competition happening both on the mass and the prestige side. But we haven't seen -- what we haven't seen in mass is the dramatic increase in points of distribution or expanded presence both with physical stores and online. And that's allowed us to continue to drive our experience. And an important aspect is while we talk about our business in mass and prestige, our guest really looks at the whole thing and comes in for both together and buy both together in the same basic from entry-level mass up through masstige, prestige, and luxury. And so we need all things to be clicking to driving traffic and engagement and basket. And so when there's pressure on one part of the business, it impacts our whole store. But our mass business is performing well, and we're confident in our outlook there. As far as the hair dynamics, I mentioned in the remarks, the primary driver. We're pleased with our hair business. It's a critical part of our business. I mentioned our salon is performing well. The hair business primary driver of the performance there was a shift in one of our strategic tent pole events in hair from the second quarter into the first quarter. And that was the primary driver of the lower results in that. But our hair business is important, and we continue to find ways to drive that business going forward."
},
{
"speaker": "Susan Anderson",
"content": "Great. Thanks so much."
},
{
"speaker": "Dave Kimbell",
"content": "Yeah. Thank you. Thank you, Susan, and thank you all again for joining us today. We very much appreciate your interest in Ulta Beauty. And I wanted to take this last moment to thank our more than 55,000 Ulta Beauty associates for their continued focus and commitment to serving our guests. Our teams have managed through significant change over these last three years, and I so appreciate how quickly they've embraced new technology, new processes, new ways of working, always while keeping our guests and each other at the center of everything that we do. So we look forward to speaking to you all again a little sooner than normal after one of our quarterly calls and at our investor event in October. I hope to see you there, and I hope you all have a good evening, and thanks again for joining."
},
{
"speaker": "Operator",
"content": "Thank you. This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation."
}
] |
ulta | 2,024 | 1 | [
{
"speaker": "Operator",
"content": "Good afternoon and welcome to Ulta Beauty's Conference Call to discuss Results for the Ulta Beauty's First Quarter 2024 Earnings Results. At this time, all participants are in a listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce Ms. Kiley Rawlins, Vice President of Investor Relations. Ms. Rawlins, please proceed."
},
{
"speaker": "Kiley Rawlins",
"content": "Thank you, Sherry. Good afternoon, everyone, and thank you for joining us for a discussion of Ulta Beauty's results for the first quarter of fiscal 2024. Hosting our call today are Dave Kimbell, Chief Executive Officer and Paula Oyibo, Chief Financial Officer. Kecia Steelman, President and Chief Operating Officer will join us for the Q&A session. Before we begin, I'd like to remind you of the Company's Safe Harbor language. The statements contained in this conference call, which are not historical facts, may be deemed to constitute forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Actual future results may differ materially from those projected in such statements due to a number of risks and uncertainties, all of which are described in the Company's filings with the SEC. We caution you not to place undue reliance on these forward-looking statements, which speak only as of today, May 30, 2024. We have no obligation to update or revise our forward-looking statements, except as required by law, and you should not expect us to do so. Now, I'll turn the call over to Dave. Dave?"
},
{
"speaker": "Dave Kimbell",
"content": "Thank you, Kylie, and good afternoon, everyone. We appreciate your interest in Ulta Beauty. For the first quarter, net sales increased 3.5% to $2.7 billion and comp sales grew 1.6%. Operating profit was 14.7% of sales and diluted EPS was $6.47 per share. We expected comp growth this quarter would be in the low single-digit range as we lapped strong performance last year. I am proud of how our teams adjusted our go-to-market activity to adapt to a rapidly evolving marketplace, thoughtfully managed expenses across the enterprise and importantly, continued to execute our transformational agenda with excellence. As we look forward to the rest of the year, we believe it is prudent to anticipate a continuation of the dynamic environment we experienced in the first quarter and therefore have adjusted our expectations for the remainder of the year. Paula will give more detail on these revisions later in her prepared comments. Before we talk about the quarter, I want to emphasize a few important points. First, we are confident in our model and our ability to gain share and drive significant sustainable value over the long-term. The actions we have taken and investments we have made over the past few years have fortified our operating foundation and we are a stronger, more profitable company today than we were just a few years ago. And we have an outstanding team that knows how to execute and deliver profitably and they are doing so every day with focus, passion and determination. However, we are not satisfied with our market share trends and we are taking actions to reinforce our leadership position and accelerate growth. For more than 30 years, Ulta Beauty has disrupted the beauty industry by bringing mass brands, prestige brands, luxury brands and services together in an accessible, fun shopping environment. This differentiated strategy, combined with welcoming an inclusive guest experiences, has enabled us to shape consumer expectations and drive profitable growth. Today, we operate nearly 1,400 stores and manage a multibillion dollar digital business, providing guests with unique opportunities to play, discover and try beauty. With warm and authentic experiences, our passionate associates are creating strong emotional connections with our guests and helping them discover beauty on their own terms. We've created a world-class loyalty program that engages with more than 43 million active members and provides us with valuable customer and transaction data, and we've expanded our differentiated assortment and built strong strategic partnership with large and emerging brands around the world. We operate in a healthy, growing category. While growth is moderating as expected after three years of unprecedented expansion and competitive intensity is increasing, we have a powerful operating model, excellent brand partnerships and I believe the impact of our winning culture and outstanding teams will enable us to protect and expand our leadership position. In the first quarter, we've strengthened our market position in several areas. Consumer awareness and brand love for Ulta Beauty continues to increase. Our marketing amplification of key brand launches, elevation of our tentpole events and culturally relevant social activation delivered 4 points of improvement in unaided brand awareness this quarter, driven primarily by key growth cohorts. Trust for our expertise, welcoming guest experiences, a diverse assortment and efforts to increase convenience through multiple touch points drove our brand love metric to record levels with strong gains among both Gen Z and baby boomers, which demonstrates the broad appeal of our model. Newness is resonating with our guests. Recent brand launches, including Sol de Janeiro, Charlotte Tilbury and exclusive brands win by Serena Williams and Kylie Jenner Fragrance, are driving sales, new member acquisition and member reengagement. We delivered traffic growth in both our store and digital channels. We increased marketing investments across TV, audio and social platforms to maximize our brand launches, support our semiannual beauty and Spring Haul tentpole events, and amplify our brand equity with the Joy Project. These strategic media investments drove higher traffic across our web and app platforms and increased traffic growth per store, even as we lapped strong double-digit growth last year. Our world-class loyalty program expanded again this quarter with the retention of our most valuable members remains very strong. We ended the quarter with 43.6 million Ulta Beauty rewards members, 6% higher than last year, primarily driven by member retention. Additionally, we continued to acquire new members and reengage lapsed members. Targeted marketing efforts are elevating more members to our platinum and diamond tiers, and exclusive promotions, point accelerators and personalized contents are driving engagement and retention of these valuable members. Our new store portfolio continues to perform well. During the quarter, we opened 12 stores, seven more than last year, and their performance exceeded our expectations. Our associate retention has improved across stores, distribution centers and our corporate teams, and we are on track to complete critical elements of our transformational agenda this year, giving us a stronger foundation for future growth. Our teams are operating at a high level as we execute these transitions, and it is worth noting that they delivered several significant operational milestones this quarter. First, we successfully completed the final phase of our digital store transition and are on track to decommission the legacy platform in the second quarter. Second, we completed an important phase of Project SOAR with a successful transition of our Dallas, Greenwood and Fresno distribution centers to our new ERP system. Now, all of our primary distribution centers are operating on the same platform. Third, we began the process of migrating stores to our new ERP system and I am pleased to share that we have completed the transition in 30% of our fleet. The benefits include an upgrade of a key digital application to provide our store teams with a guided user experience, enhanced reporting to support inventory management, and increased visibility to product information to elevate the guest experience. Beauty is a competitive category and our success reflects the differentiation we provide in the market and our effectiveness in creating meaningful and enduring guest connections. These strengths have enabled us to outperform the market, especially through the pandemic recovery. According to Circana data, between 2019 and 2023, Ulta Beauty expanded its share of both prestige and mass beauty significantly. More recently, the strength of the beauty category, combined with an attractive margin profile, has drawn significant and diverse competition to the category. Today, there are significantly more places to buy beauty, especially prestige beauty, with more than 1,000 new points of distribution opened in the last two years. Additionally, prestige brands are expanding their online availability as digital penetration grows in the category. As a result, our market share has been more challenged for the last few quarters, particularly within the prestige beauty category. Using the consumer lens of how guests experience Ulta Beauty through all of our touch points, we estimate we maintained our share of the total U.S. beauty product industry this quarter. Based on Circana data for the 13 weeks ended May 5, 2024, we outpaced the growth of the mass market but lost share in prestige beauty, primarily driven by pressure in makeup and hair. This prestige share pressure was concentrated in stores as we increased share in e-com for the quarter. Given our proven ability to engage our guests and lead the industry, I am confident we can reinvigorate market share gains. At our Analyst Day in October, we will share longer term plans to drive share growth, but today I want to highlight actions we are taking now to leverage our traffic growth, increase conversion and accelerate top line growth. Our plans are focused on five key areas; strengthening our assortment, accelerating our social relevance, enhancing our digital experience, leveraging our world class loyalty program and evolving our promotional levers. Starting with our assortment, we are enhancing our assortment with the addition of highly recognized brands as well as emerging and exclusive brands. This year, our brand pipeline includes more than 25 new brands, including many exclusive to Ulta Beauty. Importantly, this year's pipeline includes a balanced mix of category growth driving brands like Sol de Janeiro and Charlotte Tilbury and Naturium and emerging exclusive brands like Wyn, a makeup brand developed by Serena Williams and Orebella, a fragrance brand developed by Bella Hadid. To support stronger growth of our core assortment, we plan to accelerate growth with key exclusive brands including Polite Society, Live Tinted and LolaVie, among others. We plan to expand key growth driving brands into more stores and we are excited to relaunch the Ulta Beauty collection this summer. Additionally, we intend to leverage our marketing and social capabilities to lean into emerging trends, amplify key growth brands and drive relevance and engagement and activate new trend focused events across all our channels. Social media is amplifying and accelerating beauty. Social relevance is the gateway to customer reach, connection and engagement, and relevance drives sales and loyalty. While we have increased our EMV and share voice across key platforms including TikTok and Instagram, we see further opportunity to ensure we are at the heart of the social and cultural conversation for beauty. To accelerate our social relevance, we will scale our creator network, amplify brand networks and collaborations, and use our platforms to showcase our unique assortment. With the completion of our digital store transition, we are increasing our focus on leveraging new capabilities and optimizing the guest experience to accelerate traffic, drive conversion and increase average ticket. We recently expanded our partnership with DoorDash with our launch on DoorDash Marketplace, which extends our unique assortment to the more than 70 million active users of the DoorDash app. We will introduce new digital buying guides that amplify search engine optimization while providing guests with educational content, beauty tips and product recommendations. We will improve the path to purchase through guided navigation and leverage new innovative search capabilities to facilitate discovery and we will accelerate app adoption through targeted communication and offers as app users spend nearly two times more. In the first quarter, our app accounted for 57% of our e-commerce sales, up more than 450 basis points compared to last year. Our loyalty program is a powerful strategic asset and we will lean into this platform to drive greater engagement and support top line growth. Earlier this year, we rebranded the program to Ulta Beauty rewards, enhanced the birthday experience, and launched a refreshed look in stores online and across social. These improvements are driving greater awareness and deepen connections with our members. We have also introduced new mobile POS capabilities to engage existing members and drive new member acquisition, and we are testing new ways for guests to engage with loyalty benefits in store transactions. At the same time, we are leaning in to amplify the value of the program through member love events and social engagement and we are also testing new gamification platforms, creating new ways to engage with our program and Ulta Beauty. And later this year, we will activate new marketing technology that will advance our personalization efforts with our guests. Finally, we continue to enhance our promotional events and strategies. We will evolve our unique tentpole events to drive basket and new member acquisition, increase our use of effective targeted offers while eliminating or shifting less productive offers, and to create new platforms and offers to excite and engage our guests. In closing, we continue to expect the beauty category will grow in the mid-single-digit range this year barring a major economic event. We are confident we have identified the right actions to deliver stronger revenue growth, and our associates are working together as one unified Ulta Beauty team to expand our leadership position and deliver engaging guest experiences across all our touch points. I look forward to sharing our progress with you throughout the year. And now, I will turn the call over to Paula for a discussion of the financial results. Paula?"
},
{
"speaker": "Paula Oyibo",
"content": "Thanks Dave and good afternoon everyone. As Dave shared, our team responded to the dynamic operating environment with focus and financial discipline. As a result, we delivered net income and diluted EPS in line with our internal expectations. We are focused on reinforcing our leadership position and driving stronger performance, and while we believe our efforts will deliver results, we think it is prudent to expect many of the pressures we identified and faced throughout the first quarter may continue for the balance of the year and therefore have revised our annual guidance. I'll begin with a discussion of our first quarter results, followed by comments about our updated full year outlook. Net sales for the quarter increased 3.5%, driven by 1.6% growth in comp sales. The contribution from 36 net new stores opened since the first quarter last year and a $9 million increase in other revenue, primarily due to an increase in credit card income and growth in royalty income from our Target partnership. Comp transactions for the quarter increased 1.3%, driven by traffic growth in stores and on our digital platforms. Average ticket increased 0.3%. Looking at the cadence of sales throughout the quarter, comp sales in February decreased slightly as we lapped strong double digit comps last year. Comp growth accelerated in March, reflecting the impact of our semiannual beauty events and the benefit of the Easter shift. April trends were positive but softened compared to march, primarily reflecting the adverse impact of the Easter shift. From a channel perspective, e-commerce sales increased in the high-single-digit range. Sales from comp stores were flat compared to last year, reflecting the expansion of brick and mortar distribution points and the lapping of strong comp growth last year. Turning to comp sales performance by category, fragrance delivered double digit growth, driven by newness from existing brands and exciting brand launches, including Cosmic from Kylie Jenner, which is exclusive to Ulta Beauty. Additionally, Valentine's Day drove strong growth across both men and women's fragrances. The skincare category delivered mid-single-digit comp growth this quarter, primarily driven by double digit growth in body care and mask skin care, which was partially offset by a decline in prestige skincare. The strong performance of body care was driven primarily by the launch of Sol de Janeiro and the expansion of key emerging brands into additional Ulta Beauty stores. The growth of mass skincare was primarily due to strong engagement with our dermatologist recommended platform as well as the expansion of in-store presentation of select emerging brands. Our prestige business was challenged this quarter, reflecting the impact of increased distribution for key brands, timing shifts of product newness, and the lapping of the impact of strong social media engagement with certain brands last year. Hair care comp sales increased to low single digit range, primarily due to newness in hair tools. The inclusion of prestige hair care in our semiannual beauty event and high engagement with mass hair care products during our Spring Haul event. Makeup comp sales decreased to mid-single-digit range, while new brands and guest engagements with our luxury platform was strong, this growth was more than offset by sales decreases from brands that experienced extraordinary growth last year, units from existing brands that did not meet expectations, and increased points of distribution. In addition, sales of the Ulta Beauty collection were impacted by planned markdowns as we prepared to re-launch the brand this summer. Finally, the strength of our services business continued with high-single-digit comp growth in the quarter, driven by increases in hair treatment, specialty services including ear piercing, brow and makeup, and core salon cut and color services. For the quarter, gross margin decreased 80 basis points to 39.2% compared to 40% last year. This decrease was primarily due to lower merchandise margins and higher inventory shrink, which were partially offset by growth in other revenue. Merchandise margin declined during the quarter primarily due to increased promotions, adverse impact from brand mix and the lapping of benefits from price increases last year. Promotional activity in the quarter was higher than last year reflecting the expansion of our semiannual beauty event and incremental offers to drive traffic. Inventory shrink was higher in the quarter. Our investments in new fixtures and operating processes are reducing shrink in the fragrance category, but this improvement is being offset by higher shrink in other prestige categories. Moving to expenses, SG&A increased 8.8% to $666 million. Overall SG&A spend was better than planned due to disciplined expense management. As a percentage of sales, SG&A increased 120 basis points to 24.4% compared to 23.2% last year. In addition to the impact of lower top line growth, higher corporate overhead, store payroll and benefits and store expenses contributed to the deleverage in the quarter. Corporate overhead expense increased in the quarter primarily due to technology related strategic investments. The increase in store payroll and benefits was driven primarily by higher average wage rates, and the increase in store expenses was primarily due to IT investments and increased testers. Operating margin was 14.7% of sales compared to 16.8% of sales last year. Net interest income for the quarter was $6.9 million compared to $7.3 million last year. Lower average cash balances were partially offset by the benefit of higher average interest rates. The company's tax rate increased to 23.2% compared to 22.8% in the first quarter last year. The higher effective tax rate is primarily due to less benefit from income tax accounting for stock based compensation. For the quarter diluted GAAP earnings per share was $6.47 compared to $6.88 last year. Now moving to the balance sheet and capital allocation, we ended the quarter with $524.6 million in cash and cash equivalents. Total inventory increased 8.8% to $1.9 billion compared to $1.8 billion last year. In addition to the impact of 36 net new stores, the increase was primarily due to the inventory needed to support new brands in our new market fulfillment center in Greer, South Carolina. Capital expenditures were $91 million for the quarter, reflecting investments in merchandise, fixtures, new and existing stores and IT investments. Depreciation was $64.7 million compared to $57.9 million last year, primarily due to higher depreciation related to new stores and IT investments. In the first quarter, we returned $285.1 million of capital to our shareholders through the repurchase of 588,000 shares. At the end of the quarter, we had $1.8 billion remaining under our current $2 billion repurchase authorization. Now, turning to our outlook, we have updated our expectations for the full year to reflect our first quarter performance, the dynamic operating environment and the actions we are taking to draw to drive stronger top line growth. With this in mind, we currently expect net sales to be between $11.5 billion to $11.6 billion, with comp sales growth in the range of 2% to 3%. We continue to expect comp growth to be in the low single digit range in the first half of the year. We expect comp growth to accelerate in the second half of the year to be between 2% and 4%, reflecting the impact of our sales driving initiatives, our newness pipeline and decelerating growth in the second half of last year. We currently expect operating margin to be between 13.7% and 14% of net sales, primarily driven by SG&A deleverage as we protect sales driving investments, including marketing and store labor, complete many of the elements of our transformational agenda and operationalize investments made in 2023. We will also continue to maintain our financial discipline. For the full year we now expect SG&A growth to be in the mid-to-high single digit range, with growth in the low double digit range in the first half of the year and in the low-to-mid-single digit range in the second half of the year. We expect gross margin for the year to be down modestly as lower merchandise margin and deleverage of fixed costs are mostly offset by lower supply chain costs and other revenue growth. For modeling purposes, we anticipate growth margin will deleverage in the first half of the year, primarily driven by lower merchandise margin, deleverage of fixed costs due to lower sales and higher shrink partially offset by growth of other revenue. In the second half of the year we expect growth margin to be flat to up modestly as higher merchandise margin and lower supply chain costs offset deleverage of fixed costs. As a result, we now anticipate diluted EPS to be in the range of $25.20 to $26 per share. We expect diluted EPS to decline in the first half of the year and be flat to up modestly in the second half of the year, including the impact of the extra week in fiscal 2023, which was $181.9 million of net sales and $0.46 of diluted EPS. Finally, we continue to expect to repurchase $1 billion of Ultra Beauty stock this year, reflecting the strength of our cash flow and the confidence we have in our future. And now I'll turn the call back over to Dave. Dave?"
},
{
"speaker": "Dave Kimbell",
"content": "Before we begin the Q&A session, I'd like to recap our perspective on the first quarter and reiterate our confidence in our plans. Love for the Ulta Beauty brand is growing. Our member retention is strong and our teams are laser focused on delivering great guest experiences, while managing through an evolving environment. We are pleased with the progress we are making across key areas of our business and we are taking steps to drive stronger performance through strengthening our assortment, expanding our relevance, enhancing our digital experience, leveraging our world class loyalty program and evolving our promotional levers. We have a strong plan in place to navigate near-term pressures while continuing to invest in support of the long-term opportunity. I am confident in the power of our differentiated business model and our team's ability to execute with excellence against our priorities and deliver value for our shareholders. Ulta Beauty is a force in the beauty industry as we captured a large share of this dynamic category and I am as optimistic as ever about the future of our business. And now I'll turn the call over to our operator to moderate the Q&A session."
},
{
"speaker": "Operator",
"content": "Thank you. [Operator Instructions] Our first question is from Simeon Siegel with BMO Capital Markets. Please proceed."
},
{
"speaker": "Simeon Siegel",
"content": "Thanks. Hey everyone, good afternoon. Dave, I guess maybe following up on that, I was just hoping you could elaborate a little bit more on the guidance change, perhaps to oversimplify it. And I apologize if this is an annoying question, but I guess are you comfortable that you're lowering it deep enough and now work towards the long-term margin rate? Just any help in terms of thinking how you're thinking about your margin target and the underlying opportunity would probably be helpful. Thank you, guys."
},
{
"speaker": "Dave Kimbell",
"content": "Well, thanks, Simeon, for the question. I'll start with some overarching thoughts and then maybe, Paula, you can give some specifics on the operating margin outlook. I'd say broadly, we are confident in our outlook for the year. As we've assessed the landscape in which we're operating, we see the opportunities ahead of us. As I mentioned in the prepared remarks, there are a lot of positives across our business right now as we see strong engagement in our brand growth and brand love and awareness, strength in key parts and aspects of our business traffic continuing to be healthy in stores and online, newness working, new stores performing well. So we are confident in many of the key metrics of our business and then clear about our opportunity to address some of the areas that we've been more pressured. When we look at the comp outlook that we've updated for the year, which is obviously a key part of our overall model, we feel very clear and confident about that revised outlook here. We do see over the -- particularly in the second half of the year, our lap becomes a bit easier and so as we look at on a two-year stack, we feel very comfortable and confident in that. But I'd say more important, we are taking actions, as I described in the prepared remarks, to address where we have some potential to drive our business even more with more newness, strong marketing, enhanced digital capabilities as we take advantage of the new platform that we put in, and of course, leaning heavily on our loyalty program to take full advantage of our relaunch there. So we feel clear about what's ahead of us, confident in our comp. And then as that relates specifically to the margin outlook, Paula, do you want to give some more color on that?"
},
{
"speaker": "Paula Oyibo",
"content": "Sure. Thank you, Dave. Good afternoon, Simeon. What I would say is, as we think about our operating margin guide of 37 to 40 on the comp of 2% to 3%, we've shared that top line performance plays an important role in driving fixed cost leverage for us. And with the comps now below our long-term algo of 3% to 5% comps, we expect less leverage and have adjusted our operating margin expectations accordingly. One thing that I will also share is that in addition to the fixed cost deleverage on lower sales, we've embedded flexibility in our guidance to invest in sales levers like promo, marketing and store labor to strengthen our top line and defend share and so that also gives us confidence in the adjusted comp guide that Dave spoke about."
},
{
"speaker": "Simeon Siegel",
"content": "Great. Thanks a lot. Guys, best of luck for the rest of the year."
},
{
"speaker": "Dave Kimbell",
"content": "Thanks, Simeon."
},
{
"speaker": "Operator",
"content": "Our next question is from Simeon Gutman with Morgan Stanley. Please proceed."
},
{
"speaker": "Simeon Gutman",
"content": "All right, that was a setup. Hi, everyone. So my question, Dave, talking about prestige and the increased shifting to channels, can you share if that's brands that are deciding to sell on different channels or you're just seeing the customer, I guess, moving over themselves and have we absorbed the worst of that? That's the first part. And then this is connected to the question, is it fair to think that merchandise -- is merchandise margins about 200 basis points above where we were around the pre-COVID time, and it feels like you have an appropriate mix now? You kind of see where the business is going in terms of the tradeoff between sales and gross margin, such that we're not going to retest those pre-COVID lows. Thank you."
},
{
"speaker": "Dave Kimbell",
"content": "All right. Well yes, I'll talk about the overall competitive environment and what we're seeing in there, and then Paula can give you some more color on the merch margin and our outlook related to that. So to reiterate, as we look at the competitive environment, what we, as I mentioned in the remarks, this category has always been an attractive, and it's always been very competitive, given the growth potential, the connection it has with consumers, its margin profile. So we've long, for the entire 33-year history of this company, we've been competing in a very competitive environment. What's unique about what’s going on today, is the cumulative impact of the competitive intensity really driven by significant increase in distribution of prestige, both in store and online. And as consumers navigate that broader choice, they're making choices. We're confident in our ability to continue to engage, and that shows up in some of the results I highlighted, but it certainly is an impact. When we look at stores opening near our stores, we talked about this in the past, historically. We do see a short-term hit to a nearby store when a competitor opens up and we're able to recover and those stores comp at our enterprise level. What's unique about right now is the scale of it to have over 1,000 new locations within a short-term period. It's unprecedented in our history and probably in retail more broadly. So it means that we're navigating that and understanding consumer behavior as we go forward. But even with that, to highlight again some of the things that we see, our strengths even in this elevated competitive environment, holding share in total beauty for the quarter is a real positive as we gained in mass and we gained in prestige e-com, in our brand love, our brand awareness, our total loyalty members, our member retention, our traffic all up, all positive, all healthy, as we see strength with our consumer connection. So your question about our consumer, the fact that we gained 6% in total members, our retention is healthy, we're moving more members up into platinum and diamond and retention of those guests is very high and our brand love reached an all-time high. The connection to Ulta Beauty is strong and we're managing through this really again, unprecedented competitive environment. And all the things I talked about, our confidence in our model, our confidence in the health of this category, and our ability to adapt and adjust our strategies and initiatives, as I discussed, give us confidence both in delivering the updated guidance, but I'd say even more importantly, the future continues to be very bright for Ulta Beauty because we're well positioned with a strong share of the category, strong connection to consumers, and the ability to navigate and adjust our plans as necessary as we've been doing throughout the history of this company. Paula, do you want to talk then about merch margin?"
},
{
"speaker": "Paula Oyibo",
"content": "Sure, Dave. Simeon, I'll give a little color on merch margin. When we think about merch margin from a guidance perspective, we currently expect lower merchandise margin for the year due to the lower sales, increased promotional activity and category mix. We saw merchandise margin decline in Q1 generally for these similar reasons, increase in promo, adverse impacts from brand mix, and then we had a bit of lapping price increases from 2023. When we think about 2020 versus 2019, you are correct. As of last year, we were about 200 basis points of merch margin above 2019 levels. And really, what I would say is a lot of that benefit that we saw was coming from ongoing category performance improvement efforts by our merchandise team, category mix and promo efficiency. Now we are seeing that some of that merch margin is getting a bit pressured as we're seeing in Q1 and as reflected in our current guide."
},
{
"speaker": "Simeon Gutman",
"content": "Okay, thank you. Good luck."
},
{
"speaker": "Operator",
"content": "Our next question is from Kate McShane with Goldman Sachs. Please proceed."
},
{
"speaker": "Kate McShane",
"content": "Hi, good afternoon. Thanks for taking our question. We wanted to drill down a little bit more on the marketing spend that you're planning to increase for the year. We're just wondering, how much of an increase are we talking about? What are some of the tactics here? And are you building in a corresponding sales lift with the marketing spend? And then finally, just within that, did you elevate the marketing in the midst of Q1 and did that have any impact on the comp?"
},
{
"speaker": "Dave Kimbell",
"content": "Well, what I'd say is, as we look forward throughout the year to clarify, Paula mentioned in her remarks that we are protecting our investment in marketing, in store labor and other aspects that we know drive our business and that's reflected in our updated operating margin outlook and we'll continue to invest appropriately as we see opportunities to support growth, so all of that is reflected. The types of things we're doing are continuing to strengthen our connection with our guests. As I said, our unaided awareness and our brand love both increased meaningfully in Q1 after strong growth throughout 2023, we are on a good trajectory as it relates to connecting our guests. The fact that we're driving traffic in both to our stores and online, we're growing our connection to our app, our loyalty, engagement and retention is strong. Our marketing efforts are working. The point in my comments about us finding even better ways and stronger ways to connect is an always on focus for us and we see continued opportunity to drive greater connection through social, so that will be a big focus for us. I highlighted our growth in EMV, which is which we're pleased with, but we know we can do even more. It is the key driver of this category, the way so many consumers are learning and discovering and engaging in the category. So we will continue to have a focus there. And importantly, we're partnering with our brands to find ways to connect as their brands drive growth within our environment. So we're pleased with the efficiency of our spend. It is driving our results and we'll continue to optimize our spend and add appropriately throughout the year as we see opportunities and all of that is reflected both in our top line and our operating margin outlook."
},
{
"speaker": "Kate McShane",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Our next question is from Chris Horvers with JPMorgan. Please proceed."
},
{
"speaker": "Chris Horvers",
"content": "Thanks and good morning. So I'll also do a two pronged question here. So it seems like the 1.6% comp wasn't really different from your internal plan. And you had mentioned and you had expected improvement over the year on all the factors that you mentioned. So at the same time you lowered the back half. So can you just share with us, was it just you're being preemptive to maybe a hockey stick that you set up? And then can you also talk about, April ex-Easter, was that better than the 1.6% for the quarter ex-Easter shift and any commentary on how May is doing so far?"
},
{
"speaker": "Dave Kimbell",
"content": "All right, thanks Chris. Yes, let me take the first part, and again, I'll ask Paula to talk about most recent trends. Yes, 1.6% comp is and we talked about delivering comps in the first half of the year in the low single digits. The reason that we see the need to adjust our outlook for the year is the 1.6% is clearly, and we talked about this earlier in the quarter Chris, at the low end of that range of low single digits. We anticipate the pressures and dynamics that I've been talking about to continue into Q2. And so as we looked at the second half of the year, while we see upside potential through the activities that I mentioned in driving elevated efforts across many parts of our business, strong newness platform and an easier overlap, we do anticipate an increase in the second half of the year, but because of the first half landing at the low end of that range, we see, we felt it was appropriate to update our outlook for the whole year, anticipating some of the pressures, even with growth in the second half of the year, elevated growth in the second half of the year, those pressures continuing through throughout the year, so that all lands us in that updated outlook of 2% to 3%. As far as April and more recent outlook Paula, do you want to talk about that?"
},
{
"speaker": "Paula Oyibo",
"content": "Yes. Thank you. So, Chris, as it relates to the cadence for the quarter and our April exit rate for the quarter, March was the strongest period for a quarter. And it's for all the reasons you mentioned benefiting from the Easter timing as well as our expansion of our Q1 beauty event. Comps in April were positive, but did moderate from March as we expected, negatively impacted from the timing of the Easter shift. With regards to May and what we're seeing quarter-to-date, I won't comment on that specifically, but what I will share is that we expect Q2 comps to look very similar to the first quarter comp."
},
{
"speaker": "Chris Horvers",
"content": "Got it. And then just one quick follow up. You did mention that you expect merchandise margin, I believe up in the back half of the year, but lower in the first half. So what drives the change in the merchandise margin dynamic? Thank you."
},
{
"speaker": "Paula Oyibo",
"content": "Yes. Well, so we expect more pressure in the first half due to the promo and brand mix and that lapping effect of those price increases. And so when we think about the second half, we're not lapping the price increase benefits and we will be largely past the inventory markdowns associated with our rebranding of Ulta Beauty collection. We'll still have the brand mix and promo impact, but net-net, we're expecting the second half to be flat."
},
{
"speaker": "Operator",
"content": "Our next question is from Mark Altschwager with Baird. Please proceed."
},
{
"speaker": "Mark Altschwager",
"content": "Good afternoon. Thank you for taking my question. I wanted to follow-up on the competitive backdrop, but maybe slightly different angles. So you've talked about the increased points of distribution, but at the same time, Ulta has been investing a lot in its loyalty program and its data analytics capabilities for years that I suspect can drive a lot of value for brand partners. So how is your value proposition for these brands evolving? And what gives you the confidence that you can remain a premier distribution point for established and emerging brands even as this competitive environment continues to evolve?"
},
{
"speaker": "Dave Kimbell",
"content": "Mark, that's a great question and we're very confident in that. We have worked hard over many years to build very strong relationships with our brand partners, both the largest brands in the category and a real dedicated effort in supporting emerging new smaller brands. And that is an area of high confidence that we'll continue to be connected and partnering with our brands. We are a very large part of the category across all segments; mass and prestige, makeup, hair care, skincare, fragrance, bath, wellness. We play a significant role. We have a unique proposition. Nobody does what Ulta Beauty does. Our stores and the experience we deliver is special and differentiated and our brands recognize that. They value the opportunity that they have in our stores and on our online to connect with now nearly 44 million loyalty members and the activation and capabilities we have to activate their strategies directly with the largest pool of beauty enthusiasts in the country. And we have long been a destination for growth and so many of our brands are driving growth and taking full advantage of that experience. So I am confident in our brand relationships as we work through some of the changes in the category. In my direct discussion with brands and our overall relationships, we are working together to continue to drive growth and strengthen our partnership, add new brands, as many of which I've highlighted, and drive our business forward in partnership with our brands and that will continue for sure."
},
{
"speaker": "Mark Altschwager",
"content": "Thank you, Dave. Quick follow-up for Paula on inventory. As we look at the inventory growth versus the sales growth, the spread is, I think, wider there than we've seen in a bit and obviously you're adjusting your demand outlook for the back half of the year. Any pockets of aging inventory that could weigh on margins and anything incorporated there from a clearance markdown perspective in the second quarter? Thank you."
},
{
"speaker": "Paula Oyibo",
"content": "No, real concern with regards to inventory. I guess for perspective, approximately 75% of that inventory growth in the quarter was attributable to our new brands and our new stores that were mainly due to opening at DC. We do expect that growth to normalize as we progress during the year. And I know we've shared this previously, but as you think about inventory, keep in mind that most of our inventory is current and largely what we consider core product, which means very little seasonal or at risk inventory. And as you mentioned, we do look for opportunities to invest in inventory to best position ourselves to capture future demand and so we are also doing that as well."
},
{
"speaker": "Operator",
"content": "Our next question is from Oliver Chen with TD Cowen. Please proceed."
},
{
"speaker": "Oliver Chen",
"content": "Hi, David and Paula. Regarding makeup being down mid-single digits and also thinking about the newness opportunity there, what's embedded with guidance for how that meaningful category may proceed? And we continue to see a lot of innovation at competitors such as Amazon, which is leveraging a lot of personalization as well as affiliates and community members. What are your thoughts in terms of how you'll remain competitive? And I know there has always been a lot of overlap with product that they sell and you sell as well. Thank you."
},
{
"speaker": "Dave Kimbell",
"content": "Well, so first on makeup, it's the largest part. It continues to be the largest part of our business, about 44% of our business and we have a very large share of that category. And when we look at our business right now, we talked about some pressure on the prestige side. Many of the things that I've highlighted and the mass, the category slowed some as we were lapping a very strong Q1 and first half of last year. When I look out and embedded in our guidance is confidence on many parts of our makeup business and the ability to strengthen our performance in that. On the mass side, we see continued opportunities with several brands, including Elf has performed very well and has been an important partner for us. Exclusive partnership with Morphe. We've got key partnership with NYX, early lead on some of their innovation. We've got brands like Juvia's Place and about base that have demonstrated strong partnership and growth in our business. So we're confident in our ability to continue to evolve that. And on the prestige side, the newness that I've highlighted has contributed and while we've got more work to do there, Charlotte Tilbury is now in 600 stores and online and has contributed meaningfully to our business. We highlighted the continued expansion and performance of our luxury business. Brands like Wyn, the launch with Serena and we're expanding MAC into more doors. That is just rolling out really as we speak into more doors. And we've got a number of really exciting exclusive brands, brands like Live Tinted, Polite Society, Rabanne, Wyn, and others in the makeup space that are just an outstanding portfolio of emerging brands that we are confident will drive growth over time. So we will continue to drive makeup connection. We've got a very big makeup business and we've got clear plans to drive that going forward as far as other competitive environment in the digital space. The efforts that I talked about across our business apply both to in-store and online. One of the great things about our business is when we get our in-store guests shopping online, they increase their brand, love their brain connection, our share of wallet, their spend goes up two and a half times. And our efforts there and we gained share in the prestige e-com business in Q1, despite some of the other pressures that I talked about. So we see opportunity to continue to drive programs like communities and affiliates. We're doing a lot of that, drive more influencers, expand our assortment, and drive newness across the business. So competing both in-store and online is what we do, and we're focused on that and makeup as we are with all of our categories looking forward."
},
{
"speaker": "Oliver Chen",
"content": "Thank you. Best regards."
},
{
"speaker": "Dave Kimbell",
"content": "Thanks, Oliver."
},
{
"speaker": "Operator",
"content": "Our next question is from Michael Binetti with Evercore ISI. Please proceed."
},
{
"speaker": "Michael Binetti",
"content": "Hey guys, thanks for taking our question here. So Paula, I think the math for the rest of the year puts operating margin below 14%, just the rest of year on a comp range 2% to 4%. Not far from your long term guide. Can you speak to how we rebuild to the level back to the long-term 14% to 15% margin if the comp trend continues at the 2% to 4% type rate in the second half or the comment that you think you can hold share in a category that grows mid-single digits, is that supportive of 14% to 15% margins? And then I guess secondly, as you look at the higher markdowns in the marketplace today and think about the backdrop of some of the key brands and the expanding distribution you pointed to, are you seeing promotions more pronounced in the products and brands that have expanded their distribution the most? I'm curious if there's any link there."
},
{
"speaker": "Paula Oyibo",
"content": "Okay, let me, I'll take the first question and then Dave will talk about what we're seeing from the social environment with the bank [ph]. So Michael, what we've shared is that the top line performance plays a really important role in our ability to drive fixed cost leverage and comps below our long-term algorithm really causes a challenge for us to be able to drive margins at that range above the 14% and 15%. You see that with how we've adjusted our guidance. So on a 2% or 3%, our low end has come down because of the effect of that difficulty of leveraging occupancy costs. What I would say is, from a long-term perspective, we're not sharing long term guidance on the call today, but we do have an Investor Day in October and we plan to share more about the opportunities ahead, how we're thinking about the next phase of growth, and of course how that impacts our financials."
},
{
"speaker": "Dave Kimbell",
"content": "Yes. As far as promotional environment Michael, we came into the year with the assumption that the promotional environment would increase, but remain rational and we built in expectations that we would be able to continue to invest in core parts of our business going forward. What we're seeing now is largely that's holding true. We continue to plan for promotional levels to increase in 2023 because of the competitive nature of this business right now. But as we saw in the first quarter, and we anticipate through the rest of the year, we're not looking to an irrational level, I guess I'd say, of promotional. And we expect our promotional levels to be below 2019 levels for the year. And that's in large part due to our CRM capabilities, promotional efficiencies. As far as specifically about brands, I don't, we haven't really witnessed any specific trends, brands that are in this competitor or in a certain marketplace. It's a broad dynamic going on across the industry again, elevated but still below historical highs."
},
{
"speaker": "Kiley Rawlins",
"content": "So, operator, I think we have time for one more question."
},
{
"speaker": "Operator",
"content": "Our next question is from Krisztina Katai with Deutsche Bank. Please proceed."
},
{
"speaker": "Krisztina Katai",
"content": "Hi, good afternoon. Thanks for squeezing me in. So Dave, I wanted to follow-up on the call to action items. Maybe if you could talk a bit more about how these are helping with just the increased member retention you're seeing. What you can share on the promotional efficiencies of your different and point multiplier events that you have been working on to spend market share. And then secondly, just how do you view the composition of your brand portfolio currently? And I'm asking this in particular, just your legacy brands with some of them getting their own storefront at a competitor's website. Thank you."
},
{
"speaker": "Dave Kimbell",
"content": "Well, let's see the actions that we're taking to drive our business. I've highlighted them and all of them come in. We came in into the year with a number of initiatives that we're continuing to drive and then we're finding ways to do even more newness being a big part of that. We're excited about our program. I highlighted many of the activities we talked about social and marketing efforts specifically around promotional program. And a few things I'd highlight is we're continuing to amplify and elevate our key tentpole events like our semiannual beauty event we held in Q1, our Spring Haul event. We've got an event coming up in the summer of this year and more throughout the rest of the year and certainly going into holiday. That is an effort that every year we continue to find ways to improve, elevate the connection and the relationship that we build with our guests through the power of these tentpole events. We complement that through a steady effort in promotional connection that's more targeted through the power of our loyalty program and the strength in the personalization efforts and we see that right now we're in the midst of a program. If you've seen in the market what we call member love, it's a three week program, each week highlighting a different category, this week focused on skin care. And what we see with that is a really differentiated way to connect with our guests again, add more value to our guests in a way that only Ulta Beauty can to leverage our personalization and differentiation capabilities, the strength of our loyalty program, and we're pleased with the results. So we'll continue to amplify the big efforts that we have throughout the year and complement that with targeted, efficient promotions that we have a lot of data to continue to optimize. As far as our brand portfolio, I'm really proud and pleased with the portfolio that we have. We've got the very best of beauty. We've got brands across all major categories, all price points from the biggest, most established, longest term brands in this category that continue to provide great performance and outlook for us. Brands like MAC and Clinique and Lancome, the Estee Lauder brand, newer brands like Cosmic from Kylie and Wyn from Serena. We've got the portfolio of emerging brands, large brands and strength in all key segments of the category. So I highlighted that the competitive environment continues to evolve and brands will adapt to that and take advantage of growth prospects where they see them. But to reiterate something I mentioned in a previous question, our brand relationships are incredibly strong. It's something that we value immensely and work hard to continue to develop. And so our brand CS as a place for growth they're experiencing, so many of them are experiencing that growth right now. And that's one of the many reasons that I am very confident in the future of Ulta Beauty. And we're very clear on our, what's ahead of us throughout 2024 and ready to continue to lead the category for the long-term."
},
{
"speaker": "Krisztina Katai",
"content": "Okay, great. Thank you very much."
},
{
"speaker": "Dave Kimbell",
"content": "Okay. So with that, let me wrap up today with just a couple of quick remarks. Our teams are working hard to deliver against our short-term objectives while also taking necessary steps to position Ulta Beauty for longer term profitable growth. And I want to thank our more than 50,000 Ulta Beauty associates across the country for all that they are doing. Again, I appreciate your interest in Ulta Beauty, and we look forward to speaking to you all again when we report, our results for the second quarter on August 29. I hope you all have a great evening. Thanks again for joining."
},
{
"speaker": "Operator",
"content": "Thank you. This will conclude today’s conference. You may disconnect your lines at this time and thank you for your participation."
}
] |
unh | 2,024 | 4 | [
{
"speaker": "Operator",
"content": "Good morning, and welcome to UnitedHealth Group Fourth Quarter and Full Year 2024 Earnings Conference Call. A question-and-answer session will follow UnitedHealth Group's prepared remarks. As a reminder, this call is being recorded. Here are some important introductory information. This call contains forward-looking statements under U.S. federal securities laws. These statements are subject to risks and uncertainties that could cause actual results to differ materially from historical experience or present expectations. A description of some of the risks and uncertainties can be found in the reports that we file with the Securities and Exchange Commission, including the cautionary statements included in our current and periodic filings. This call will also reference non-GAAP amounts. A reconciliation of the non-GAAP to GAAP amount is available on the financial and earnings reports section of the company's investor relations page at www.unitedhealthgroupcom. Information presented on this call is contained in the earnings release we issued this morning and in our form 8-K dated January 16, 2025, which may be accessed from the Investor Relations page of the company's website. I will now turn the conference over to the Chief Executive Officer of UnitedHealth Group, Andrew Witty."
},
{
"speaker": "Andrew Witty",
"content": "Jennifer, thank you very much, and good morning, everyone. I'd like to start by expressing a sincere thank you from my colleagues and from me for the overwhelming expressions of condolence and support following the murder of our friend, Brian Thompson. Many of you knew Brian personally. You knew how much he meant to all of us and how he devoted his time to helping make the health system work better for all of the people we're privileged to serve. He would dive in with passion and caring to find solutions to improve experiences, whether for an individual consumer, an employer or a public health agency. Right now, there are 400,000 nurses, doctors, case workers, customer service specialists, pharmacists, technologists and so many others in this organization, who share that commitment and are determined to advance that work. The task in front of us, all of us, healthcare providers, payers, employers, drug companies and policymakers is to continue improving quality and health outcomes for individuals and their families, while lowering costs for everyone. We need to build on the unique foundational strengths of healthcare in America and address the areas we can make work better. Among those strengths, world-leading innovation, the U.S. has developed the most advanced clinical approaches and patient-centric care at a pace not seen anywhere else. It's why, if provided with the option, people from all over the world come here to seek care for the most complex conditions. Yet, the health system needs to function better. Through decades of federal and state policy making and private sector innovation, we have a variety of program structures and processes. There are strong merits to that variety as they can be more tailored to meet the specific needs of individuals at various stages of life and health status and provide extra help for those who need it. It avoids a one-size-fits-all approach, but it needs to be less confusing, less complex and less costly. America faces the same fundamental healthcare dynamic as the rest of the world. The resources available to pay for healthcare are limited, while demand for healthcare is unlimited. Every society wrestles with that issue and approaches it in various ways. We have incredible opportunities here to improve system performance both from a care and a cost perspective, while building upon the foundational strengths I just mentioned. The mission of this company, why we exist, is to improve this system for everybody and help people live healthier lives. That means getting more people into high-quality value-based care and keeping them healthy in the first place, so fewer Americans find themselves with a chronic and, in many cases, preventable disease. It means continuing to invest in programs like Medicare Advantage, which by providing coordinated care to seniors is proven to deliver better health outcomes at lower cost to consumers and taxpayers compared to fee-for-service Medicare. Seniors recognize that value, which is why the majority of them choose Medicare Advantage. It means making healthcare easier to navigate. We're enhancing digital tools for consumers, harnessing data and using AI so they can find the best value care option and decide what is best for themselves and their families. People's health interaction should be as intuitive and seamless as every other aspect of their lives: banking, shopping, streaming. This past year, we saw an extraordinary increase in the use of these modern channels. We know there is still a large gap there, and we intend to keep at it until it is closed. It means making coverage and cost easier to understand. Just one example where we already have advanced plans, we're eager to work with policy leaders to use standardization and technology to speed up turnaround times for approval of procedures and services for Medicare Advantage patients and to materially reduce the overall number of prior authorizations used for certain MA services. Some of this work we can do on our own, and we're doing it, but we're encouraged also by industry and policymaker interest in solving for this particular friction across the whole system. Ultimately, improving healthcare means addressing the root cause of healthcare costs. Fundamentally, healthcare costs more in the U.S., because the price of a single procedure, visit or prescription is higher here than it is in other countries. The core fact is that price, more than utilization, drives system costs higher. Tackling that problem will require all parts of the system and policymakers to come together. Yet, there are participants in the system who benefit from these high prices, lower-cost equivalent quality sites of service, for example, can be good for consumers and patients, but threaten revenue streams for organizations that depend on charging more for care. Another example is the persistently high cost of drugs in the U.S., leaving American consumers, employers and public agencies to pay disproportionately more than people in other countries. Just look at GLP-1 prices. One drug, which costs $900 in the U.S., costs about a tenth of that in Europe. Pharmacy benefit managers play a vital role in holding those prices down, which is why drug companies and their allies have spent the past several years attacking them. Optum Rx alone delivers many tens of billions of dollars in savings annually versus the pricing set by the manufacturers, including on the GLP-1s. That sharply reduces the gap versus other countries, but even then prices in the U.S. are still multiples of what the rest of the world pays for the same drugs. Last year, our PBM passed through more than 98% of the rebate discounts we negotiated with drug companies to our clients. While we offer customers 100% pass-through options, a small number have historically elected other models. We're committed to fully phasing out those remaining arrangements so that 100% of rebates will go to customers by 2028 at the latest. We will continue to encourage all of our clients to fully pass these savings directly to patients at the point of sale, as we already do for all of the people we serve in our fully insured employer offerings. This will help make more transparent who is really responsible for drug pricing in this country, the drug companies themselves. Healthcare in every country is complex and the solutions are not simple, but you should expect this company to continue to work at it, finding what is needed, developing solutions, bringing those solutions to scale, making a positive impact on the lives of millions of people. We deliver on our commitments to the people we serve, including our investors. Even in highly challenging periods like 2024, our results bear out that we find a way, even if it's not always how we may have initially envisioned the path. Among some of the formidable challenges we navigated over the course of the year were the first year of the three-year CMS Medicare rate cuts, the effects of the state-driven Medicaid member redeterminations, and the Change Healthcare cyberattack. Our people found a way to deliver solidly within the range we first offered back in November of 2023, all while improving patient and consumer health outcomes and experiences, focusing on quality and expanding upon our potential to help make the health system work better for everyone. We're invigorated by the path ahead. There are so many areas that can be enhanced, reworked, reengineered or even scrapped to make the health system work better as we know it needs to. That is both our responsibility and it's our passion. We begin 2025 with a strong outlook for the year as we continue to deliver on our commitments and excel for those we serve in all of our key growth pillars. Now, John will walk you through this performance in a little more detail."
},
{
"speaker": "John Rex",
"content": "Thank you, Andrew. And I'll add my deep gratitude for the enormous outpouring of support over the past few weeks. Brian helped build this company and forged deep trusted relationships for over 20 years, and the positive impact he had on people will be felt for years to come. This morning, I'll discuss both 2024 results and our performance expectations for '25, including some of what we had planned to discuss with you in December. 2024 revenues of over $400 billion and adjusted earnings per share of $27.66 were well within the outlook ranges we set out over a year ago. To be sure, things played out differently than initially anticipated, but it is an enduring trait of this enterprise that we deliver on our commitments to the people we serve and to you, even amid unforeseen circumstances. Over the course of '24, we undertook initiatives and made investments to strengthen us for the future, initiatives to improve consumer experience and bring new innovations to market more quickly, drive the most compelling ways to further our mission to help make the health system work better for everyone, and continue to optimize and refine our offerings and business portfolio to enhance future growth potential, whether that meant moving into new opportunities, reconfiguring or moving out of areas, which contributed historically but may no longer be core, all with an eye to unlocking value. We know you have a number of questions that we were not able to discuss last month. So, today, I'll start by stepping through a couple you have indicated are top of mind. The first one is, why our '24 medical care ratio was 150 basis points above our original outlook? It's important to frame up the challenges of '24 to offer some perspectives on the commitment and response of our people. Compared to the midpoint of the care ratio range we stepped out with over a year ago, that alone created a nearly $5 billion gap we needed to overcome, and that's before we get to the nearly $1 billion in business disruption impact due to the cyberattack. So, we start with about $6 billion in unanticipated impacts just from these two examples, in addition to managing through the already known multibillion dollar impact of the Medicare rate cuts, as we sought to preserve as much benefit stability for seniors as possible. Regarding the elements impacting our '24 care ratio, we've spoken about the key factors on prior earnings calls, so no surprises here. The first comprise about 70% of the total impact and are comparable in magnitude to each other. First, the mix of people served. We ended up with a different profile of consumer than expected. This is because of one factor. We didn't grow as anticipated due to the unusual Medicare Advantage benefit designs in the marketplace in '24. Next, the timing mismatch between the health status of the remaining people being served by Medicaid and lagging state rate updates. Then, there were the costs related to the cyberattack and our South America business impacts. The remaining two elements comprise about 30% of the impact and are evenly split. These include a more rapid-than-expected acceleration in the prescribing of certain high-cost medications as drug companies took early advantage of the Inflation Reduction Act, and an aggressive upshift in hospital coding intensity. This is incorporated into our outlook even as we work to get it back in line. Those are the '24 care ratio elements. Next question, given all that, are we confident in the adequacy of our pricing for '25? The answer is yes, and here's why. To start, for '25, the outlook we shared in December incorporates a view of care activity commensurate with what we saw in '24, even the care activity we experienced as we exited the year. I'll break that down with some business line perspectives. In Medicaid, we see the gap between people's health status and state rates narrowing over the course of the year. Our outlook assumes a measured pacing of that process. Actions to date, including the important January 1 renewal cycle, support this view. In commercial, pricing for '25 is appropriately capturing the care activity we are seeing. This is evidenced by growth heavily weighted towards self-funded offerings. We will continue our disciplined approach. In Medicare, we had strong AEP results, which included winning back people we had served previously and near-record retention. These are a direct result of our long history of offering sustainable benefits for seniors. With strong retention and the many returning consumers, we start the year with highly informed insights into the care needs of the people we will be serving. In addition, this year, we have seen a notable uptake of our more managed offerings; think HMO style, which provides strong value for consumers, effective care tools for doctors and more predictable performance. We expect a '25 full year medical care ratio of 86.5%, plus or minus 50 basis points, 100 basis points above the '24 result. In addition to factors discussed earlier, the increase is driven by IRA impacts, the second year of the Medicare funding cuts, a continued mix shift toward public sector offerings, and a respectful view of care activity. Our '24 operating cost ratio improved about 150 basis points over the prior year. Roughly half of the change was driven by contributions from the business portfolio initiatives mentioned earlier. The other half was due to accelerating our efforts to realize operating efficiencies, even as we improve consumer experiences. Some of these advances are a result of the very early stage impacts we are beginning to realize from AI-driven initiatives to help our customer service representatives respond to consumers' needs more effectively and quickly. And we see continuing opportunities both in the near-term, with operating costs for '25 improving still further, and well beyond, given the rapidly expanding scope and impact of these initiatives. These actions and the resourcefulness of our people helped deliver upon the objectives set out over one year ago, and helped to partially balance the multiple billions of unanticipated impacts. With that, I'll run through our businesses, offering some key points for each, starting with Optum Health, where revenues grew to about $105 billion in '24 and are expected to approach $117 billion in '25. Our care delivery business continues to deepen its presence in existing areas, while expanding into new geographies and services. In '25, we expect Optum Health will serve about 5.4 million value-based care patients, growth of 650,000 over '24. While our current position provides a solid footing, it's a small fraction of the hundreds of millions of patients who can ultimately benefit from value-based care. We see value-based care as foundational. It is perhaps the fullest expression of our mission. As Andrew noted, the outdated activities-based fee-for-service system won't help the health system work better for people. Value-based care is outcomes-based, aligning processes, actions and incentives, helping keep people healthy in the first place rather than just seeing them when they are sick. Optum Health is an integrated multi-payer care delivery company, helping to lead the transition to a truly sustainable value-based care system. As we move into '25, we will continue to enhance access and care integration through the home, a much needed area to help people with their health. More than three quarters of our in-home patient visits result in a primary care visit within 90 days. Medicare Advantage patients with chronic conditions who receive a home care visit have a lower rate of ER visits, fewer in-patient stays, stronger health outcomes and a better experience, all while saving the health system billions. Turning to Optum Rx. Revenues in '24 grew to over $130 billion and will be about $146 billion in '25. Our pharmacy benefits management team again had customer retention exceeding 98%, while welcoming a record 750 new clients. Further proof of the value sophisticators, employers, health plans and labor unions see in Optum Rx's ability to negotiate lower drug prices for consumers. Optum Rx's pharmacy care services support the entire system in the delivery of clinically-driven pharmacy care, serving the highest need and hardest to reach patients. These offerings include community pharmacies, specialty and infusion drug services, all large, strongly growing areas, with our current presence quite small. Optum Insight revenues were $19 billion in '24, and in '25, we'll approach $22 billion, with a backlog of $35 billion as sales of new products begin to take hold and the customer clearinghouse business continues to rebuild. The solutions offered through Optum Insight and our health technology growth pillar, delivered at scale, will improve consumer experience and payment and claims flows, enable access to the next best action guidance in a doctor's workflow, and help life sciences customers more rapidly bring innovations to market. And there will be much more to follow. Shifting to UnitedHealthcare. Full year revenues in '24 approached $300 billion, and for '25, we'll approach $340 billion as we grow to serve upwards of an additional 1.9 million people balanced across both the commercial and public sectors. Within our domestic commercial offerings, we grew to serve 2.4 million more people in '24 and expects to continue to grow strongly in '25, especially in our self-funded offerings, which serve some of the most sophisticated buyers of healthcare, large employers. The fact that so many more people are choosing UnitedHealthcare is a direct result of our bringing much needed innovation to these more mature markets through consumer-centric offerings. As noted earlier, UnitedHealthcare's '24 Medicare Advantage growth was impacted by the unusual benefit designs in the market. Our focus has always been on providing consumer stability and sustainable value, a factor that has built confidence and trust over the long-term. As a result, in '25, we expect growth of up to 800,000 people in individual, group and special needs offerings. And the growth outlook for the years ahead remains strong, with nearly half of American seniors still in outdated Medicare fee-for-service offerings, which provide less value to them and cost taxpayers more. In Medicaid, we expect to serve more people in '25 with redetermination activities now concluded. UnitedHealthcare's value proposition is resonating with state customers, consumers and provider partners, and we are participating in a substantial number of expansion proposals. Most recently, we were honored to have been awarded a new opportunity in Georgia. Our growing businesses support and -- are supported by substantial financial capacities and a strong balance sheet. In '24, we deployed nearly $17 billion in growth capital to help build for the future, further strengthening our capabilities to serve more people more comprehensively. We also returned over $16 billion to shareholders through dividends and share repurchase. In '25, we expect cash flow from operations will approach $33 billion or 1.2 times net income. We will continue to deploy growth capital and remain committed to returning to shareholders as outlined in December. Our growth capital deployment efforts delivered their greatest benefits over the course of two, four, or even six years, and as new capabilities are scaled and deployed across the enterprise and beyond. To summarize, our strong start to the year reinforces the growth objectives we shared last month and is underpinned by the broad growth drivers, operational excellence and strategic capital deployment you have come to expect from us. Now, I'll turn it back to Andrew."
},
{
"speaker": "Andrew Witty",
"content": "John, thank you. The strength of this organization lies in the resilience of our people and the fundamental belief that there is no higher calling than helping other people and nothing more vital to the human condition than healthcare. Looking ahead to 2025 and beyond, we're confident in our ability to continue to add value to the health system through our focus on value-based care and consumer-orientated efforts to help build the health system America deserves. And that's also why we remain solidly committed to our long-term 13% to 16% growth objective, a goal that reflects both the opportunities and the capabilities that we have. And now, operator, we'll open it up for questions."
},
{
"speaker": "Operator",
"content": "The floor is now open for questions. [Operator Instructions] We'll go first to A.J. Rice with UBS."
},
{
"speaker": "A.J. Rice",
"content": "Hello, everybody. And I appreciate the words about Brian. He's missed by all of us. Just maybe to focus in on the comments about cost trends and the MLR. Obviously, in the fourth quarter, there's variance relative to consensus expectations. It was probably a little greater than what we thought. It sounds like the cost items you're calling out are similar to the things you had seen all year long. Was there anything that changed in those - the intensity of any of those trends? And anything -- any unusual items in there that impacted the results? And it sounds like you're still confident in your '25 MLR outlook, so nothing you saw in the fourth quarter changes your view on '25?"
},
{
"speaker": "Andrew Witty",
"content": "A.J., thanks so much for your question. I'm going to ask John in a sec to obviously go much deeper in response to your question, but just to the last part of your question, yeah, you're totally right, nothing we saw there that changes our view of '25. We feel very good about how we priced into '25. We feel really good about how the mix has come in, in terms of that growth. That's a huge difference to '24, and we really didn't see anything in Q4 that we believe represents a challenge to that view going to '25, but I'd love John to go deeper for you on the Q. Thanks."
},
{
"speaker": "John Rex",
"content": "Good morning, A.J. So, a few things on this. So, in terms of the items that we called out on the third quarter call, so hospital coding intensity and the specialty prescribing trends that we are seeing, very much in line with what we saw in the third quarter in terms of that ran into the fourth quarter. So, in line with the view on that, we weren't seeing acceleration in that. We're seeing stabilization in those trends, I would tell you, at the levels we saw before, and we expect that to continue. That specialty prescribing, those trends were something we anticipated in our '25 outlook. And as we had noted back in the third quarter, that was something that just moved faster in '24 than we expected, but in terms of the levels we're seeing and how we anticipated that in our '25, we feel very good about that. Those coding intensity levels staying at the levels that we thought that we had seen also. And then, the other elements that we talked to mix kind of important element in terms of the improvement we see as we move into '25 in those elements. For the call out kind of things in the 4Q, a couple of things I'd say. So, first of all, the move vast -- mostly driven by seasonality. Typical seasonality, we see normal deductible wear offs, those elements. A move, sequentially that was similar in terms of the basis point move that we saw a year ago also, 3Q to 4Q on that, but I'd call out a couple of things, A.J., just to your point here. So, in the sequential move, I'd call out probably 80 basis points to 90 basis points I put in the revenue effect category here. So, in that, think about some elements that might have been coming in, such as group MA refunds and elements there where our performance, which was strong over the course of the year, and those hitting in the quarter. Just some elements like that, that I'd put in the non-recurring revenue -- non-run rate revenue category in terms of impacts. And that was probably about 80 basis points to 90 basis points of the impact 3Q to 4Q. The flu RSV impact, that typical seasonal, that was kind of a, I'd say, in the quarter 50 basis points to 60 basis points. That's kind of a normal move. And then, think of the rest of that move being in the zone of pretty much expected seasonal impact. So, the one element I'd call out there is the revenue effects that probably would be -- would probably be having some impact. Thank you."
},
{
"speaker": "Andrew Witty",
"content": "Great. Thanks so much, John, and thanks again, A.J., for your question. Next question, please."
},
{
"speaker": "Operator",
"content": "We'll go next to Josh Raskin with Nephron."
},
{
"speaker": "Josh Raskin",
"content": "Hi, thanks. A question on the Optum Health segment. I guess, and I apologize if I missed this, but did you comment on the change in the consumers? I know you talked about portfolio changes and things like that, but the consumer count dropped about 4 million. And then, sort of a noticeable drop in margins. And I'm wondering if some of that is related to the MA rebates that you just mentioned in terms of the impact on the UHC side as well."
},
{
"speaker": "Andrew Witty",
"content": "Yeah, Josh, thanks so much for your question. Let me ask John to start and then ask Dr. Desai to pick up a few details on that, please. Thanks."
},
{
"speaker": "John Rex",
"content": "Good morning, Josh. So, in terms of the consumer count and impacts on that, so that would go into the category of some of the strategic initiatives that have been ongoing here. So, think about some elements where -- that we may have just been -- that we are maybe deemphasizing in terms of our focus on that. So, an area that we deemphasize that would go in that category is urgent care. We're approaching that a bit differently now. There was a time when kind of standalone urgent care was an important element here. As you start developing more geographic density, however, in a marketplace, you can probably better serve those patients by just having one of your clinics have afterhours of presence and focus on that. So, one area that we have diminished in terms of emphasis is urgent care. And that's one of the areas we got out of. So, really those counts are driven by, I'll call it, somewhat narrow offerings typically, that we have been diminishing and that were part of kind of some of the strategic initiatives that we talked about. In terms of kind of some of the broader margin impacts you're seeing and some of the emphasis and where Optum Health was headed in terms of in the 4Q and where their focus was, I'll turn that to Dr. Amar Desai to comment on."
},
{
"speaker": "Amar Desai",
"content": "Thanks, John. Hi, Josh. So, to take a step back, post V28, we've been executing on our multiple year plan to reshape the business, including efforts around direct patient engagement and medical management as well as integrating our business to deliver on operating cost efficiencies. So, as we look at the quarter, we took a number of planned actions, including restructuring and refining some of our legacy contracts, which had a one-time impact of the year. We had some membership mix changes, which has been noted. And then, we did make some investments in the quarter around clinical quality and the STARS program as well as onboarding for new membership coming on for 1/1. That being said, we feel very good about our position stepping into 2025. Our AEP growth was strong. We've also had very strong retention across our care delivery organizations, again reflecting the strength of our provider network and the differentiated care they provide. We also have a better understanding of V28 as we're in the second year of it. And with this progression, our payer relationships and contracts have evolved into the year. As we step into '25, we're in a more favorable spot. And then, the impact of our engagement efforts in 2024, 85% of our value-based patients were engaged and 90% among our highest risk patients. And again, this is best ever patient engagement for us and is the foundation for the maturation of our value-based cohorts over time. So, overall, our operating model for Optum Health is stronger, it's underpinned by significant momentum around these engagement and affordability as well as operating efficiencies and we're confident in delivering against our long-term margin targets. Thanks for the question, Josh."
},
{
"speaker": "Andrew Witty",
"content": "Amar, thanks so much. And I'll maybe just finish off that response, Josh, if I might, by really reiterating something you heard me say just a month ago that even in a very challenging year of 2024 with a lot of changes coming from the outside world in terms of funding reductions and the like from the administration, alongside our commitment to perform, we're also relentless around how we continue to modernize and shape the company for the longer term. And what you heard John just talk about and you just heard Amar refer to really there is within Optum Health, alongside strengthening our core business, we recognize some parts of that business aren't necessarily as important in the future as they were in the past. We're not going to shy away from making the choices to ensure that we have real clarity and focus on what we know supports our business, and most importantly, gives us the highest chance of giving the best possible service to patients and members who we serve. And I think, during 2024, you saw the organization be very focused not just on the year, but on the shape of how we want the company to develop over the next several years. And that's really what you're seeing reflected in the commentary that John and Amar just touched on. Josh, thanks so much for your question. If we could go to the next question?"
},
{
"speaker": "Operator",
"content": "We'll go next to Lisa Gill with JPMorgan."
},
{
"speaker": "Lisa Gill",
"content": "Thanks very much for taking my question. Andrew, I want to talk about PBM reform. There seems to be a very large drumbeat right now that will see reform at some point in 2025. Really two things here. One, what do you think that means to your business? And then, secondly, you talked about educating those in the marketplace to better understand what you actually bring to the market from a PBM perspective. Are there incremental ways that you can potentially maybe educate Congress? Because it seems to be a very big disconnect versus how Congress is viewing this versus what PBMs actually do."
},
{
"speaker": "Andrew Witty",
"content": "Lisa, thanks so much for your question. And this is, obviously, a topic of a lot of people's interest. And that's not surprising, because pharmaceutical prices in the U.S. are too high. And I just made that super clear in my comments, and it's not the first time you've heard any of us at United make those comments over the last several years. As you think about that, the issue really is that you have a situation where the PBMs are really the only effective mechanism across the system, which really holds the pharmaceutical company to account once it chooses to set its price, and by the way, also has the freedom to inflate that price every single year, which is what we see happen. The PBM is there to try and hold that to account and negotiate on behalf of employers, unions, states and others to try and bring down those prices. But within that, Lisa, is the very first thing that people really need to truly understand. The PBM acts on behalf of the ultimate payer, the employer, the union, the state and such. It acts on their behalf, because they're ultimately the ones who are typically underwriting the ultimate cost of the medicine for the patients, the consumers who are beneficiaries of their plans that are supported by those organizations. That is often lost in terms of how this mechanism works. And it's critical to understand it. What's important, therefore, is that we, and you heard me make a couple of references to this, and I hope alongside others across the sector really focus on the facts of the situation. Prices in America are de novo set too high relative to any other price in the world, first off. Secondly, they're inflated every year, which is pretty unusual when you compare that to the rest of the world. Thirdly, as we negotiate to bring those prices down, the benefit of that negotiation, those rebates which are achieved are very significant, are passed back to the employers, unions and states. They choose what to do with those rebates. Now, in the case of UnitedHealthcare, where in the population of employer benefits that we manage, where we have essentially control over that decision, we pass those all the way through to the consumer and the patient who receives the drug. So, they see the benefit of that rebate. We'd like to see others do the same. Within that overall system, there is also opportunity for people to lose a thread of where the money goes in the system. And that is often what you hear policymakers be concerned about. That is why this morning we are committing to a full 100% pass-through of all rebates that we negotiate at the PBM back to the payer, the state or the union. Right now, we already passed 98% of that through. But unfortunately, even that's just that small residual that we retain because those clients want to pay us that way is enough to give people the excuse to argue that the system is not working properly. We're taking that excuse off the table today. We are committed to full transparency. We are committed to full pass-through to clients. We believe that takes away the excuse of who really is setting the price, and we would like to work with others across the system to relentlessly achieve the lowest net cost for everybody in the system. We'd like to see patients see the benefits of that, and we'd like to work with anybody who wants to work with us to make it happen. And that's how we're going to engage this year with policymakers and others across the country. With that, Lisa, thanks so much for the question. Let me go to the next question, please."
},
{
"speaker": "Operator",
"content": "We'll go next to Stephen Baxter with Wells Fargo."
},
{
"speaker": "Stephen Baxter",
"content": "Hi, thanks. So, to stay on the policy front, I was wondering if you had any early perspective to share on the Medicare Advantage advance notice for 2026. I guess, anything you see as encouraging or any potential areas of concern as you progress from advance to final? And then, I guess as a related point, it seems like many would think that the reimbursement that's embedded in these rates is still not reflective of the elevated cost trend that we saw in 2024. Even if taking a step in the right direction, is that a company perspective that you share? Thank you."
},
{
"speaker": "Andrew Witty",
"content": "Hey, Stephen, thanks so much for the question. I'm going to ask Tim to -- Tim Noel to comment on that, please."
},
{
"speaker": "Tim Noel",
"content": "Yeah, thanks for the question, Stephen. As you know, these rates are preliminary at this point in time and won't be finalized until April. And so, therefore, probably not super productive to start speculating on elements of that. I will say we are looking forward very much to engaging the new administration on this item and also a host of other items as it relates to the Medicare Advantage program. Thanks."
},
{
"speaker": "Andrew Witty",
"content": "Great. Thanks so much, Tim. And as you suggest, Stephen, what's most important is that this is all rational, right? So, it's not difficult to figure out in retrospect what trend was, and we'd like hope that over the next few cycles, we see that reflected in a way that it hasn't been over the last several years. And that, for us, is really the important element of what we hope will come. And it's simply just rational and it's interesting. When you look at the states in Medicaid, you see that kind of rational behavior. We've seen that improve. We've been super clear that there's been historic offset lag, if you will, to that. That's not surprising. That can create some discontinuity as we saw this year in '24, but underneath all of that, we see rational understanding and engagement from the state. We super appreciate that. It's important, and that's what we want to hope to see a return around the MA rate setting in a way that we have not seen over the last several years. Okay. Next question, please."
},
{
"speaker": "Operator",
"content": "We'll go next to Justin Lake with Wolfe Research. Thanks."
},
{
"speaker": "Justin Lake",
"content": "Thanks. Good morning. I've got a question here, but first, I wanted to ask a quick follow-up on this Medicare Advantage revenue adjustment. Given the MLR for the quarter came in higher than expected, it appears this might have come as a surprise given that the employers -- the size of the employer segment, feels like this adjustment is pretty large, like maybe 5% or more of annual revenue. So, just trying to understand, can you give us more color here? How did the mechanics work? And what's going on? Maybe you could tell us why this would have been a surprise? And what periods do they relate to? Is it all 2024? And then, my actual question is more on MA growth. Curious what you saw during AEP both in terms of what proportion of your 8% growth expectation do you expect to come from AEP? And then, do you still see industry growth at mid-single digits? Thanks."
},
{
"speaker": "Andrew Witty",
"content": "Hey, Justin. Thanks so much for the question. That was an impressive way of sneaking two instead of one. I'll let you get away with it just this time. So, John, if you wouldn't mind taking the first part of Justin's good question, and then I'm going to ask Bobby Hunter to take the second. Bobby leads our business in Medicare. So, please go ahead."
},
{
"speaker": "John Rex",
"content": "Justin, good morning. So, yeah, in terms of those elements, so MA kind of group customer refunds was one element of it. And certainly, these are -- and there were a few other adjustments running through that were all putting the non-run rate revenue impacts here. In terms of surprise or not, so perhaps not anticipated a year ago when we set out kind of in terms of our expectation for medical care ratio and revenues and such, not a surprise in terms of where we've been the last while though in terms of understanding these things, because as they develop and you see, okay, better performance in certain group MA plans, there's going to be a refund that's given to those employers as we do, as we're performing well. And then, some of the other elements, I wouldn't call them surprise. Certainly relative to a year ago, we didn't have those incorporated in our view in terms of relative to months ago, it would have been something we would have understood in those elements. And that was one of those, trying to give example. But there were a few and they totaled up to that 80 basis points, 90 basis points. Group MA refunds being one of them. But I wouldn't call it a surprise to where our view has been the last few months here on this. And then, I'll go to Tim..."
},
{
"speaker": "Andrew Witty",
"content": "No, to Bobby."
},
{
"speaker": "John Rex",
"content": "Yeah, Bobby."
},
{
"speaker": "Bobby Hunter",
"content": "Yeah. Thanks, John, and thanks, Justin, for the question. So, in terms of AEP results, we are very pleased with how things played out for us. They're very much aligned to our expectations, and it puts us on track to achieve the full year MA growth target of up to 800,000 that we've communicated. Really important to remember that with the selling changes for 2025, we do expect more than 50% of our full year growth to come in AEP. Also worth noting, this level of growth is not something we're unfamiliar with, and I'm really proud of our teams and the 1/1 readiness activities we've executed on to ensure a smooth transition for our new and returning customers. Maybe to offer a few highlights on the growth itself, seeing really balanced and diversified growth across our products and our geographies, in particular, some really nice strength within our HMO and full dual plan offerings. John also mentioned retention performing at near record levels, a great testament to the value that we're offering to consumers. And maybe lastly, of the members who have left us in prior years, we are seeing about 3 times as many return to UHC this year as compared to last year. I really view that as a testament to the service models and experiences we offer. And folks clearly put a lot of value in that when they're making their decisions, and I'm really proud to see those individuals coming back to us this year. In terms of the growth rate, we certainly still continue to believe in our long-term growth rate of 7% to 9%, acknowledging that, in certain years, you can see fluctuations based on benefit changes and other factors. Some of that was present in 2024 and similar dynamics will play out here in 2025. So, we expect '25 to generally pace in line with '24 from a growth standpoint. That said, more confident than ever in the value that MA offers to consumers and the path that we're on for MA to surpass 70% penetration over time."
},
{
"speaker": "Andrew Witty",
"content": "Bobby, thanks so much. And I just want to acknowledge Bobby personally, because he -- over the last couple of years, he's really led the strategizing of how to navigate through the very many external changes, which have played out through V28 and the like. And I think you've always heard us talk about playing a multi-year strategy here, and I think that's really coming to fruition. Bobby owns a ton of the credit associated with that, and I'm delighted to see that reflected in the growth performance in the cycle we're in right now that you've just heard described. And it's that mix improvement that you just heard in Bobby's answer, which completely differentiates 2025 from 2024 for UnitedHealthcare, is super important. And all of those elements you just heard described are essentially what makes up that very important mix improvement, which we've been aiming for and we feel very, very good about. Let me go to the next question, please."
},
{
"speaker": "Operator",
"content": "We'll go next to Lance Wilkes with Bernstein."
},
{
"speaker": "Lance Wilkes",
"content": "Great. Thanks so much. And really appreciate your comments at the beginning of the call. Could you talk a little bit about one of the things I think is hanging over long-term investors out there, which is levels of customer satisfaction. I know that's difficult to measure, but I know [NDS] (ph) and other metrics are things you guys look at. Can you talk a little bit about what you perceive to be the major sources of dissatisfaction in those sorts of measures? And then, what are some of your strategies and priorities? And does it have any impacts on long-term algorithms for the company as far as economic algorithms, growth algorithms or just where you prioritize your capabilities? Thanks."
},
{
"speaker": "Andrew Witty",
"content": "Yeah, Lance, thanks so much for the question. And listen, I mean, at the core of the company and if you look at the mission of the company, it's all about trying to improve the health system for everybody. And by that, it means not just reducing the cost of that, making it more affordable, but it's also about trying to make it easier to access, less complex, less confusing. And as I said in my opening comments, we recognize there's still a lot of work to be done in that regard. Some of the areas, like, obviously, claims where people get frustrated about how long it takes for a claim to process or maybe some confusion that goes on in that, those are key areas for us to continue to work hard at to improve. And I could tell you when you look across claims, less than half of 1% of claims are ultimately rejected for clinical reason because for whatever reason they're not deemed to be a safe or effective treatment option. But we all know there are other claims which get held up in the process before you get to that stage. Now, the overwhelming majority of those claims which are held up are held up because they were either sent to the wrong company, they didn't have the right information on them, the patient didn't have the right benefits, all of those things. Now that could all be dealt with through technology and a more standardized approach across the industry. And I'm very, very pleased to say that we are experiencing and engaged with a much heightened energy across the organization to solve this across the whole sector for everybody. And in my view, probably 85%-or-more of all of those claims, which end up going to the wrong place and then having to be resubmitted back, could all be avoided with the adoption of real-time processing, a standardized approach, a standardized intake mechanism. That's a key area for us to focus on. And that -- we've alluded to that. I mentioned an effort we're very close to around Medicare Advantage improvement. That's just one of the first steps. And all of this sits very much in line with the work that Brian frankly led over the last several years to really reduce overall activity around PAs and the like and the company will continue to do that. But I just want to emphasize the criticality of collaboration here to try and design something not just for one company, but for all companies, not just for one patient, but for all patients. That's what we got to work toward. Really looking forward to opportunity to engage with the administration on this, because they can also be an important aid to help catalyze those sorts of changes. The second area of consumer improvement opportunity, where I believe we are -- we really are making great progress is just around that consumer experience. So, there's no reason in the world why engaging with the healthcare system should feel any different or any less easy than any other engagement you have in your life. And that's why we've been focused over the last several years on this move toward a consumer capability for the whole company. And that I really believe we're making breakthroughs on in terms of how we're operating. If you just look at 1/1 of this year, so January of this year, and you just look at a couple of examples, our UHC mobile app visits were up 66% year-over-year. That's another record year of growth. The UHC app remains the #1 healthcare app in the Google and Apple App Stores. Across the whole of UnitedHealthcare, our consumers are choosing to increase their digital engagement with us by about a third a year. So, the app is two-thirds up. Everything across the whole of UHC is up by about a third. Our app registrations are up nearly 100% year-over-year. This is us moving to where American consumers want to be. They want to talk to us digitally. They want to use their phone to be able to access us. They don't want to make a phone call. It's been an extraordinary shift. We continue to work that way through. We're able to talk to members now about 10% less every year of our members who are making phone calls. They're getting what they need without needing to pick up the phone and make the call. All of those are fantastic metrics. You go to Optum Rx, the other big consumer engagement point, the most common interaction point across American healthcare is in pharmacy. You look at the 1st of January, you heard already today from John, we enrolled 750 new clients. They represented 1.6 million new American consumers who are now using Optum Rx. We're privileged to serve those people. We were able to bring them on board at a third less cost than in the prior year. That is entirely due to the adoption of digital technology and other modern capabilities. Our digital engagement registrations across Optum Rx themselves are up 16%. Those are all examples of how this company has been investing relentlessly, first and foremost, to understand what American consumers want and then build it. And we are committed to continuing to build those capabilities and deliver the very best, most convenient experience possible, not just in the insurance business, but also in the Optum service business led by Optum Rx. That's where we're going. We're committed to this agenda, Lance. We always have been, and you should continue to see us make substantial improvements to make the experience of engaging with the healthcare system easier tomorrow than it was yesterday. I appreciate the question. Next question."
},
{
"speaker": "Operator",
"content": "We'll go next to David Windley with Jefferies."
},
{
"speaker": "David Windley",
"content": "Thank you for taking my questions. And Andrew, thank you. I want to give you kudos for your emphasis on price. I feel like that's underappreciated in the United States. My question is around SG&A. If I extract -- if I ignore the portfolio changes, the way you might call normal course SG&A improvement, efficiency improvement in '24 was still substantial. You need another step down in 2025 per your guidance. Both of those are significant relative to historical norms. Could you talk about the sources of that efficiency, perhaps a nod to AI and some of the technology that you've talked about, but the sources of those savings and the durability of the savings that you're extracting? Thank you."
},
{
"speaker": "Andrew Witty",
"content": "Yeah, David, thanks so much. I'm going to ask John to give you a kind of overview, and then I'm going to ask our Chief Technology Officer to give you a little like a few examples or a little insight into our ambitious -- I'm going to call it modernization agenda of technology, because it's not just AI, it's all of the different aspects, but I think it'd be good for you to hear from Sandeep. But John, would you mind starting off?"
},
{
"speaker": "John Rex",
"content": "Good morning, David. So, the source of those savings along the lines of the commentary that Andrew was offering a few moments ago, led by digital adoption. So, we serve roughly almost 150 million people across the breadth of UnitedHealth Group. And as we seek to make those experiences smoother, simpler, faster, that's being led by digital adoption. It's being led by having our customer service representatives much more informed when they do pick up the phone if the customer needs to call, much deeper insight into frustrations or any kind of experience the customer may be having or had so they can get to the root cause much more quickly. So, you're seeing those elements just accelerate. Look, I said it a little bit in my commentary, it feels very early stage to us in terms of what we're actually doing here. And as I work with the technology team, Sandeep and the teams and what they're hitting here, these are -- we're just kind of scratching the surface of the opportunity. So, when you ask the important questions about durability, it's super early stage in terms of what we see as the opportunity. I would tell you these -- what we're doing right now feel like just kind of the initial scratching the surface that we'd be doing in terms of where we could -- where we believe we can take this and the opportunities that we're seeing. So, one of the things we're most excited about is the team as we sit together and we think about the experience that consumers are going to have, how we're going to be able to make these much smoother, simpler and satisfying for everyone, including our employees who work with our customers. And Sandeep, maybe you could offer a few comments?"
},
{
"speaker": "Sandeep Dadlani",
"content": "Sure. Thank you, John, and thanks, David, for the question. Our AI, digital, automation and in general, our modernization agenda has focused largely on removing administrative menial tasks in the system and improving consumer experiences. Some examples earlier that you have noticed has been around our call center efforts. Andrew just mentioned, we received 10% less calls for the same consumer base compared to last year. And we haven't even scaled this fully. By the end of 2025, we will be scaling this fully, and that's one of hundreds of use cases that we are scaling. Last quarter, we talked about clinical summaries for nurses that helps our nurses focus on healthcare, and that's getting scaled fully. As we focus in 2025, we actually are excited about more compelling consumer experiences, helping providers and clinicians with documentations and summaries, and frankly, digitizing all the paperwork in the entire healthcare experience; [think of] (ph) benefits documents, facilities, provider contract, helping drive much more automated seamless, frictionless claims processing as well. So, we're excited about the agenda. Thank you."
},
{
"speaker": "Andrew Witty",
"content": "Sandeep, thanks so much. David, I appreciate the question. If we could move on to the next question, please?"
},
{
"speaker": "Operator",
"content": "We'll go next to Scott Fidel with Stephens."
},
{
"speaker": "Scott Fidel",
"content": "Hi, thanks. Good morning. I was hoping just given some of the unusual patterns that we saw in '24 and that then will have effects on 2025 when thinking about the sequencing of Medicaid margins and MLRs and some of the utilization patterns, if you would help us maybe in thinking about any comments on EPS seasonality that may be different in 2025 relative to '24? And then similarly, MLR sequencing that you're thinking maybe having a bit of a different pattern around that guidance that you gave for the full year? Thanks."
},
{
"speaker": "Andrew Witty",
"content": "Scott, thanks so much. John?"
},
{
"speaker": "John Rex",
"content": "Good morning, Scott. So, I'd say in terms of seasonality, first half, second half, think of that as relatively balanced in terms of seasonality for earnings progression. In terms of medical care ratio and thinking about kind of those elements, you start first, of course, with a view that at the midpoint, the full year care ratio will be 86.5%. So, as we noted earlier, about 100 basis points above the elevated '24 level. And I just had discussed '24, it's included a number of discrete items. Within that, the quarterly pattern will look familiar with the first quarter below the midpoint of that and the fourth quarter above the midpoint and trending up to the middle of the year. And then, within the year, the pattern familiar. So, those would be the elements we'd kind of think about as that patterns through. Slope a little impacted, of course, by some of the Part D changes that are out there also, that I think you're well aware of already because those have been out for a while. So, the slope of that will be impacted a bit by that also. Those would be the key elements."
},
{
"speaker": "Andrew Witty",
"content": "Great. John, thanks so much. Appreciate it. Next question?"
},
{
"speaker": "Operator",
"content": "We'll go next to Sarah James with Cantor Fitzgerald."
},
{
"speaker": "Sarah James",
"content": "Thank you. I'll stick on MLR. John, could you help us bridge '24 to '25 by sizing some of the impact of the components that you called out, like your assumptions on core trends versus IRA, and any offsets like rates or non-repeat of the MA Group refunds? Thanks."
},
{
"speaker": "John Rex",
"content": "Yeah, good morning, Sarah. Certainly. So, kind of big elements that we'd call out here, certainly, the IRA impacts, a mix of our -- the people we're serving, we're serving more people than public sector plans. Of course, that's kind of a normal course element. And then, of course, second year of the CMS funding rate reductions here. Elements kind of probably going the other direction here would be certainly the cyber in South America impacts, we'd size those, think about that as about 30 basis points in our 2024. Some of the trend affordability and other initiatives that we have in there also. And then, as I mentioned also, just taking appropriately respectful view of the care activity environment as we step out. Thank you."
},
{
"speaker": "Andrew Witty",
"content": "Thanks so much, John. We just have time for one last question, and operator?"
},
{
"speaker": "Operator",
"content": "We'll go next to Joanna Gajuk with Bank of America."
},
{
"speaker": "Joanna Gajuk",
"content": "Hey, good morning. Thanks for squeezing me in. So, I guess something that maybe didn't come up probably in the discussion of MLR being high in '24, but also the outlook for '25, can you talk about the margins in your Medicare Advantage business? So, I appreciate second year of V28 and such, but just can you explain for us how the margin in that particular business was in '24 versus your target margins? And do you expect the margins to improve year-over-year in '25? Thank you."
},
{
"speaker": "Andrew Witty",
"content": "Joanna, thanks so much. Let me ask Tim Noel to respond to that."
},
{
"speaker": "Tim Noel",
"content": "Thanks, Joanna, for the question. As we think about our long-term planning approach to Medicare Advantage, we remain consistent in our view of targeted margins. And that doesn't change as we were thinking about '25 like any other year, which is good because as we think about our forward view in any sequential year, not a lot of pricing catch-up that we need to engage in and it can really focus on stability for people, the people we serve and the prospects who may want to choose us in the future. So, really not a lot of change here, very consistent with how we've thought about it previously."
},
{
"speaker": "Andrew Witty",
"content": "Great. Tim, thanks so much. And Joanna, thanks so much for the question. Unfortunately, that's all the time we have this morning. And I want to thank you all for a robust and productive discussion. I hope that during our session today, you heard a team that is very focused on both effectively navigating the challenges and distinct growth opportunities ahead for UnitedHealth Group. A team leading an enterprise with the capabilities and energy to help each day to make healthcare better for the people we are privileged and proud to serve. Thanks so much for your time."
},
{
"speaker": "Operator",
"content": "This does conclude today's conference. We thank you for your participation."
}
] |
unh | 2,024 | 3 | [
{
"speaker": "Operator",
"content": "Good morning, and welcome to the UnitedHealth Group's Third Quarter 2024 Earnings Conference Call. A question-and-answer session will follow UnitedHealth Group's prepared remarks. As a reminder, this call is being recorded. Here are some important introductory information. This call contains forward-looking statements under U.S. federal securities laws. These statements are subject to risks and uncertainties that could cause actual results to differ materially from historical experience or present expectations. A description of some of the risks and uncertainties can be found in the reports that we file with the Securities and Exchange Commission, including the cautionary statements included in our current and periodic filings. This call will also reference non-GAAP amounts. A reconciliation of the non-GAAP to GAAP amount is available on the financial and earnings reports section of the company's investor relations page at www.unitedhealthgroupcom. Information presented on this call is contained in the earnings release, we issued this morning and in our form 8-K dated October 15, 2024, which may be accessed from the investor relations page of the company's website. I will now turn the conference over to the Chief Executive Officer of UnitedHealth Group, Andrew Witty."
},
{
"speaker": "Andrew Witty",
"content": "Good morning and thank you for joining us. As you saw in our release, the people of UnitedHealth Group continue to deliver on our growth pillars. Our teams are providing more people with more high-quality health care services and benefits and restlessly looking for ways to simplify the health system and deliver more value for patients, employers and providers alike. By the end of this year, we will have grown to serve more than 2 million new consumers with commercial offerings, fulfill more than 1.6 billion prescriptions through Optum Rx and care for 4.7 million people in value based arrangements. Our people have done all this and more in a challenging period, navigating the first year of the CMS Medicare rate cuts and its impact on member mix. The effects of the state driven Medicaid member redeterminations, certain novel care patterns and the changed health care cyber-attack. While many of those factors could not have been anticipated, thanks to our people's efforts, we can affirm a full year 2024 earnings outlook still within the range, we first offered back in November 2023. It's a distinctive part of the culture of UnitedHealth Group that we continue to strive to deliver on our financial commitments to you through changing environments and unforeseen challenges. As we look to 2025, and I will address this shortly, we remain in a dynamic period for the healthcare sector. Amid this, it's important that we continue to invest in the durable value creating capabilities of this company that support our 13% to 16% long-term growth objective. We will balance our commitments to investing in the promising future before us with managing the known and potential challenges. We remain highly optimistic for the future, even as we are respectful of the pressures the sector faces again next year. Even within this environment, we're well positioned to continue our growth in the years ahead. I want to highlight two important reasons for this optimism. First is our relentless focus on execution, quality and innovation. In particular, we continue to work tirelessly to improve people's experiences with the health system. To that end, this month, we launched a first of its kind national gold card program, which will reduce the number of prior authorizations by 500,000 every year for qualified in network providers. This can help improve both the quality and the affordability of care while reducing friction in the system. Artificial intelligence is starting to be an important tool in improving our work. Our advanced practice clinicians use AI to summarize lengthy patient histories, freeing up hundreds of hours that can be better spent caring for people. Our nurses use Generative AI to review documentation more efficiently, saving time and improving patient service. AI is helping our consumer advocates, powering tens of millions of consumer interactions and provider searches. This allows our advocates to spend more time with people on more complex inquiries, driving better efficiency while also improving the consumer experience as reflected in higher NPS scores. And finally, using AI to help build software is enabling technology engineering teams to enhance the speed and quality necessary to help drive our technology modernization. Our focus on execution and quality is also evident in the Medicare Advantage plans we are offering for 2025. Once again, we focused on consumer value and as much as possible on benefit stability, even as we navigated the adverse Medicare funding environment. With annual enrollment beginning today, we believe we will continue to be a top choice for consumers. A second element underpinning our growth is delivery on our commitment to the transition of the health system to value based care. For over 20 years, there has been a bipartisan consensus among healthcare experts and policymakers that value based care that is integrated, patient centered and outcome focused care is superior to the often fragmented and unnecessarily expensive fee for service system. Across four presidential administrations, CMS has called for private public innovation in the development of value based care models in Medicare and Medicaid. It provides better outcomes for patients. It saves money for the customers and taxpayers who fund care. And it empowers clinicians to focus on providing the most beneficial care. The rationale for these decades long effort to develop value based care is both simple and sound. It moves from incentives based solely on volume to incentives based on a patient's health outcomes and experience. And it helps ensure patient care is delivered not at the highest cost sites of service, but rather those that combine the highest quality and value. The effectiveness of value based care for patients is proven and powerful and it's good for the system. At UnitedHealth Group, we're purposefully organized to support the transition to value based care. It requires deep engagement with patients, setting the foundation to move setting the foundation to move to more coordinated care, connecting patients to primary care earlier driving clinically accurate diagnoses, more effectively recognizing and managing chronic conditions, and slowing disease progression. We're seeing the benefits of this work come to fruition. People served by OptumHealth's value-based care models are more likely to receive cancer screenings and be in better control of their diabetes and hypertension than people in fee for service in Medicare and 10% less likely to visit the emergency room or be re-admitted to hospital program. One example of the impact of better care coordination is our emergency room space discharge program, which helps patients who may be at risk for unnecessary and expensive ER use and readmissions. We have learned that the specific ways in which a discharge is managed can have a substantial impact on readmissions, which are a problem for both patients and facilities. Our nurse care managers proactively engage the emergency teams to provide them relevant information from the outpatient medical record and to facilitate a safe discharge. This approach, currently in eight markets, is already helping to avoid hundreds of inpatient stays each month. It preserves emergency resources for those, who truly need them, saves money and is a better experience for patients. Our many care offerings now serve people in value-based care arrangements in dozens of service areas, integrating primary, surgical behavioral and home care. These patients come from many diverse payers and employers, a clear sign of confidence from the market that we're on the right track. This is the value proposition of UnitedHealth Group, committed to serving patients, providers, payers and customers with quality, integrity and innovation and joining with federal and state governments in the effort to help to build a better health system that meets the needs of all stakeholders now and into the future. Fundamentally, we continue to grow, because more people and organizations are purchasing more of the products and services we offer. It's a simple statement to make, yet a hard thing to do year in and year out. But it's the enduring reason for our optimism about the long-term growth and future of this enterprise. Now I'll turn it over to John Rex, our President and Chief Financial Officer."
},
{
"speaker": "John Rex",
"content": "Thank you, Andrew. Strong growth across the company sets us up well to deliver upon our commitments to you. Amid all the puts and takes of this unusual year, we are seeing what we always look for. New products and innovations taking root among customers, more people being served through our services and continued improvement in the experience people have. These are key to our long-term success. I'll start today by offering some observations on care activity patterns, as we know that is most likely top of mind for many of you. Certain care patterns persisted at higher levels than we expected in the period for three specific and we believe primarily transitory reasons, two of which we noted last quarter. First, the still pronounced upshift in coding intensity by hospitals, which we flagged last quarter. In some cases, the coding actions are extreme. Certain entities have been notably and persistently aggressive, having up shifted their coding intensity factors by more than 20%. We are actively addressing this unnecessary additional cost burden to the health system. The second item, also noted last quarter, is the continued timing mismatch between the current health status of Medicaid members and state rate updates. States often use care activity data that is well over a year old in setting their rates. That typically has minimal impact when member mix levels are relatively stable. But with eligibility redetermination significantly shifting, both the number and average acuity of people covered has changed. As a result of the lagging care activity data as well as the annual rate cycle timing, updates remain well short of current care activity, a factor that for us was more pronounced through the period than anticipated. A third item that emerged more substantially in the period was a rather rapid acceleration in the prescribing of certain high cost specialty medications, primarily those used to treat cardiovascular disease, autoimmune disorders and cancer. We believe a contributing factor to the acceleration was the Inflation Reduction Act, which eliminated the individual coinsurance requirement during the catastrophic coverage phase. As many of you know, more people enter this phase in the second half of the year. While we anticipated this will become a more meaningful factor in 2025, drug manufacturer campaigns pulled some of this activity into this year more sharply than anticipated. With that, let's turn to our Q3 results. Revenues of $101 billion grew more than 9% over the prior year, with strong growth again at both Optum and UnitedHealthcare. OptumHealth revenues grew by over $2 billion and are approaching $26 billion. This was driven by an increase in both the number and type of care services we offer and the patients we serve, especially in the home and among those with complex needs. OptumRx revenues grew by over $5 billion to more than $34 billion driven by strength in our pharmacy care offerings, as well as growth in pharmacy benefits management from new customers and expanding specialty services. OptumInsight revenues in the quarter were stable, approaching $5 billion and the nearly $33 billion revenue backlog increased by more than $1 billion from last year. Turning to UnitedHealthcare. Our domestic commercial business has added more than 2.4 million people through the third quarter. Selling season indications are tracking favorably as we head into ‘25, reflecting continued strong uptake of UnitedHealthcare's innovative offerings. Our Medicare Advantage plans on offer this fall balance providing as much benefit stability as possible for seniors, while contending with the CMS funding cuts, IRA changes and expected care patterns. The initial stars ratings for plan year ‘26 for consumers in four-star or better rated plans is largely consistent with what we saw in our initial results last year. As has been the case in recent years, we expect these percentages to increase. In Medicaid, our new state customer expansion and retention performance remains strong, including recent awards in Massachusetts, Colorado, Rhode Island, Florida and Michigan. We hope to continue to support people and families in the post-redeterminations period and are advocating with states to ensure adequate funding and resources for these often underserved people. Our capital capacities remain strong and continue to underpin our long-term growth objectives. In the quarter, cash flows from operations were $14 billion or 2.2x net income and year-to-date we’re nearly $22 billion. So far this year, we have returned $9.6 billion to shareholders via dividends and share repurchase. Additionally, we have invested more than $11 billion in a wide range of strategic opportunities; including updating and extending our long standing and productive relationship with AARP to better serve older Americans. As highlighted last quarter, after the cyber-attack, we prioritized devoting resources to support care providers, over some activities such as share repurchase. Payments and claim flows for most care providers have normalized, and repayment of these capital advances is underway. Regarding Change Healthcare, for full year '24, we now estimate the business disruption costs will be about $0.75 per share, an increase of $0.10 from the former midpoint. As you may recall, business disruption largely encompasses the loss of revenues combined with the cost of keeping these capabilities fully ready to serve. These effects are not excluded from adjusted earnings. We continue to work with customers to bring transaction volumes back to pre-event levels and to win new business with our now more modern, secure and capable offerings. We expect to continue to build back the business to pre-attack levels over the course of '25 and estimate next year's full year impact will be roughly half of the '24 level. As we enter the final quarter of the year, we are narrowing our '24 adjusted earnings outlook to a range of $27.50 to $27.75 to reflect business disruption impacts and the care patterns we discussed. Our company's ability to deliver within the range of the commitments established nearly a year ago, even in challenging circumstances is another example of the discipline and innovation of the enterprise and the confidence we have in delivering diverse growth for the long-term. Now I'll turn it back to Andrew."
},
{
"speaker": "Andrew Witty",
"content": "Thanks, John. Before we turn to your questions, I want to provide some preliminary observations about next year, which we'll review in more depth at our upcoming investor conference. Perhaps the most important element is that our businesses are operating well and our growth potential remains strong. We see continued momentum in the selling season performance for UnitedHealthcare's commercial business and Optum Rx, which both offer best-in-class innovation and performance for customers. The consumer value proposition of Medicare Advantage continues to be highly compelling and we see strong growth potentially in this market for many years to come. The Optum Health value-based care businesses that we've been building for well over a decade are beginning to approach the very early stages of their potential and will be a key differentiating growth factor in the years ahead. At the same time, and as we build for the future and contemplate our 2025 outlook, we're taking into account several unique dynamics. First, the concurrent timing of the second year of the CMS Medicare rate cuts and the most significant Inflation Reduction Act impacts into a single year and the negative effects of that on the people we serve. Second, within Medicaid, the timing mismatch of state customer rate actions, which do not yet reflect the higher acuity of remaining consumers. And third, a respectful view of the care activity that John noted. We're actively addressing and managing for these and continuing to believe our 2025 planning assumptions appropriately capture these components, though we will be prudent in an initial early view. The majority of those 2025 factors are expected to be most impactful to the UnitedHealthcare businesses. As a result, we anticipate stepping out for 2025 more conservatively than is typical. At this distance, we expect the upper end of the likely range will offer in December has been around $30 per share. As always, we will seek to advance beyond this initial view as the year progresses and we remain committed to and focused on our long-term 13% to 16% earnings per share growth objective. We see 2025 as a year of opportunity in building to that commitment, so you will see us investing in our growth pillars aggressively, modernizing our company with AI and other technologies and always exercising discipline in our operating performance. We look forward to discussing this with you in much greater detail at our Investor Conference on December 4 in New York. Now operator, we'll take some questions."
},
{
"speaker": "Operator",
"content": "Thank you. The floor is now open for questions. [Operator Instructions] And we'll go first to Lisa Gill with JPMorgan."
},
{
"speaker": "Lisa Gill",
"content": "Thank you for the comments. John, I want to go back to where you talked about your observations here in the fourth quarter. Can you talk about some of those that you expect to impact ‘25? And I really want to focus on the third one, which you talked about the rapid acceleration in Rx, but you also talked about the positive impact that you're seeing within your OptumRx business on the specialty side. How do we think about that playing into 2025?"
},
{
"speaker": "Andrew Witty",
"content": "Let me ask John to start, then I'm going to ask Brian, UHC to make a couple of comments, and then we'll come back to Patrick at OptumRx. It's a wide range and set of impacts that you're alluding to. So let me start with John."
},
{
"speaker": "John Rex",
"content": "So just a few comments here and maybe kind of shape some of these messages here. So first of all, in terms of what we would expect to persist, what we expect to subside here. So I'd start with our planning assumptions, as Andrew noted, we're looking for some of these elements here. What was different for us in the quarter than the thoughts we would have had at the end of last quarter is, most notably, what we saw in terms of the rapid increase in the specialty drugs. And we'll get a little bit more to that. There really was a midyear issue. We think really tied into the IRA and the components that shifted for that. And as you look at some of the prescribing patterns that are out, those shifted sharply in the second half of the year. And we would have been planned on some of that happening really more next year. The pull forward in this year was one of those elements that was a bit unexpected. I think the other elements are probably more understood out there. The timing mismatch in Medicaid has been in the conversation, what we've been seeing in the provider in the providing coding intensity also more understood. So maybe we'll go around a little bit to Brian Thompson, let him address some of those elements."
},
{
"speaker": "Brian Thompson",
"content": "Sure, John. As John mentioned, specialty Rx, again, largely contained to our Medicare Advantage book. And let me start with, I feel very adequately priced for how this will play out in 2025, despite the surprise here in the second half. And you might ask how that's possible. What we had done is planned for the IRA to drive a greater induced utilization as it continued to roll out with the biggest elements being in 2025. Obviously, there's a lower out of pocket maximum for consumers in 2024. We expected that to play out more in 2025. We're seeing that accelerate into 2024, but not at levels that would suggest we're not at levels that would suggest we're not covered for it in 2025. Again, we thought it would be a little more gradual. We've certainly seen some manufacturers doing some promotion. I believe that's also contributing. But, certainly feel good about how we priced for it in 2025 because we did anticipate these step-ups, particularly with the large scale changes and more richness and benefit for consumers that will come to play out in 2025."
},
{
"speaker": "Andrew Witty",
"content": "Patrick, maybe just reflect on it from an OptumRx position."
},
{
"speaker": "Patrick Conway",
"content": "In terms of OptumRx, first, I would call out volume where we had a record PBM selling season last year that plays into this year and renewal rates in the high 90s. The growth in mix, including in specialty, drives significant revenue growth for us. I call it pharmacy services, which as you know, Lisa, in our specialty arena, significant growth but also infusion, hospital health system and our community pharmacy platforms, and then new products and services, including around specialty, whether it's Savings IQ, which has saved consumers over $1 billion this year or Price Edge, where we have over 9 million members and saved consumers $125 million or our [wait engage], we've got a number of new products and services around the specialty arena that continue to deliver value to our customers. We're really purpose built to help our customers manage specialty spend."
},
{
"speaker": "Andrew Witty",
"content": "Thanks, Patrick. Thanks, Lisa, for the question. Next question."
},
{
"speaker": "Operator",
"content": "We'll go next to A.J. Rice with UBS."
},
{
"speaker": "A.J. Rice",
"content": "I appreciate the early comments on 2025. I wonder if -- relative to sort of a normal year of 13% to 16% growth, is there any way to sort of size some of the different headwinds and tailwinds you're looking at to formulate what looks like at $30 is about 8% growth?"
},
{
"speaker": "Andrew Witty",
"content": "A.J. thanks so much for the question. Let me just context this a little bit. First off, as you would see in a typical year, we'd always start the year with the plan to obviously deliver but ideally beat and that will continue to be the culture of the organization. We are clearly in an unusual situation right now in terms of the various pressures that we've seen coming externally from particularly government funded reductions and to some extent the continued strength of MedEx cost. Probably net-net, all still somewhat hangover effects of the COVID pandemic still playing through the system, both in terms of volume and also some pressure on unit costs that we've seen, all of which you see in the kind of pressure that we see this year. Now, as we think about 2025, what we're trying to set out here, A.J. is something really important for the long-term future of the company. Those external pressures which we've described, I think, clearly both in the press release and in the commentary this morning, we're being clear about what they are. At the same time, what we mustn't do is pull away from investing in what's going to drive the future of this organization over the next decade. What does that mean? That means, really making sure we're investing in filling out and continuing to build out our value based care platforms. It means really leaning into taking advantage of the technology opportunities, which now exist in reality. So the chance to really modernize our full stack across our organization, transform the way in which we develop new products, give us opportunity to bring forth a new look, OptumInsight based on much newer technologies, give us the opportunity to transform consumer experience, something which is sadly lacking across U.S. healthcare. All of those things are opportunities we sit right now. They sit in the same year, as we have these various headwinds that we've been talking about. And so, what we're doing for 2025 is we're putting in place what we believe is a really responsible plan, really focused on making sure, we don't pull back from investment in the long-term, not shortchanging the next decade. And that's what we're leaning into in terms of making sure our ‘25 plan is responsible for longer term value creation of the organization. Now as I said at the beginning of the response to your good question, A.J., we're always going to go into every cycle aiming to do better than we lay out at the beginning. But I think it's appropriate for us to make sure that we build a plan for 2025, which acknowledges the external pressures and make sure that we retain the capabilities to continue to build what we think is a really distinctive set of capabilities, which will play out very powerfully for the next 10 years. Next question, please."
},
{
"speaker": "Operator",
"content": "We'll go next to Stephen Baxter with Wells Fargo."
},
{
"speaker": "Stephen Baxter",
"content": "Thanks for the color on the MLR factors that you called out. When you think about the Q3 MLR unfavorably developing in the quarter, is it fair to think that all three of those factors were about the same? Or would you call out one of them as maybe being larger? And when we think about the coding and utilization management, I guess, operationally, what needs to happen if you're to make progress on this front? I don't think you've attributed much of this to midnight rule to date. Can you update us on whether that changed at all in the quarter? And maybe if not, where the pressure is manifesting on the coating side?"
},
{
"speaker": "Andrew Witty",
"content": "I'm going to ask John to start and then ask Brian to give you a little bit more perspective on that also."
},
{
"speaker": "John Rex",
"content": "And yes, I would say in the quarter versus our initial expectations that we shared with you a quarter ago, it was really they were all roughly in the same zone in terms of impact in the quarter, those elements that we called out kind of give or take, but they're roughly in the same zone as we look at them. Brian?"
},
{
"speaker": "Brian Thompson",
"content": "As it relates to upcoding new inpatient stays versus what we feel is more appropriately build as outpatient, we did expect that behavior to somewhat subside here in the third quarter. Last quarter, we had talked about the timing of that spike being largely related to our own utilization management waivers during the cyber-attack, but it certainly has persisted. As John mentioned at the outset, this is a few large systems driving it. We certainly do remain focused on evaluation of this practice. It's a key part of our utilization management. The difference between an inpatient and outpatient stay is largely borne by our consumers on an already too expensive cost of care in a hospital setting. So we remain vigilant on focusing on this, hoping to see it abate to levels that we're more used to seeing in the past. And we'll continue to review this as we look forward. Right, Brian. Thanks so much. Next question please."
},
{
"speaker": "Operator",
"content": "We'll go next to Josh Raskin with Nephron Research."
},
{
"speaker": "Josh Raskin",
"content": "There seem to be more moving pieces to the Medicare Advantage landscape than usual entering 2025. So maybe can you just take a step back and speak to your strategy over the next few years? And specifically, how important is growth in Medicare Advantage to UnitedHealth's overall enterprise strategy? And then maybe a potential weakness from competitors changes how you think about coming to market?"
},
{
"speaker": "Andrew Witty",
"content": "Josh thanks very much for the question. Let me just make a couple of comments and then ask Tim Noll, who leads our MLR business to go a little deeper for you. And obviously, very timely given that today is the first day of the selling season for the new MA year going into 2025. So as you look across the whole of UnitedHealth Group, Medicare Advantage, of course, is a very important part of the business, but it is one of several different pieces of what is really a very diversified group of health care businesses. There are obviously linkages from Medicare Advantage to Optum, in particular obviously through Optum Health and elsewhere. But I would say over time, what you're seeing is as important as MA is, you'll see many other elements of the business continue to grow, and that's critical for the long term the long-term sustainability of the company, of course. That's why we've laid out the five growth pillars of the business over the last two or three years, Josh, as really signpost of where you should expect us to deploy capital. It's where we put our mindshare. It's where we look for opportunities to improve the health care system. So, whether that be in benefit design, whether that be in building our value-based care, bringing new technologies to the marketplace, transforming and modernizing pharmacy or bringing forward what ought to be a state-of-the-art financial services capability into a part of the economy, which represents 20% of GDP. Those are the five growth areas of the company. MA is an important element within all of that, but it is one of several key opportunities for us to drive forward. Having said all of that, as we come into this cycle, I think, what we're seeing is the benefits of some very thoughtful, calm, not over reactive planning last year. I think the way in which the team led us through 2024 in terms of benefit design has proven out to be on balance, right, given the very, very many moving parts that you correctly alluded to. I think that sets us up in a good place in terms of how we enter this year. We'll see how this cycle goes. I'll ask Tim to give more comment. But most importantly, it really gives us confidence as we look out over the next four or five years that we're not we don't feel like we're having to fix significant problems that were avoided, if you will, that we didn't make those step mistakes a year ago, which is always a thing to worry about in this situation. We have a lot of moving parts. It's critical not to be over reactive. It's critical to be very much consumer patient centric, and that's really been the guidepost that we followed. And I think it served us well. Tim, I think, is going to serve us well this year."
},
{
"speaker": "Tim Noel",
"content": "Thanks, Josh, for the question. Yes, and I would underscore some of the pieces that Andrew mentioned. And also, yes, it is a very dynamic period right now in the Medicare marketplace. But our strategy and our vision here for the business really doesn't change a lot. I'll just underscore a couple of those that are key to this environment today. One is that, we've always had a long-term planning view and that's never more important than it is today. Right now, that includes a very rational response in any particular year to the revenue pressures that the program is facing. You saw that play out for us in ‘24; you'll see that continue to play out. As Andrew alluded to, that ensures that we don't have any deferred maintenance and pricing carryover into a subsequent year, given the environment that we're in. Along with that, we always strive to provide as much stability as possible to consumers in any one year. In this year, in 2025, that has meant preserving PCP co-pays of $0 for our consumers, and trying to do what we can to make sure that co-pays are near zero for the most commonly prescribed medications as well. And then also to preserve as much choice as possible that we have for consumers that's really important for Medicare beneficiary that we design products and plans that meet their needs and listening to what consumers want will always be a core element as well. Lastly, and this is really important is, this environment is continuing to create more value. And the headline there is around our partnership with our value-based care providers. That's the best opportunity for us to continue to create value in light of some of the pressures that the program is facing and we continue to see great opportunities there. And that's what we're leaning into right now. Finally, the newest technologies that are emerging around AI and ML are giving us some really nice opportunities to provide more efficiencies in our operation and be able to pass those efficiencies along to beneficiaries and then be another and there'd be another considerable way that we offset some of the headwinds of the program. So yes, very dynamic environment, but really our strategy and some of the core principles and foundations of our Medicare Advantage programs don't change."
},
{
"speaker": "Andrew Witty",
"content": "Thanks Tim. And I just want to thank Tim and his team for if you just step back, Josh, and you're super well aware of this. And you just look at the amount of regulatory change, change in funding dynamics, IRA coming into the marketplace, insufficient growth coefficient in terms of future MA funding on top of V28 cuts. What Tim's team has done is basically try to neutralize a lot of that volatility and noise in terms of how it flows through to touch patients and members. It's really important that stability, never more important to have that -- than in this cycle we're in right now. Because otherwise you would see tremendous amount of, I think, disturbing volatility flow through into the market. And we're not going to do that. We are going to put our patients and our members first. We're going to strive to do everything we possibly can to give them a fantastic experience. By working with Optum, we believe that for many of those patients, we can introduce them to an unparalleled set of quality outcomes, both in terms of care and cost and experience. And that work has never been more valuable than when you see the kind of volatility that we've seen last year. And we're going to see again next year because of the things that have already been announced. And what you're seeing us plan for is how to work through that. We're not going to sacrifice long-term potential of all of what we've built in this short period of volatility. What we're going to do is work to insulate members, make sure that members have great experience. And today is the first sell in day and hopefully, lots of folks are going to be picking up the line to UHC today. Next question, please."
},
{
"speaker": "Operator",
"content": "We'll go next to Justin Lake with Wolfe Research."
},
{
"speaker": "Justin Lake",
"content": "Given all the volatility you've been -- we've seen in the sector, I was hoping you could share with us some incremental color on how your Medicaid business ex Duals and your Medicare Advantage business including Duals are performing in the third quarter and for the full year of 2024 relative to target margins. And maybe also give us some color on the expected pace of potential improvement that's implied within 2025 guidance, if there is any improvement expected?"
},
{
"speaker": "Andrew Witty",
"content": "Let me ask Brian to respond."
},
{
"speaker": "Brian Thompson",
"content": "Let me start with Duals, and I would say we remain very encouraged about the outlook for our duals business. Certainly, about the position of those products as we approach 2025, I think that will be a growth element for us. Inside 2024, obviously, we talked about it in our prepared remarks last quarter as well as this quarter. One of the three items contributing is the pressure we see from redeterminations. And that's obviously impacting our Medicaid book. I'd like to say that we probably weathered the storm on the volume impact of redeterminations, and that's now behind us. What we're really looking at now is how do these rates catch up to where our current cost trends are. And I think we've seen some strong momentum with our state partners, but it's not yet responsive to the trends that we're seeing real time. And we're hopeful that through our partnership and our advocacy that we'll close this gap on funding at a faster rate than maybe normal rating cycles would suggest. But the key items in the quarter, again, were just higher volumes of disenrollment. And if I was to point to one element beyond just the traditional acuity of those that left and those that stayed that we had planned for, I'd point to behavioral care. Many of our states have looked to us to expand access to behavioral care. And I think many of us that partner with our states have done so. That does have some cost implications. So we're really hopeful that these states will be more responsive than traditional rating cycles would suggest and that we'll see these tailwinds soon as we pace through this big year again of largely the volume being the driver of the implications in year and now hopeful that we'll see these rating cycles catch up to our cost trends that we're seeing emerge."
},
{
"speaker": "Andrew Witty",
"content": "Great. Brian thanks so much. Next question please."
},
{
"speaker": "Operator",
"content": "We'll go next to Scott Fidel with Stephens."
},
{
"speaker": "Scott Fidel",
"content": "I was hoping just to toggle over to the commercial business and how some of those -- I guess, those three elements, obviously, excluding the Medicaid one, but the other two elements that you talked about that were -- costs were coming in higher than expected. Just if you could maybe sort of bifurcate that between commercial group and then commercial individual and I guess how you're seeing those flow through into both of those markets. And then just on the individual side, just how that informs your view on how you've priced your exchange products for 2025, and sort of comfort with the margin trajectory there?"
},
{
"speaker": "Andrew Witty",
"content": "Let me ask Brian to give you kind of an overarching view and then maybe pass to Dan Kueter to give you a little deeper on the commercial business."
},
{
"speaker": "Brian Thompson",
"content": "Yes, Scott, thanks for the question, it provides me an opportunity to clarify. The three items that we mentioned at the outset and throughout really aren't a part of our commercial business. What we've talked about, obviously, redeterminations in the Medicaid space and the other pressure points around inpatient stays and specialty -- largely around Medicare Advantage. I feel really good about not only our performance, but our cost management inside our commercial business, and I'll hand it to Dan Keuter, our CEO of that business."
},
{
"speaker": "Daniel Kueter",
"content": "I can offer that in the exchange business, as you asked about, our pricing is respectful of the brand and the other market dynamics in that space, which include our product offering, our geographic footprint and the competitive environment. For 2025, we have priced with a forward view of our cost in full respect for trend. As Brian and John have noted, those impacts that are driving some trend in the government programs are not applicable to the commercial business, whether that be on the individual side or the group side. So our outlook on trend for 2025 is consistent with our view for 2024, and the drivers in the commercial business remain the things that we have discussed for some time now: provider unit cost, pharmacy cost and enabling expanded access to behavioral health services. So those have been the driver in '24. We expect those to continue into '25. And we have priced both the individual business and the group business with full respect and awareness of those trend items."
},
{
"speaker": "Andrew Witty",
"content": "Dan, thank you so much. And really, the two elements that Dan just raised there, the pharmacy unit cost and utilization, and of course, the hospital unit cost, are two kind of strategic areas that we really want to lean into. And we've been very outspoken for years about the need to bring down a list price of drugs. We continue to advocate very strongly for that. Until that happens, we continue to utilize all of the tools at our disposal through OptumRx to try and bring down those costs on behalf of our members and on behalf of the companies who we serve within the commercial books of business. We're also exploiting as much as we possibly can, opportunities to be leaders in how we think about biosimilar adoption and how we create wraparound programs on important areas like weight loss. All of which are designed to try and bring down essentially the ever kind of increase in inflationary pressure that we see from the drug bill, and that's an important one. The second one Dan referred to is hospital unit costs. And we've seen really some unusually aggressive and high unit cost asks, we are very much -- we fully recognize the critical role of the hospital systems and hospitals, obviously, within the care delivery environment. But we need to -- we want to continue to work to try and find new compact, a new way of working with hospitals. We want to see less abrasion in the marketplace. We believe that ought to come with more competitive rates in the marketplace. We see a critical role for hospitals as acuity needs rise and rise. But at the same time, we see great opportunity for us to partner with the right health systems to create much better value for money for the overall system. So the two areas we really want to be a willing partner to innovate. And whether that be with drug companies who are interested in new ways of working to bring down cost or whether that's with hospital systems who want to work with us to reimagine what the patient experience, the doctor experiences, and all part of bringing down the unit cost, those are areas that are super important for the long run and it's going to be a space where you're going to see us continue to be very active in terms of putting forward ideas, trying -- piloting new approaches. The national gold card program I mentioned 30 minutes ago, is just one example, and we're going to continue to look for those sorts of opportunities."
},
{
"speaker": "Operator",
"content": "We'll go next to Lance Wilkes with Bernstein."
},
{
"speaker": "Lance Wilkes",
"content": "Could you talk a little bit about OptumHealth? And I had three points there. If you could talk a little bit about some of the drivers of margin improvement in the quarter. If you talk about the outlook for ‘25 for risk contracting. In particular, what things might be driving that as far as adoption in MA and if you're seeing adoption in other segments like employer. And then maybe a sort of related question, are you seeing any other responses in the employer segment to the high premium inflation environment that's out there, like PBC adoption, but also things like binder or whatever?"
},
{
"speaker": "Andrew Witty",
"content": "Let me ask John just to comment on margin. And I'd like to go to Dr. Desai, who looks after OptumHealth, on your second two points, if that's okay."
},
{
"speaker": "John Rex",
"content": "A few things benefiting Optum here is as it continues to progress. Let's start with -- now this is roughly a $100 billion a year business that we've been building over the past decade or so, advancing strongly along the way and we're able to make refinements in the business as we look ahead and such. So that is -- you should expect us to see us continue to refine the portfolio that we are in the types of businesses that we're in. What is OptumHealth is mostly a care delivery business at this point versus kind of what it was maybe even five years ago. And so you should continue to see us focus the portfolio strongly on that. So we'll focus the portfolio on those businesses that make a lot of sense for us, and we will not be in businesses that don't hang as tightly with the theme we have in value-based care and where we're heading for this business for the next decade. In addition to legacy elements in there, such as maybe contracts and such that needed refinements that have been in there for a while and so moving those along, also getting them into a better zone. So really, the company performing very strongly, fundamentally in here and the type of engagement they're having with the people that they serve at OptumHealth. And Dr. Desai and his team and how they've advanced that with the engagement of the most complex patients. Those are the fundamental drivers of how that business has performed. And then our job is to make sure that we refine the portfolio, refine the elements here as we look ahead for the next decade and build."
},
{
"speaker": "Andrew Witty",
"content": "Great. Thanks, John. And Amar?"
},
{
"speaker": "Amar Desai",
"content": "So first of all, we feel very good about the overall performance of OptumHealth. We are continuing to execute against our three year plan that we put in place in 2023, focused on medical cost management and affordability initiatives, clinical engagement, our operating cost management activities and then accelerated diversified growth in some of our services businesses. On that point, in particular, with services, we're pleased with the growth in our OptumServe business, where we've had new product launches in the areas of medical disability exams that have resonated very well in the marketplace and have contributed to a leading position as a clinical provider for the largest government and federal agencies in the country. As it relates to your broader question around growth across payers, we have strong relationships with over 100 planned partners and are poised to execute on a broad, diverse growth agenda. In fact, in this dynamic rate environment and benefit environment we've discussed here, we're actually seeing increased outreach from payers who are looking for really an enduring partner who can operate in capitated arrangements. In particular, a number of productive discussions ongoing around funding and market level planning as we plan for AEP, but also in other lines of business. And foundational to all of these conversations is really first and foremost, the quality of our providers anchored in the community, particularly our ability to achieve clinical outcomes, including closing gaps in care for Stars programs and HEDIS measures, the strength of that network in the geographies that plan partners are looking to grow in, and then continued focus around our clinical engagement. In fact, year-to-date, we've engaged over 80% of our members. 90% year-to-date for our highest risk members. So when I take that together, great momentum and strength to not only grow but grow in a broad and diverse way across multiple lines of business."
},
{
"speaker": "Andrew Witty",
"content": "Amar, thank you very much. And I'm going to ask Heather in a second just to give a little bit of perspective from Hersey the Head of Optum in terms of the value-based care ambition and where we're looking to take that particularly as it differentiates. But both Heather and I have recently been out with some of our key commercial clients, and it's been striking to me the rise in interest and -- it's a beginning, I think but the rise in interest for some commercial employers to start to explore moving to value based as an alternative. And I do think that we're going to see that start to move forward now. It's one of the reasons we've been investing heavily in some new groups, I'll call out particularly Kelsey-Seybold who joined Optum just a couple of years ago. They're really good at the leading edge of that kind of model. And I do think that we're going to see -- Lance, to your good question, I think we're going to see that start to evolve over the next few years. And we're certainly starting to see the beginnings of important employers begin to ask those questions. And there are obviously some who already do it, and I'd expect to see that trend accelerate as we go forward. But Heather, it'd be good just to share a little bit how you're viewing the overall value-based care kind of point of differentiation, maybe from a member perspective and the like."
},
{
"speaker": "Heather Cianfrocco",
"content": "And just maybe, Lance, thanks for the opportunity. I think you're right, you're seeing -- in this dynamic environment and a complex funding environment, you're seeing the value proposition of the value-based care in the sense that Amar described it, not just for those plan sponsors that predominantly take risk for Medicare Advantage, but we're seeing it from employers as well direct to employer. And I think the principles of it, as Andrew said, is one, they're looking for alternatives that give clear predictability. They're looking for a better member holistic experience and that means integrating their wellness programs, it means better answers and closer proximity to the wraparound services they need, including behavioral health and at times home based services. And it means, again, more predictability and the ability to invest dollars in other areas of well-being and health for our employers. The other thing I'd point out is not only to Amar's point are we continuing to invest in value-based care. And with every month, we see more aligned physicians with better tools, with better platforms with increased signals and incentives to ensure that they're focused on the outcomes and the affordability of our members. And you're seeing that show through in OptumHealth's performance. But don't forget the other services, they -- across Optum, also help our payers and our employers, including our risk and quality services that we offer through OptumInsight. Those are the administrative and clinical services, they're more high-powered, they're more universal. We're using AI to bring down the cost of those and increase the universes. And in OptumRx, OptumRx PBM services, if the employer or the plan wants it, is a value-based accountable construct. They can do a pass-through where they manage the cost or they can do an accountable construct, when we talk about our clear guarantee programs. We take the risk for all of those services, including the specialty services. Now it's really important to note, I think this is incredibly important that with guarantee or accountability, our clients don't lose transparency. OptumRx stands for transparency, but we're trying to make it simpler and we're trying to take accountability. So I would point to the value-based services across Optum and say, yes, they're resonating with payers. We're seeing that, and that's why we're so optimistic about our long-term value proposition. But every other service that Optum offers through Insight, through the Bank and throughout OptumRx contributes to that value-based mission and helps all of our clients, payers, state customers, federal customers, employers and should benefit our consumers with better outcomes and with a better experience."
},
{
"speaker": "Andrew Witty",
"content": "Heather, thanks so much. And Lance, thanks again for the question."
},
{
"speaker": "Operator",
"content": "We'll go next to [Joanna Gaik] with Bank of America."
},
{
"speaker": "Unidentified Analyst",
"content": "So I just have a follow-up question on the OptumHealth discussion sites question was about margins. But I want to ask about revenues. In the quarter, the revenues actually did decline sequentially quarter-over-quarter from second quarter about 4%. So -- and I know there was a commentary around streamlining the portfolio and some contracts. So, is that sequential decline and a fraction that you -- there was something that actually did already take place in the third quarter in terms of exiting maybe some underperforming contracts or business lines? So can you comment on that? And I guess, were margins also benefiting from investment income and to what degree? And then I guess for the quarter, real question is about trying to ask again what you assume for margins in OptumHealth next year?"
},
{
"speaker": "Andrew Witty",
"content": "Let me -- I think actually the sequential is a pretty straightforward explanation, let me just ask John to give you a little detail on that."
},
{
"speaker": "John Rex",
"content": "On, yes, so the refinements that I was discussing would be the primary impact in terms of the sequential and what you're seeing sequentially in terms of revenues. And as we continue to refine the portfolio, refine contracts, legacy contracts that might be out there and work ahead on that. That would be the really prime component that we'd see in there."
},
{
"speaker": "Operator",
"content": "We'll go next to Sarah James with Cantor Fitzgerald."
},
{
"speaker": "Sarah James",
"content": "I was hoping you could give us a little bit more color on OptumInsight. So excluding change, how are -- how is the sales pipeline and margins going versus your expectations on the non-change business? And then on change specifically, as we think about its transition into 2025, is that business an earnings drag? And how should we think about the revenue being a headwind or a tailwind compared to '24?"
},
{
"speaker": "Andrew Witty",
"content": "Sarah, thanks so much. I'm going to ask Roger Connor, who leads OptumInsight, to give you a little deeper on this. But I just want to thank and acknowledge that the tech team and the OptumInsight team more broadly for the extraordinary response to the change attack, and Joe shared you in a second, the great progress we've made in recovery in that business. Continues to be -- work to do, obviously, bringing back all the clients who we asked to go work with other folks during the attack. We did the right thing in terms of protecting the system and encouraging people to find alternatives. We're now bringing them back. We've made a huge step forward in that. That work will continue as we roll into New Year, as you heard in the introductory comments, but great progress on that. And the speed at which we will to rebuild a modern platform has been just extraordinary. And I think actually bodes very well for us in the future in terms of how we think about our speed of technical modernization as an organization. More broadly, I think it's also given us the stimulus to really, really reimagine what the future of OptumInsight is going to be, and I'll pass it now to Roger to give you a little more detail on just where we are on the recovery and, more importantly, on the non-change modernization aspects."
},
{
"speaker": "Roger Connor",
"content": "Thanks, Andrew, and thanks very much for the question. I think hopefully, you're going to get a sense of the confidence we feel in OptumInsight going into 2025 as we move through the change event. Maybe if I just start there, first of all, with the cyber recovery and in terms of the progress that's been going well. From a Q3 perspective, you'll see that the business disruption reduced quarter-on-quarter. I suppose where we're focused through the first half of the year has really been on the restoration of the systems, and we've made very good progress. Not really, it's all about reconnecting our customers. And as John shared, we are seeing slightly higher business disruption trend going into the end of the year, and some of that will carry over. Maybe just a couple of reasons to a little bit deeper as to why that's happening. From a reconnection perspective, customers are coming back. We're actually making good progress there. What we're seeing is the volume that's coming back isn't coming back to the pre-attack levels. And customers are really looking for vendor redundancy, what they're out there looking for is in another one or two sources of their software systems, for example. Now we understand that. We think that's a good thing for the health system, but that is having an impact on us this year. But that also creates an opportunity for us. We've got an opportunity to go out and get new customers or sales and become an additional supplier for them. So again, that's a focus. That's going to take a little bit longer, a slightly more complex implementation time. So when you add those to factors together, that's why you see that carryover impact into 2025. I think it's important just to understand just the scope of OptumInsight overall. Because if you look at our core business outside of change, which is the vast majority of OptumInsight, that's where we're feeling very confident around the opportunities that we've got through the end of this year and going into next year. And you can see that we're performing well. We've got momentum. You can see that in our operating earnings in terms of outperformance in terms of our growth year-to-year when you adjust for change. That confidence comes really in a couple of areas. One, the market needs us. The payer and provider markets are where we see real opportunity. There's significant cost pressure in that client base, and they really see our services and software as a bit of a sweet spot. That's where we can help and provide their solutions. And then where I'm actually most excited is what we're going to do in innovation and what we're doing in innovation to accelerate currently, because we're building off that new modernized tech environment that we've built this year at Insight. And we're using AI to not only transform the functionality of our current products, like payment integrity revenue cycle, but to create these differentiated products and creating this exciting portfolio of AI-driven innovations. Now the good news about Insight is that we can go and test those with our partners with UnitedHealthcare, we test them with OptumHealth. We conclude our big health system partnerships. That allows us to test these things quickly and bring them to market fast. And you're going to see us doing that more as we go into next year. So when I add that underlying market opportunity, I add that this AI-fueled acceleration of innovation, that's why I think that we've got -- we're really set up well going into 2025 and for our performance next year."
},
{
"speaker": "Andrew Witty",
"content": "Great. Thanks, Roger."
},
{
"speaker": "Operator",
"content": "We'll go next to Andrew Mok with Barclays."
},
{
"speaker": "Andrew Mok",
"content": "SG&A has been a strong contributor to earnings this year. Just curious how we should think about the permanency of some of those cost changes as we look forward to 2025. Is there anything that you would call out as being more temporary in nature?"
},
{
"speaker": "Andrew Witty",
"content": "Listen, I think you should expect us to be very, very disciplined around cost management. And again, I want to go back to first principles. I'll take you back to the investor conference last year in New York. I stood on the stage and I said, look, essentially, what you're seeing from the CMSP28 rate change is a price cut. I mean that's what it is. And the price cut requires us to respond accordingly. And a key piece of that response, if you want to protect members, which we do is we have to take cost down inside the organization, and we have to try and eliminate waste in the MedEx environment outside of the company. So, we have been relentless around how can we find sustainable cost reductions for the organization, particularly in both businesses. You see this year, I'd say, Optum, in particular, has been doing a remarkable job of taking cost out. I think there's more to go, and we will be very relentless about that. And as an organization, we recognize the payer has the right to change the price they want we have to respond. Cost reduction is a key piece of it. And MedEx management is the other key piece, and those are going to be two really important features of the future for the organization in terms of how we robustly respond to all of this. So yes, you should expect more of that and it will be a key piece of the plan going forward. We just have time for one last question, if we could take the last one, please."
},
{
"speaker": "Operator",
"content": "Yes. We'll take our last question from Erin Wright with Morgan Stanley."
},
{
"speaker": "Erin Wright",
"content": "So you mentioned some of the internal investments just around AI and other initiatives into 2025. But what about broader capital deployment? I guess, how should we be thinking about the priorities heading into 2025 in the context of everything that's going on in and otherwise, but also just what's embedded in your expectation share buybacks or otherwise?"
},
{
"speaker": "Andrew Witty",
"content": "And I'll ask John just to comment in a second. But broadly speaking, our capital deployment is going to be very much led by our five growth pillars of focus for the organization. So as you think about that benefits business, obviously, UnitedHealthcare, value-based care, our technology-led opportunities, our pharmacy businesses and of course, financial services. Those are going to be the areas in which we think about capital deployment. Value-based care is really the organizing principle, which binds all of that together. So that's going to be a key kind of element to that also. And then I would add to that, something we talked about over the last two years extensively is consumerization. You should expect us to continue to challenge and push on how we can constantly modernize the consumer experience that we're able to offer. Technology as a facilitator of that, but also philosophy as a facilitator of that, right? The organization is changing. It's biased to being much more consumers in the way it thinks and operates. We want to continue to bring that to life. So those five growth pillars, the opportunities, the technology of the 2020s gives us, and then a shift in emphasis from the company towards a more consumerist experience, those are really the guide points. And then, John, maybe just more broadly summarize beyond that element, if you could for capital."
},
{
"speaker": "John Rex",
"content": "So you should see -- expect our capital deployment agenda remain very much like it has the past many years, focused on expanding the capabilities of the company, orienting how we look at that orienting around our five growth pillars and where we need to be adding capabilities, clearly generating strong returns for shareholders as we deploy that capital. So first and foremost, that's always been the first priority, how can we build new capabilities for the company that will deliver strong returns for shareholders for the next decade and where should we be putting that capital. That will continue very much the same. You shouldn't see any shift on that. That's always first priority. And then we look at other elements there in terms of in share repurchase and dividend and those other elements where we can return capital to shareholders. So you should see that be very, very steady as you look to the decade ahead in terms of how we've always approached this business."
},
{
"speaker": "Andrew Witty",
"content": "And thank you for the question, and thank you all for your questions this morning. As we look to conclude in this year and further preparing for 2025, we're excited about the future of UnitedHealth Group. We believe we have the focus, the discipline and the adaptability to continue to grow our 13% to 16% long-term target. And we remain, as always, committed to the people we serve. Despite the challenges that we see in the environment externally, we believe at UnitedHealth Group, we have the right mix of people, capabilities, passion and compassion to allow us to not just navigate 2025, but actually in doing so, set the foundations for continued differentiated performance for many years to come. We appreciate very much your attention this morning. Look forward to having the chance to see you in person in New York at our investor conference. Thank you."
},
{
"speaker": "Operator",
"content": "This does conclude today's conference. We thank you for your participation."
}
] |
unh | 2,024 | 2 | [
{
"speaker": "Operator",
"content": "Good morning, and welcome to the UnitedHealth Group's Second Quarter 2024 Earnings Conference Call. A question-and-answer session will follow UnitedHealth Group's prepared remarks. As a reminder, this call is being recorded. Here are. Some important introductory information. This call contains forward-looking statements under US federal securities laws. These statements are subject to risks and uncertainties that could cause actual results to differ materially from historical experience or present expectations. A description of some of the risks and uncertainties can be found in the reports that we file with the Securities and Exchange Commission, including the cautionary statements included in our current and periodic filings. This call will also reference non-GAAP amounts. A reconciliation of the non-GAAP to GAAP amount is available on the financial and earnings reports section of the company's investor relations page at www.unitedhealthgroupcom. Information presented on this call is contained in the earnings release we issued this morning and in our form 8-K dated July 16, 2024, which may be accessed from the investor relations page of the company's website. I will now turn the conference over to the Chief Executive Officer of UnitedHealth Group, Andrew Witty."
},
{
"speaker": "Andrew Witty",
"content": "Thank you, Jennifer. Good morning, and thank you for joining us. The second quarter results we reported today reflect diversified and durable growth and a commitment to ensuring high quality care is available to every person we're privileged to serve. In the first half of the year, revenues grew by nearly $14 billion, with strong contributions from across the enterprise, led by double-digit growth at Optum. UnitedHealth Group entered the second half of the year with continuing and broad-based growth momentum. As a result, we are affirming our full year adjusted earnings outlook even as we absorb $0.60 to $0.70 per share in business disruption impacts related to the cyberattack. These results come from the sustained focus of the 400,000 people of UnitedHealth Group on adding value for patients, consumers and customers through the fundamental execution of our key priorities. We're also well positioned for growth in 2025. In the selling season to date, the most sophisticated thoughtful buyers of health benefits and services in the US, such as large employers, unions, states, seniors, all continue to choose the offerings of UnitedHealth Group, when they're looking for managed care, pharmacy services or a Medicare Advantage plan that provides the best value. This consistent growth reflects customers' recognition of the need for a company like ours. As you know, UnitedHealth Group strives to help reduce the fragmentation and lack of coordination that drives up costs and erodes care outcomes in the $5 trillion US healthcare marketplace. We aim to better coordinate and align incentives among caregivers, payers, and pharmacy, enabling us to focus on the whole patient throughout their health journey. We believe this increases value for customers and consumers, improves people's experience and health, reduces redundancies and waste, and ultimately leads to a more sustainable health system. For example, the proven health and economic value to consumers and taxpayers of Medicare Advantage. A recent study by Milliman found that the cost of taxpayers of Medicare Advantage is 4% less than traditional fee-for-service Medicare. At the same time, Medicare Advantage provides seniors well over $2,000 per year in additional value through lower out-of-pocket cost and important services like dental, vision and hearing, none of which fee-for-service Medicare covers. That means a lot to the majority of the people Medicare Advantage serves, who have limited economic resources and otherwise would lack access to such services. The home visits we offer seniors further illustrate the value of MA. Last year, our medical professionals made more than 2.5 million home visits. As a direct result, our clinicians identified 300,000 seniors with emergent health needs that may otherwise have gone undiagnosed. They connected more than 500,000 seniors to essential resources to help them with unaddressed needs such as food insecurity, medication affordability, transportation, and financial support. They also identified and helped close more than 3 million gaps in care that made a real difference in people's lives. Within 90 days of one of our home visits, 75% of patients received follow-up in a clinical setting. Additionally, Medicare Advantage patients with chronic conditions who receive these home visits end up with better managed and more stable health outcomes, as evidenced by spending measurably less time than fee-for-service patients in emergency room and other hospital settings. The bottom line, our home visit programs help patients live healthier lives and save taxpayers money. It is only Medicare Advantage that makes programs and results like this possible. Similarly, Optum Rx clients continue to appreciate the efforts we make to ensure delivery of the lowest cost drugs in the face of drug companies' sole ability to set prices. They also recognize the importance of the comprehensive pharmacy services we provide to people that's driving our momentum this year and bodes well for 2025. We also continue to bring practical innovation to people through new products and services, and by using new and emerging technologies to improve our own operating efficiency. For example, Surest continues to differentiate itself in the marketplace, which is why more and more customers are offering it to their employees, and why the offering continues to grow substantially. Additionally, investments in modernization of legacy technology and new emerging technologies are enabling our consumer-centric advancement of healthcare. For example, our growing AI portfolio made up of hundreds of practical use cases will generate billions of dollars of efficiencies over the next several years. These investments enable us to improve consumer experience, enhance provider find and price care capabilities to meet people's needs and improve clinical back-office execution. We expect technology innovation to become an increasingly core driver of our growth over the next two to five years. And now, I'll turn it over to our President and Chief Financial Officer, John Rex."
},
{
"speaker": "John Rex",
"content": "Thank you, Andrew. I'll start this morning by providing context on some of the unique items in the quarter. Then, I'll follow with perspectives on care activity and general business updates. The overarching theme I hope you leave with today is that UnitedHealth Group continues to deliver broadly diversified growth with expanding opportunities, work that positions us for continued strong performance in '25 and beyond. Now to update on Change Healthcare. Our focus has centered on the patients, care providers and customers who rely on us to keep the health system running. Payment and claims [slows] (ph) for most care providers are back to normal, but we know that is not the case for some, so we continue to work with those who are not there yet. UnitedHealth Group has provided more than $9 billion in loans and advance payments to help providers mitigate the impact of the attack, all at no cost to them. Cyber impacts in the quarter totaled $0.92 per share, and we now estimate the full year impact will be $1.90 to $2.05 per share. But let me break that down a couple of steps further for you. Of the total in the quarter, $0.64 per share were direct costs incurred in restoring the clearinghouse platform and other response efforts. These included higher medical expenses directly stemming from the temporary pause of some care management activities. For the full year, we now estimate these direct costs at $1.30 to $1.35 per share. The $0.40 to $0.45 per share increase in this estimate is primarily related to care provider financial support and costs for producing and mailing the consumer notifications that will begin later this month. As a reminder, these direct costs are included in net earnings but are excluded from adjusted earnings per share. The other component affecting our results relates to disruption of the ongoing Change Healthcare business. This largely encompasses the loss of revenues combined with the costs of keeping these capabilities fully ready to serve. Notably, these effects are not excluded from adjusted earnings. In the second quarter, this impact was $0.28 per share. For the full year, we now estimate the business disruption impacts at $0.60 to $0.70 per share compared to the $0.30 to $0.40 we estimated last quarter. Most of the service functionality is now restored and revenues are rebuilding even as the pacing of this process varies. These important services are now more modern, secure and capable, and continuing to advance rapidly. Our ambition continues to be to return to baseline performance in '25 and to grow strongly from there. Turning to international. Following the sale last quarter of our much larger Brazil operations, we classified the remaining South American businesses as held for sale. This is a natural step following the Brazil sale. We highly value the relationships we have built with our dedicated colleagues over the last several years and wish them continued success. In a diverse enterprise with a strong growth record and capabilities such as ours, such portfolio evolutions enable us to keep our focus on the many compelling growth opportunities before us. The second quarter includes a total of $1.3 billion in South American impacts, the majority of which is non-cash and largely due to foreign currency translation losses accumulated over the years. About $220 million of this stems from a regulatory action in Chile, affecting all health plans. You'll see that as a component in the supplemental financial tables we provided this morning. The action relates to industry premium increases dating back to 2020, but as configured, will be reflected in consumer premium credits to be issued in future years. As a result, the entire $220 million was recorded as a reduction to premium revenue in the second quarter, increasing our reported medical care ratio by about 25 basis points. Turning to the second quarter medical care ratio, it was also impacted by about 40 basis points, or $290 million due to the suspension of some care management activities after the cyberattack. That makes for a total of about 65 basis points of non-repeating impacts, including South America. Beyond these effects, the care ratio in the quarter was also modestly affected by three other factors. One being member mix within Medicare Advantage and dual special needs plans, which this year has been shaped by the unusual competitive benefit configurations in the marketplace. A second being the timing mismatch between the current health status of remaining Medicaid members and the state rate updates, a timing mismatch we expect to realign in the months ahead. And third, the lingering upshift in provider coding intensity, which we believe was spurred by the temporary suspension of our care review activities and carried past. This impact is not reflected in our cyberattack direct response costs, and we have been addressing it. Nonetheless, we continue to expect our full year medical care ratio, excluding 30 basis points of cyber and South American effects to be within the range we offered in November, albeit at the upper end. For our 2025 Medicare Advantage planning process, we assumed care patterns and mix at the levels we are seeing today, in addition to fully incorporating the second of the three-year phased funding cuts, and we have been fully attuned to how the Inflation Reduction Act will affect Medicare Part D offerings in '25. Also, as noted, we expect the Medicaid timing mismatch to subside as rates are updated throughout the remainder of this year and into next, appropriately reflecting current member health status. Turning to the performance of our businesses. At UnitedHealthcare, revenues of $74 billion grew by $3.6 billion. UHC domestic commercial membership grew 2.3 million in the first half of this year as employers and consumers responded to our distinctive offerings. And while the '25 selling season is ongoing, we are encouraged by the continued momentum we see. Our recently filed Medicare Advantage bid for '25, again took a balanced approach to provide as much stability for seniors as possible, while factoring in the realities of the funding cuts and current care patterns. You can expect us to continue to prioritize balanced and durable performance over transitory market share gains. In Medicaid, we expect membership levels to stabilize as we head into the second half of the year and our teams are executing well with both renewals and expansions. Optum Health revenues grew by 13% to $27 billion, and the operating margin expanded over last year. We are on track to approach 5 million patients in value-based care by the end of this year and are progressing strongly on our earlier and deeper engagement with patients, with a purposeful focus on our newer regions to more rapidly improve health outcomes and experiences. Optum Rx revenues grew 13% to over $32 billion, driven by strong customer response to the differentiated value, consumer experience and clinical expertise we offer. At Optum Insight, for the services beyond Change Healthcare, we see strong performance in line with our expectations. The revenue backlog increased to nearly $33 billion, growth of over $1 billion from a year ago, driven by business process and information technology services for health systems. A few additional items of note. As we highlighted in April, we established an additional $800 million in medical reserves in the first quarter to reflect the potential for the cyberattack to have affected claims receipt timing. With claims now flowing at more normalized levels, we continue to prudently analyze these trends. Similar to last quarter, the second quarter results do not reflect any favorable earnings impacting medical reserve development. Days [and] (ph) claims payable at 45.2 compared to 47.1 in the first quarter. The change was due primarily to the return to more normal claims submission patterns from providers and to a lesser extent, some impact from reclassifying the remaining South American operations to held for sale. Cash flows from operations in the quarter were $6.7 billion, or 1.5 times net income, even with the accelerated funding for care providers. In June, our Board of Directors increased the dividend by 12%, marking the 15th consecutive year of double-digit dividend increases to shareholders. During the quarter, as I mentioned earlier, we prioritized devoting resources to support care providers in the wake of the cyberattack over some activities such as share repurchase. It was the right thing to do, devoting all our efforts to provide stability for the health system. Still, with our ongoing strong capital capacities and with support needs abating, we expect to achieve the full year repurchase objective we shared with you last November. In summary, it is the confidence we have in the performance of our diversified businesses that allows us to affirm full year adjusted EPS in the range of $27.50 to $28.00, the objective we established last year. Even as we have absorbed the unanticipated $0.60 to $0.70 in business disruption impacts. Within this, we expect a balanced pacing in the second half. Now, I'll turn it back to Andrew."
},
{
"speaker": "Andrew Witty",
"content": "John, thank you. As I said in November at our investor conference, we operate in an environment where change is constant. What you've come to see is that when changes happen, foreseen or unforeseen, we just deal with it. UnitedHealth Group is a nimble and adaptable enterprise, well suited to meet the challenges that come our way and the opportunities we pursue with the many and diverse capabilities available to us. In this first half, as we've done before, we navigated a complex external environment while managing through a significant business disruption. We continue to deliver on our growth objectives and are committed to delivering on our 13% to 16% long-term growth target. We'll now answer any questions you might have. Operator, please."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] We'll go first to A.J. Rice with UBS."
},
{
"speaker": "A.J. Rice",
"content": "Hi, thanks for the question. Just to make sure, expanding on John's comments, if we're thinking about the -- your thinking on MLR overall for the rest of the year, it sounds like beyond Change, beyond Latin America, there's two items you're calling out. One is Medicaid timing mismatch, which sounds like you think it’s short term and then this upcoding, coding intensity comment. And I assume that's mainly in the insurance business, but maybe it's in Optum as well. Can you just give us a sense of how much those are impacting your thinking? And how much is second quarter versus the impact in the back half on those?"
},
{
"speaker": "Andrew Witty",
"content": "Yeah, A.J., thanks for the question. Let me ask John to get right to it."
},
{
"speaker": "John Rex",
"content": "Good morning, A.J. Yeah, and really kind of three items that we're talking to in addition to those two here, also the member mix component here when you bring it all together, those additional items that we're looking at in terms of -- versus where we were and how we're thinking about it. I would say they’re in kind of roughly equivalent -- in roughly equivalent zone in terms of their impact here. And then how they flow throughout the year -- the rest of year, really, you'll see some of those elements. So, as it relates to Medicaid impacts, pricing goes on over a period of, say, kind of 12 months or so. So there's pricing that occurs over the rest of this year into next year. So those elements in terms of catching up -- that mismatch catching up with the acuity that we have in the remaining population occurs over a period. Certainly, we are addressing the elements we talked about in terms of what we're seeing in the coding up shift, and we're well underway in addressing those elements, but we'll continue to address them throughout the course of the year. The member mix is kind of the member mix we have now at this point. And that really pertains to just the elements that I mentioned in my prepared comments about some of the benefit design impacts and how that impacted both our growth and also the type of membership that we were left with as we saw our full configuration. That really lasts with us throughout the year. So -- but that was an element we also incorporated into our view for 2025 as we approached our bids for '25. Thank you."
},
{
"speaker": "Andrew Witty",
"content": "Well said, John. And maybe just to reiterate one thing John said and then maybe add a further point, A.J. Super important just to hear what you said in terms of that member mix, obviously, we deal with it during this year, but we obviously had the opportunity to incorporate into our '25 planning and bids. So, feel very good about that. And then the secondly, maybe just to reflect, step back just a little bit on as we think of MLR. Really, the biggest incoming dynamic on MLR at the beginning of this year was the funding reduction in MA, the V-28 significant reduction in funding. And you can see that we are fundamentally navigating that, I think, extremely well. And yes, there are a couple of areas of pressure at the margin. I think as you just heard from John, they're primarily boxed off in terms of they're going to work their way through the pricing cycle with Medicaid or in the case of concerns around coding activity, we're very focused on that, confident we'll be able to -- we are addressing that. So those things feel transitory. Most importantly, we feel good about the way our response to the V-28 funding cut is playing out for us in the overall business. And really that -- as we started the year, that was the much bigger thing to make sure we got right, and I'm feeling like we're well on our way through the first year of this three-year cycle, and we've talked to you repeatedly about how critical it is to make sure we navigate that over the long run, and we feel good about that. So, thanks, A.J. Next question?"
},
{
"speaker": "Operator",
"content": "Yes. We'll go next to Lisa Gill with JPMorgan."
},
{
"speaker": "Lisa Gill",
"content": "Thanks very much and good morning. I want to focus for a minute on SG&A, which came in much better than expected. Can you maybe talk about the key components of where you're seeing cost savings, the durability? And, Andrew, you touched a little bit about AI efficiencies there. Are you starting to see that in this quarter? And how much opportunity is there from an SG&A perspective when we think about AI?"
},
{
"speaker": "Andrew Witty",
"content": "Lisa, thanks so much for the question. I'm going to ask John to comment a little bit. Let me make a couple of kind of upfront comments and then maybe a couple of examples more specifically to help you a little bit on this. So, to get your last point, we are running now hundreds of AI use case deployments. I'd say the first wave of those are essentially allowing us to do things much more quickly, much more reliably, much more efficiently than humans can do them. So an ability to navigate complexity to find answers within complex datasets. And super important, and I'll give you a couple of examples of how that begins to help us as we go on. I think we are now -- you will also start to see as we roll through the end of this year and next year, those same kind of tools begin to be deployed in fundamental reimagination of business process. So one is essentially allowing an existing process to run more efficiently. The second is, can we actually take steps out of a process and really start to change things. I'd call out payment integrity as a front-runner in that particular regard. And you'll start to see a lot of movement there over the next year or so, Lisa. And it's going to be, I think, OptumInsight '25, '26, '27 in terms of deployment of technology to change many of the processes that we've been used to for decades is coming, and that's going to be a very exciting phase. If you look in the short run, I'll give you a couple of examples. And this plays a little bit around technology. I certainly wouldn't say these are all Generative AI examples, but they're certainly digitization examples. They are certainly technology-enabled examples. So for example, we brought on this year at OptumRx a record number of clients. You've seen the growth. You can imagine the number of folks who've been signed up into Rx platforms. We actually spent 9% less this year in the onboarding of that record volume than we did the prior year, 9%, that’s entirely due to digitization, technology efficiency deployed through the organization. Let me take you into another part of the organization, OptumHealth. We've more or less increased our number of risk -- fully risk delegated lives within OptumHealth by about 40% over the last two years. That's -- by the way, that's in excess of 1 million -- almost 1.5 million more lives over that period with zero increase in personnel headcount in the risk-based businesses. So, zero increase in headcount in a business which has increased its served members by close to 40%. So those are just a couple of examples. You're seeing that show up in those two examples, Optum. That's why you're starting to see that leverage flow through the Optum business line and it’s something we obviously expect to continue to sustain over many, many quarters and years. And, John, I'd love you to go a little deeper."
},
{
"speaker": "John Rex",
"content": "Yeah. Good morning, Lisa. As you can -- I guess I'd start by -- it is early in that journey in terms of the potential and opportunity for what we can do. And yes, it was a very strong quarter in terms of cost management. But let me just step back a moment here. As you can imagine, given how some of these businesses were built and the fragmentation of the system, there are duplicative functions and uneven consumer experiences throughout that we're addressing. And as our businesses begin to scale, our ability to produce efficiency accelerates while, at same time, we can improve those customer experiences and expand the best practice across the broader base. The comments that Andrew was offering in his answer to your question, it's just really a natural outgrowth as these businesses begin to move beyond what we have viewed the earliest phases to a more adolescent phase. That's what we're seeing. Very strong this quarter. Over the longer term, we can expect advancement. I wouldn't expect it to remain at this level consistently as we look ahead over the next few quarters, though. It was a super strong quarter. But we are going to look to invest in many of these items that Andrew just articulated here, getting to a more modern streamlined experiences as these businesses evolve further. So I wouldn't expect it to persist right at this level as we make those investments, and we're anxious and ambitious to make those investments."
},
{
"speaker": "Andrew Witty",
"content": "Great. So, Lisa, thanks for raising it. You can tell it's a big focus for us. We laid out when V-28 first was announced, that one of the three ways that we would respond to this is we would double down on our own cost management efficiency and productivity, you're absolutely seeing that. And that coincides with an extraordinarily and exciting moment around technological innovation, whether that's Generative AI, digitization, all wrapped together in our march toward a greater consumer focus within the organization. All of that really hangs together is very much the core focus of how we think about things going forward. Thanks, Lisa. Next question."
},
{
"speaker": "Operator",
"content": "We'll go next to Josh Raskin with Nephron Research."
},
{
"speaker": "Josh Raskin",
"content": "Hi, thanks. Good morning. Looking at your bids that you submitted for MA for 2025, I'd be curious if you could tell us if you were bidding to improve MA margins in 2025, or if you're still within that target range in light of the G&A savings? And then more importantly, maybe just some early thoughts on what sort of growth assumptions you have included in those bids, both your assumption for the market as well as any potential market share gains?"
},
{
"speaker": "Andrew Witty",
"content": "Hey, Josh, thanks so much. I'm going to ask Tim Noel to address the first part of your question. On the second part, you're not going to be surprised. I'm going to defer from making any predictions about next year. It's still a little early. We'd like to see where everybody else plays out in this cycle. I think we [also are] (ph) in the 2024 cycle. Ultimately, the way growth plays out in the marketplace depends on how everybody bids, not just on how you bid. And it only takes one bid to be kind of out of expectation to completely distort your view of how things could play out. So, just going to defer a little bit on that one, but on the first point, Tim, I'd love you to make a few comments."
},
{
"speaker": "Tim Noel",
"content": "Thanks, Josh, for the question. So, as we think about margins in the MA business and as it relates to our bid, I think we've talked about the consistent approach to how we plan margins. And we maintain -- continue to maintain that and we're operating comfortably within that margin range as we have in the past and as we're planning in 2025. And then when I think about our pricing approach for 2025, as Andrew mentioned, too early to get into a lot of specifics as CMS is reviewing those bids right now. But we're in a posture and how we've priced those products as we'll be comfortable with whatever growth is the outcome of the products that we bring to marketplace in 2025."
},
{
"speaker": "Andrew Witty",
"content": "Great. Thanks so much, Tim. And, Josh, appreciate the question. Next question, please."
},
{
"speaker": "Operator",
"content": "We'll go next to Stephen Baxter with Wells Fargo."
},
{
"speaker": "Stephen Baxter",
"content": "Yes. Hi. Thanks. Can you speak in a little greater detail about your expectation that the Medicaid pressure starts to subside in the second half of the year? I guess specifically, can you maybe speak to what you actually know about rates today, either draft or finalized, versus perhaps speaking to a general reliance on actuarially sound rates playing out over a reasonable period of time? Just trying to understand the level of visibility that you have a bit better. Thank you."
},
{
"speaker": "Andrew Witty",
"content": "Okay. Hey, Stephen, thanks for the question. I'm going to ask Krista Nelson, who leads our Medicaid business to respond to that. Kristen?"
},
{
"speaker": "Krista Nelson",
"content": "Yeah, thanks so much for the question. So as it relates to visibility, we've got visibility into the majority of our rates for ‘24. And while there's just a slight gap in the second quarter, we really like how our 7/1 rates are shaping up and continue to work with state partners to influence key assumptions before those rates become final in the future. And while we might see a little bit of dislocation the rest of the year, states have really committed to accurately reflecting the change in acuity from redeterminations into current and future adjustments and really expect this to even out as we pace through the remainder of ‘24 and early ‘25. Thanks for the question."
},
{
"speaker": "Andrew Witty",
"content": "Krista, thanks so much. So I mean, listen, Stephen, I think you heard there why we're confident that this is really a kind of time-fenced issue and in the grand scheme of things, I would characterize this as a margin. It's a part of what you've seen in this small deviation in Q2, but we don't really see it as a sustainably structural issue and you heard exactly why just there. So, thanks, Krista. And, Stephen, thanks for your question. Next question, please."
},
{
"speaker": "Operator",
"content": "We'll go next to Justin Lake with Wolfe Research."
},
{
"speaker": "Justin Lake",
"content": "Thanks, good morning. Just a quick clarification and then a question about second half MLR. So first, the clarification. On the MLR, it sounded like, John, you're guiding to a core MLR at the high end of the range or 84.5%, and then I would add 30 basis points of the one-timers for the full year that you've seen in the first half, that would leave GAAP MLR at 84.8%. Is this correct and to be clear, is there any expectation for further one-timers in the second half of the year? Or should the third and fourth quarter kind of be clean? And then my question is just around, core MLR in the first quarter, ex the one-timers was 84.2%. Sounds like it'll be 84.8% in the second half. Maybe you could help us think about 3Q versus 4Q just to make sure our expectations are set correctly, given how much focus there is here. Thanks."
},
{
"speaker": "John Rex",
"content": "Good morning, Justin. I’d say first, yes, the way you described our assumptions around core full year MLR are consistent with our expectations. So how you describe that is quite consistent. As it relates to just looking at towards the 3Q and such, I'd expect that to be in the neighborhood of 84%, very likely a few tens of basis points higher than that. So, it's kind of a little bit above that in that zone. As it relates to kind of other elements that we've pulled out here, no, they shouldn't be material. Those cyber effects should continue to abate. As we mentioned, we're not adjusting for the elements we talked about the provider and coding intensity, so that kind of pulls through a little bit. But there shouldn't be any material other impacts that we're thinking about. Thank you."
},
{
"speaker": "Andrew Witty",
"content": "Thanks, John. Thanks, Justin. Next question, please."
},
{
"speaker": "Operator",
"content": "We'll go next to Scott Fidel with Stephens."
},
{
"speaker": "Scott Fidel",
"content": "Hi, thanks. Good morning. Actually, I was hoping we could maybe do a similar exercise as Justin just asked about with MLR for OptumHealth margins. And maybe first, if you can talk about how the OH margins came in at 2Q relative to your expectations. And then how you're thinking about OH margins progressing in 3Q and 4Q? And then how comfortable you are with getting into that -- the full year target range that you had provided. And, John, I thought it might be helpful to -- as we think about the sort of pacing in the back half of the year, in particular, how you're thinking about an exit rate for OptumHealth margins as we're exiting 2024 would be helpful? Thanks."
},
{
"speaker": "Andrew Witty",
"content": "Scott, thanks so much for your question. I'm going to ask Dr. Amar Desai, who leads OptumHealth to give you a few comments there. I mean, let me just preface that by saying, look, we feel good -- very good about the continued progression and in particular, the way in which OptumHealth is -- has adjusted to deal with the new funding environment. I'm also very, very encouraged by the degree of external payer engagement with our OptumHealth platform as they deal with the environment themselves and look at Optum as a part of that solution. And I think the performance of the business you see is, it continues to improve over last year. You continue to see decent progression. And let me ask Amar to give you a little bit of a sense of how he sees the second half of the year playing out."
},
{
"speaker": "Amar Desai",
"content": "Hi, Scott. Thanks for the question. So as Andrew said, we're in the middle of the first year of a large rate reduction over the next three years, effectively being a price cut. And as we think about the initiatives, we're pleased with the early success, mitigating the impact of that changing rate environment. In '23, we developed a three-year plan to manage through V-28. Medical cost management and affordability initiatives was at the center of it. Proactive clinical engagement that impacts member experience and total cost of care is obviously core to that, including better prevention and chronic disease management and then disciplined operating cost management, more efficient ways to work, improvements in productivity, driving consistency in our workflows and systems, which Andrew and John alluded to. We're executing very well on this plan, seeing solid progress across each of these areas. As an example, at this time last year, we had engaged 62% of all members. Year-to-date, we've engaged three-fourth of all members and above that for our highest risk membership. We're also focused on coordination of care, particularly at transition points in care, where we've increased post-discharge visits for patients who have been hospitalized that has, in fact, reduced readmission rates by 10% in our most mature markets. So, as we pace through the balance of the year, we expect to continue to build on this momentum across engagement, affordability and operating cost management and are confident in the 7.7% to 8% target for the year."
},
{
"speaker": "Andrew Witty",
"content": "Great. Amar, thanks so much. And, Scott, thanks again for the question. Next question please."
},
{
"speaker": "Operator",
"content": "We'll go next to Kevin Fischbeck with Bank of America."
},
{
"speaker": "Kevin Fischbeck",
"content": "Great, thanks. Just wanted to clarify, I guess, something and ask another question. It wasn't clear to me what you were saying about no favorable reserve development. Does that mean the $800 million that you mentioned previously is still somehow in the numbers? Or is that kind of worked its way through at the end of Q2? And then I guess just trying to understand better where the outperformance is because obviously, you guys have assumed $0.60 to $0.70 of Change costs in your guidance but reaffirm the numbers and it doesn't sound like Medicare is the answer, doesn't sound like Medicaid is the answer, Change isn't the answer. So where has the outperformance come in that’s allowed you to maintain guidance? Thanks."
},
{
"speaker": "John Rex",
"content": "Yeah. Good morning, Kevin. This is John. So yeah, exactly what we said there was nothing material there going on in development. No favorable P&L impacting development in the quarter, very similar to last quarter in terms of there was just no impact being there. And in terms of just a comment -- or questions regarding outperformance, well, maybe some across a number of the businesses in terms of where we're seeing, we're seeing very strong growth, certainly in our commercial health benefits business, we're seeing strong growth. We're seeing margin progression in OptumHealth. So we're seeing advancement. The -- really, the strong approach that the team at M&R took and tell how they looked at '24 in terms of overcoming the headwinds at V-28 and the very disciplined approach they took to how they stepped out into the marketplace with the products that they took. Even with some of the elements that we talked about that we’re overcoming there, but certainly, all those creating a good impact from us. Clearly, just across the company, the strong operating efficiencies that the company is driving, strong and sustained. And as I said, look, we will continue to make investments, but really a significant progress on that and still very early stage. So as Andrew commented in terms of the potential we have as we look over the next three years and this impact, and we're just getting some of these businesses to a maturity level where we think we can really harness that. Thank you."
},
{
"speaker": "Andrew Witty",
"content": "Yeah. Thanks, John. And let me just also reiterate that point. I mean part of what you're seeing here, Kevin, is obviously, the big change this year was the V-28 funding cut price reduction, which obviously focuses primarily on our Medicare Advantage business that Tim runs and the OptumHealth business that Amar runs, both of whom are responding super well. But let's be clear, while those pricing cuts are focused on two businesses, team UHG is responding, right? The entire corporation is engaged in how it manages itself better, reduces cost across the company, leverages technology, accelerates our consumer agenda, all designed to play our part across the board in how we offset the pressure that's been inflicted on those two important businesses. Why we're confident we can navigate this? I think you're seeing that in the performance of the business, and we're going to continue -- it’s why I said what I said earlier today. We're going to continue to focus on every aspect of our business to make sure that the model we've laid out and we believe is the right one for delivering best value care for patients is the one that prospers and we're super confident in that. Next question?"
},
{
"speaker": "Operator",
"content": "We'll go next to Andrew Mok with Barclays."
},
{
"speaker": "Andrew Mok",
"content": "Hi, good morning. The OptumInsight backlog was down about $200 million sequentially. Can you give us color on the drivers of that and the nature of conversations you're having with providers following the cyberattack? Do you expect further declines in the backlog this year? Thanks."
},
{
"speaker": "Andrew Witty",
"content": "Andrew, thanks so much for that. Let me ask Roger Connor to address that. It's pretty straightforward. But let me ask Roger to answer that and maybe give you a little bit more flavor on what he's seeing."
},
{
"speaker": "Roger Connor",
"content": "Yeah, Andrew, thanks very much for the question. Just in terms of backlog, obviously, an important measure and there has been some impact from the Change events within that. What it doesn't include, obviously, is what we're doing in terms of bringing in new clients and what we're doing in our whole innovation space. But fundamentally, we are very confident in terms of the performance going into next year with the cyber event certainly from an impact on the overall health system is not absolutely minimal. When you look at our overall focus, it's now on driving that business recovery. And that's all about bringing volume back into the system. And we're seeing that actually really ramping up and seeing momentum acceleration. We're not only trying to bring volume back into our current customers. We're also going to bring new clients in, and that's exciting because this event has really transformed the marketplace. They're looking for, again, access to innovation, access to security in the system and that’s what we've brought back. We've brought back a very secure system, and that is resonating or seeing that momentum. You add that to the underlying strength of the OptumInsight business. Again, Change is only 15% of our overall business performance this year, was planned. That's why we're confident in terms of getting back to our baseline performance in 2025."
},
{
"speaker": "Andrew Witty",
"content": "Great. Thanks so much, Roger. Thanks, Andrew. Next question."
},
{
"speaker": "Operator",
"content": "We'll go next to Nathan Rich with Goldman Sachs."
},
{
"speaker": "Nathan Rich",
"content": "Hi, good morning. Thanks for the question. I wanted to go back to the provider coding activity that you called out and asked maybe what you saw kind of change in the quarter and what actions you're taking to address this change? And is this pressure something that accounted for in bids for next year? And then if I could just ask a very quick clarification on the Change impact on EPS. You talked about the return to baseline performance in 2025. Does that mean you would expect to recover the $0.60 to $0.70 [that is in] (ph) earnings this year? Thank you."
},
{
"speaker": "Andrew Witty",
"content": "Okay. Thanks so much for the question, Nathan. Brian, if you'd like to go first?"
},
{
"speaker": "Brian Thompson",
"content": "Sure. I'll answer that first part on the upshift that we saw in provider level of care coding patterns. We actually believe that was largely induced by our level of care waivers that we did during the cyber disruption. The reason we believe that is we really saw a higher level of mix to inpatient versus observation after we went back to turning on our utilization management protocols. Pretty distinct on April 15th and thereafter. So that's why we see that. Certainly aware of that activity as we plan for 2025 in our bid. So, really no concerns with respect to that. I feel like it's an anomaly tied to what we saw during our waiver. And we have reinforced our utilization management protocols and believe that these impacts will dampen as we pace through the remainder of the year."
},
{
"speaker": "John Rex",
"content": "Yeah. And regarding Change, yes, as we mentioned in our comments and Roger mentioned, our ambition is to get back to baseline expectations performance for that business in 2025. So those baseline expectations being what we would have expected prior to any of this happening. And clearly this quarter, we have increased the impact of the business disruption here. So as we bring those back, there's the pacing of those revenues coming back, taking sometimes a little bit more time to bring in, but that is our ambition, actually, as we look ahead."
},
{
"speaker": "Andrew Witty",
"content": "Thanks, John, Brian. I mean, again, just on this business interruption piece, I mean, I think in all honesty, we were a little optimistic in hindsight at the pace at which we thought people would come back in terms of putting their flow through the system once it was reconnected. I think as we've looked at the last several weeks, that momentum and pace, and particularly as we look at new clients come in and as well as returning clients feel good about where we are now. So I think probably a little overoptimistic three months ago. I think now, I feel like we have this now and we're in good position and the rest of the year we've got a clear path how this plays out. And I think the platform that we've rebuilt is going to serve people extremely well. Next question."
},
{
"speaker": "Operator",
"content": "We'll go next to Erin Wright with Morgan Stanley."
},
{
"speaker": "Erin Wright",
"content": "Great, thanks. So on the earlier topic of potential offsets, I wanted to ask on Optum Rx and with the recent level of industry attention kind of on the PBM business as well as kind of specialty pharmacy, how should we think about how those drivers are playing out relative to your expectations, whether it's biosimilars or GLP-1s in terms of that therapeutic category, how should we think about those near-term drivers across Optum Rx? Thanks."
},
{
"speaker": "Andrew Witty",
"content": "Erin, thanks so much for the question. Let me ask Heather, who runs Optum for us, to make a couple of comments on that, if you don't mind, Heather."
},
{
"speaker": "Heather Cianfrocco",
"content": "Sure. Just basically, I think you can see in the quarter, just strong performance, maybe a couple of things I would just highlight for that. We've talked for a few years about the investments we've been making in Optum Rx on both the PBM side, but also on the pharmacy side. PBM side, you've seen the growth there in client and just in volume, sort of same with respect to volume within our existing clients as well. We take that as a sign of strong retention of existing clients and continuing to perform with them. I think the thing I'd highlight on the PBM side is, I've said this before, the modular effect of the PBM business. We serve at the privilege of our clients, so what they need, we serve, And that is we administer their benefit. And we offer the programs, the services to drive affordability of medications for them in the best interest of their members. And we've brought a lot of products and services in the last year. Two or three new products this market that are leading differentiating in the marketplace that we are seeing our health plans and our employers take advantage of this year that are really market differentiating and we are seeing that drive not just growth with health plans, but growth in products and services. So I think you're seeing that show up. The other thing you're seeing is the cost efficiency show up in the business. One of the -- Andrew brought up an example. And you're seeing some of the timing of supply chain efficiency. On the services side of the business, you mentioned specialty, I call out the diversification of the pharmacies in general. Remember, we've got the integrated behavioral health business which continues to grow and expand. It's a very differentiated business in that it's co-located and it's specifically directed at those behavioral health members to ensure access and affordability and holistic care to individuals with mental health conditions. And then our frontier and our infusion services that really drive those specialty medications in-home, we're seeing continued need for that from our PBM clients, but also non-PBM clients. And so that's where we're really seeing that diversified growth. So you're just seeing that show up in continued, consistent performance in that business through the quarter."
},
{
"speaker": "Andrew Witty",
"content": "Heather, thank you. Erin, thanks so much for the question. We have time for one final question, please."
},
{
"speaker": "Operator",
"content": "We'll go next to Lance Wilkes with Bernstein."
},
{
"speaker": "Lance Wilkes",
"content": "Great, thanks. For OptumHealth, could you talk a little bit about what pricing has been like there? And, in Investor Day, it seemed like you may have seen some improved pricing as far as global cap rates, and likewise given higher global cap rates out of the MA business. Was wondering if ‘25, we should be expecting continued improvement in that, or whether there needs to be a retrenchment or retracing of that kind of makeup for what was given? And also, are you starting to exclude things from global cap as you look at 2025? Thanks."
},
{
"speaker": "Andrew Witty",
"content": "Hey, Lance. Thanks for the question. And love the cheeky attempt at the end of the call to get us to predict, give you some numbers for ‘25. We're going to defer from that, but well done on the last-ditch effort. I'm going to ask Amar to give you a little bit more of a kind of general sense of how we're seeing that. And please go ahead, Amar."
},
{
"speaker": "Amar Desai",
"content": "Thanks for the question, Lance. Look, we continue to have very strong relationships across our over 100 plan partners. And in fact, in a pretty dynamic rate and benefit environment, we've seen increased outreach from payers looking for an enduring partner that's very adept at operating within fully capitated value-based arrangements. In particular, the discussions have been productive around benefit design, funding, market level planning and we're confident in the position as we go into 2025. We're down the path in adding plan partners as well as adding geographies for 2025. Foundational within that to those relationships and as we think about those arrangements is quality, quality of care of our providers that are anchored in the community, our strong ability to drive clinical outcomes, improvements and achievement in star measures, and of course strong documentation and diagnosis. We also are seeing that the strength of our network that's aligned in geographies is an important focus area for plan partners, and of course continued focus on clinical engagement which I mentioned previously. So when you take that together, great momentum across those areas gives us confidence as we drive value for our plan partners and as we pace through the next two years of the risk model changes and grow."
},
{
"speaker": "Andrew Witty",
"content": "Amar, thank you very much. And as I think you could probably sense from those couple of answers that Amar has given you over the course of the call, Amar leads a very, very special team of people running a very, very special business in terms of what it’s able to do on behalf of patients and the way it's able to provide great work experience for the healthcare professionals and colleagues who work in that business. I'm very pleased with how the continuation of that business progresses. We're coming toward the end of the call. I'd like to thank you all for your questions this morning. As you've heard, our focus on fundamental execution, our restless spirit, and our ability to adapt to changing environments gives us great confidence as we look ahead and as a testament to the hard work and discipline of the people of UnitedHealth Group who work every day to serve patients, consumers, and care providers, customers efficiently and effectively. We appreciate your time this morning. Thank you."
},
{
"speaker": "Operator",
"content": "This does conclude today's conference. We thank you for your participation."
}
] |
unh | 2,024 | 1 | [
{
"speaker": "Operator",
"content": "Good morning and welcome to the UnitedHealth Group First Quarter 2024 Earnings Conference Call. A question-and-answer session will follow UnitedHealth Group's prepared remarks. As a reminder, this call is being recorded. Here is some important introductory information. This call contains forward-looking statements under US Federal Securities Laws. These statements are subject to risks and uncertainties that could cause actual results to differ materially from historical experience or present expectations. A description of some of the risks and uncertainties can be found in the reports that we file with the Securities and Exchange Commission, including the cautionary statements included in our current and periodic filings. This call will also reference non-GAAP amounts. A reconciliation of the non-GAAP to GAAP amounts is available on the Financial and Earnings Reports section of the company's Investor Relations page at www.unitedhealthgroup.com. Information presented on this call is contained in the earnings release we issued this morning and in our Form 8-K dated April 16, 2024, which may be accessed from the Investor Relations page of the company's website. I will now turn the conference over to the Chief Executive Officer of UnitedHealth Group, Andrew Witty."
},
{
"speaker": "Andrew Witty",
"content": "Good morning, and thank you for joining us today. We have a lot to cover. First, we'll discuss the status and impact of the Change Healthcare cyberattack, then we'll turn to the performance of our businesses, which continue to grow and perform well. It's important to underscore at the outset that even as we have devoted significant attention to addressing the Change Healthcare attack, the vast majority of the 400,000 people of this enterprise have remained as usual, intensely focused on delivering for all those we serve. That dedication is reflected in our overall performance this quarter. Directly as a result of their hard and -- hard work and the broad performance of our diversified businesses, we're able to reconfirm our full year adjusted earnings outlook, even as we absorb $0.30 to $0.40 per share in business disruption impacts related to Change Healthcare. Now turning to Change Healthcare, this was an unprecedented attack by a malicious actor on the US health system. We promptly disconnected the affected services and turned our focus to two main areas, restoration and support. The attack disrupted the ability of care providers to file claims and be paid for their work, we moved quickly to fill this gap. Fortunately, we were able to bring to bear the substantial resources of UnitedHealth Group to drive the recovery and begin to mitigate the impact. Resources, which are standalone to Change Healthcare, would not have had access to on its own. These are the resources and the philosophy that underpinned our remediation of healthcare.gov back in 2013, and our distribution of CMS COVID emergency relief funds to care providers in 2020. Here, we assisted care providers in financial need, providing over $6 billion in funding, all at no cost to them. We rapidly deployed resources to develop alternative solutions and move promptly to restore claims and payment services. We've made substantial progress and we will not rest until care providers' connectivity needs are met. And to help care providers mitigate workflow disruptions and help ensure the uninterrupted delivery of care, for a period of time, we suspended some care management activities. I'm immensely grateful for our colleagues who continue to work tirelessly day and night to restore services, free up funds for providers, and protect the broader health system. Let me touch on two more items we know are of interest to you. First is care activity. The central point is that overall care patterns are consistent with what we anticipated last year heading into 2024 and within the outlook we shared with you in November. The second item is the essential value of Medicare Advantage to seniors. Here are what we see, some of the core facts regarding Medicare Advantage. It drives better health outcomes, provides a higher-value, significantly more comprehensive benefit for people, all at a lower cost to beneficiaries and taxpayers, and is more popular with and valuable to seniors than traditional Medicare. Medicare Advantage consumers spend on average 45% less on premiums and out-of-pocket costs than those in traditional Medicare. That translates into nearly $2,400 in savings annually and several times more for the country's most underserved and medically challenged populations. That's one of the many reasons why more than half of seniors choose Medicare Advantage today versus 30% 10 years ago and why we believe these offerings will continue to grow strongly for years to come. 2025 is the second year of the significant three-year phase funding reductions to Medicare Advantage introduced by CMS last year. Here, in early 2024, we're at the beginning of our thoughtful responsible three-year plan we developed last year to adapt to those changes. Our strategy continues to focus on providing as much stability as possible in the reduced funding environment. Improving outcomes and experiences for the consumers we're privileged to serve, and delivering the performance you expect from us. We believe our long-term perspective and the deliberate multi-year approach we began last year is serving us well, putting us into a position of sustainable competitive strength. Among a handful of notable business developments to share, UnitedHealthcare was honored to secure major Medicaid wins in Virginia, Texas and Michigan. While we're disappointed in the outcome in Florida, we'll be seeking to better understand the process and considerations there. There is a substantial pipeline of Medicaid RFPs and we're confident that our offerings will resonate in other states as well. UnitedHealthcare's commercial benefits continued their momentum from last year, growing to serve two million more people in the first quarter, the largest increase in years. This growth was across UHC's commercial customer segments from individuals up through the largest of employers. This is further evidence of our innovative and consumer-centric products have established the footing for sustained growth. We also see continued momentum at Optum Rx, coming off last year's record-selling season with a recent win in Hawaii and the renewal of our contract with the Department of Veteran Affairs. We're grateful for the opportunity to support them. And Optum Health is tracking well to achieve its objective of growing to serve another 750,000 patients in value-based arrangements this year in partnership with many payers. Before I turn it over to John Rex, our President and Chief Financial Officer, I want to acknowledge Dirk McMahon, recently retired after more than 20 years of service, I'd like to thank him for his leadership and partnership. Dirk has left an indelible mark on this company through the example he set and the many of our leaders he has mentored. John?"
},
{
"speaker": "John Rex",
"content": "Thank you, Andrew. This morning I'll first provide color on some of the unique items in the quarter directly related to the Change Healthcare cyberattack, followed by care activity trends, business updates, and finally thoughts on the remainder of '24. But first, let me start at the most fundamental level. The UnitedHealth Group businesses continued to grow and perform well during the quarter, and we are encouraged by the momentum and the many opportunities to serve we're seeing across the enterprise. On the Change Healthcare cyberattack, as Andrew noted, our guiding focus throughout has been to make sure patient care is delivered and care providers' access to funding is secured as we work to bring back services fully. The cyber impacts in the quarter totaled about $870 million or $0.74 per share. At this distance, we estimate the full year impact will be $1.15 per share to $1.35 per share. Let me break that down into its key components. Of the $870 million, about $595 million were direct costs due to the clearinghouse platform restoration and other response efforts, including medical expenses directly relating to the temporary suspension of some care management activities. For the full year, we estimate these direct costs at $1 billion to $1.15 billion or $0.85 per share to $0.95 per share. It's important to note these direct costs are included in net earnings, but are excluded from adjusted earnings per share. The other component affecting our results relates to the disruption of ongoing Change Healthcare business. This is driven by the loss of revenues associated with the affected services, all while incurring the support and costs to keep these capabilities fully ready to return to service. Notably, these effects are not excluded from adjusted earnings. In the first quarter, this impact was about $280 million or $0.25 per share. At this distance, we currently estimate the business disruption at $350 million to $450 million or $0.30 per share to $0.40 per share for the year. This, of course, will depend on the ultimate timing of service and transaction volume restoration. These elements are broken out for you in the supplemental tables provided with our press release this morning. Of course, we will provide regular updates on our progress and outlook throughout the course of the year. While much of Change Healthcare's functionality and services have been restored, we are working hard to restore more and the objective we all share is for an even stronger Change Healthcare to be fully returned to expected performance levels next year. I'll come back to some of these elements in more detail in just a moment. Turning to underlying care patterns. The headline is that these continue within our expectations. Outpatient care activity among seniors remains consistent with the elevated levels we began seeing in the first half of '23 and for which we planned. So we continue to be comfortable with the outlook we established last June when we filed our 2024 Medicare Advantage benefit offerings. The winter seasonal activity we discussed with you in January, particularly related to strong vaccine uptake, higher respiratory illness incidents, and related physician office visits has subsided. Overall inpatient care activity also remains within our expectations. The first quarter medical care ratio at 84.3% included roughly 40 basis points or about $340 million related to the temporary suspension of some care management activities. These have been recently reinstated. The majority of the remaining $325 million of full year medical expense impact included in our outlook will land in the second quarter. Notably, we did not reflect any favorable earnings impacting medical reserve development in the quarter. Out of prudence, due to the potential for the cyberattack to affect claims receipt timing, we reflected an additional $800 million of claims reserves. We'll continue with a judicious view as we progress over the next several quarters. Turning to the performance of our businesses. The most important takeaway is they are growing and performing at a level, which allows us to maintain the adjusted earnings per share objectives we established last November, even while taking on the business disruption impacts of the Change Healthcare attack. At UnitedHealthcare, revenues of $75.4 billion grew nearly $5 billion. Within our domestic commercial membership, we're off to a strong start, powered by disciplined growth, serving 2.1 million new consumers in the first quarter. We are encouraged by the momentum and positive customer response to our differentiated offerings and look forward to building further upon that momentum heading into '25. For Medicare Advantage, as you would anticipate, we are deeply into our '25 planning activities. As we finalize our '25 benefit designs over the next several weeks, we will build competitive offerings that once again appropriately reflect the funding and cost environment. We approached this last year with a deliberate three-year plan, which continues firmly on track and positions us well going into '25. Our Medicaid business ended the first quarter with 7.7 million members. As Andrew noted, key wins in Texas, Virginia, and Michigan demonstrate the value state customers see in our offerings. In Virginia, UHC was the highest-scoring plan with particular strength in member-centric care, benefits and service delivery, quality, and value-based payments. In Texas, UHC was awarded the maximum number of possible service areas, expanding the number of people we will have the opportunity to serve. And in Michigan, UHC achieved perfect scores in such critical consumer-centric areas as social determinants of health and health equity, further solidifying our value proposition. Optum Health's revenues grew by 16% to $26.7 billion, as we increased the number of patients served and are on track to approach five million patients in value-based care by year end. For the most complex patients that Optum Health serves, we have engaged 75% through the first quarter this year, a significant increase in the number of patients engaged over last year. This reflects progressively earlier connectivity with patients and the ability to improve their health outcomes and experiences more rapidly. Optum Rx revenues grew 12% to $30.8 billion, driven by new client starts, continued expansion within existing partnerships, and growth within pharmacy services. Optum Insight, as you know, is where the Change Healthcare business resides. In the quarter, about $500 million of the $870 million total impact is within Optum Insight. Just under half of this are direct response costs, think clearinghouse restoration activities, which we have excluded from adjusted earnings, and slightly over half are the business disruption effects, which are not excluded from adjusted earnings. For many of the impact of Change Healthcare services, transaction volume drives revenues. So the effect of the attack in the period is one of keeping all the lights brightly burning at full readiness to resume services, while revenue production was essentially suspended. To be clear, the Optum Insight team did the critical and right thing, promptly shutting off services and finding any method possible to keep the care system working, including helping clients find alternative solutions. Coming out of this incident, the team will be working tirelessly with customers to recover transaction volumes and demonstrate that Change Healthcare is ready to serve and is more valuable than ever. Beyond Change Healthcare, the Optum Insight revenue backlog increased to nearly $33 billion, growth of over $2 billion from a year ago, driven by health system partnerships to provide business process and information technology services. A couple of other items of note that were affected by the cyberattack. Days claims payable in the first quarter were 47.1 compared to the 47.9 in the fourth quarter '23, and 47.8 a year ago. The accelerated payments to care providers and the Brazil sale reduced what would have been our reported measure for the quarter by about three days. The medical cost payable balance increased $1.6 billion from year-end '23 to $34 billion. The change reflects a $3 billion increase in the incurred but not yet reported component or IBNR. This is a result of the prudent ongoing claims receipt assessment, offset by a $1.6 billion reduction in the fully processed claims component, due to care provider payments acceleration. Cash flows from operations in the quarter were $1.1 billion, impacted by about $3 billion due to the funding acceleration to care providers and collection extensions to affected customers, and were additionally impacted by the timing of some public sector receipts. To summarize, a continued focus on better serving patients and the health system underpins our mission and growth drivers, which remain strong. And as we move further into this year, the broadly strong performance across our enterprise allows us to continue to expect full year adjusted earnings per share in the range of $27.50 to $28.00, even as we incorporate a $0.30 per share to $0.40 per share of business disruption impacts. Now I'll turn it back to Andrew."
},
{
"speaker": "Andrew Witty",
"content": "Thank you, John. As we look out over the next several years, we, like many others, see a healthcare environment in need of improvements in quality, value, simplification, and consumer responsiveness. While we're a comparatively small part of the $5 trillion US Health System, UnitedHealth Group's strategy is focused on helping to meet those very needs and we're well-positioned to do so. Our focus on understanding opportunities to align incentives, notably led via our value-based care offerings, demonstrates what can be achieved through partnership and realignment of ways of working. Our commitment to improving all we do for consumers stimulates our drive to help bring care to patients, where they need and want it, at prices and with an experience worthy of the 2020s. We have a proven commitment to making available our insights and innovations widely and quickly throughout the market alongside our relentless multi-payer orientation at Optum. We remain committed to partnering with others throughout healthcare to help make the health system more modern and responsive. Our success depends on enabling partners and customers outside our company to succeed. The combination of this strategic design, strengths, and behaviors underpins our high confidence in our ability to navigate the inevitable environmental change and challenge, and it reinforces our confidence in our ability to perform and grow strongly as you have come to expect from us. With that, operator, we'll turn to questions."
},
{
"speaker": "Operator",
"content": "Thank you. The floor is now open for questions. [Operator Instructions] And we'll go first to Lisa Gill with JPMorgan."
},
{
"speaker": "Lisa Gill",
"content": "Thanks very much and thanks for all the comments. I just want to go back to your comment around your three-year plan as it pertains to V28, does the 2025 final bid change anything around that plan? And how do I think about the impact in the quarter of V28 in both Optum Health as well as on the UnitedHealth side?"
},
{
"speaker": "Andrew Witty",
"content": "Yeah, Lisa, thanks so much for the question. Yeah, as we've said a few times and certainly repeated this morning, we've looked at the changes that CMS finalized last year really thoughtfully and we see this as a three-year strategy in response. Obviously, it's phased in over three years. We want to make sure we don't do anything that chases short-term growth, for example, but puts a lot -- puts at risk long-term sustainability. What you're also not going to see from ours is a kind of knee-jerk reaction between growth and margin. We want to be very focused on ensuring that year in, year out, we're a super reliable performer in this environment. As you look at the most recent final rate, I don't think it really changes the story. Obviously, a little disappointing that we don't think CMS really reflected what we've seen over the last year in terms of actual in-market medical trend. But in reality, it's just a little extra pressure for '25 on top of what we'd already seen previously. We're well-positioned for that in terms of all the work we've been doing really from the get go last year. Really from February last year, we've been getting ourselves lined up for this. You're seeing that reflected in Q1 in a few really key features, right? So you're seeing really strong cost control inside the company as you'd absolutely expect us to do, making sure that we're not incurring any expense that we don't need to support our members and patients on the outside of the organization. You saw us take a very thoughtful bid strategy last year, and of course, we continue to focus on how to make sure that we manage medical cost as effectively as possible, ensuring quality of care delivered and avoiding waste. All of that plays through. I'm very, very pleased with how this first quarter has played out in that respect. If you look at the performance of Optum Health and our MA business within UnitedHealthcare, both very strong performance during this quarter despite the pressure that's been incurred on them from the rate notice last year and I think that bodes super well for the rest of this year and the strategy that we've laid out for the next three. Thanks, Lisa. Next question."
},
{
"speaker": "Operator",
"content": "We'll go next to Josh Raskin with Nephron Research."
},
{
"speaker": "Josh Raskin",
"content": "Hi. Thanks. Good morning. Can you just explain what medical costs you categorized as accommodations to support care providers? I think the UM management that you guys are talking about, what a certain medical -- what puts a certain medical expense in that bucket? And then when you look at your actual claims received or claims processed inventories, what percentage of a normal or expected quarter did you actually see in the quarter versus how much did you just sort of put into IBNR?"
},
{
"speaker": "Andrew Witty",
"content": "Josh, thanks so much. I'm going to ask Brian Thompson in a second just to give you a little bit more color on the first part of your question. Listen, I think by the time we got to the end of the quarter, we had the overwhelming majority of what we'd anticipate in receipt -- in terms of claims received into the organization because it's always a little bit tricky to be absolute about that, because you're kind of comparing against what you would have expected, and as you obviously know, every quarter you see corrections both up and down in terms of actual claim submissions catching up with what you may have estimated and that's been obviously the feature of this marketplace. But overall, I would say, UHC claims receipt was very, very close to normal by the time we closed the quarter. But maybe, Brian, you could give a little more color commentary on how you would characterize some of that relief we gave."
},
{
"speaker": "Brian Thompson",
"content": "Sure. I appreciate the question. Yeah, Josh, I believe we started March 8th and what we did, I call it foregone utilization management protocols and those are really in two categories. The first is we suspended our inpatient level of care reviews, where we assess for appropriateness of inpatient versus outpatient and that was the lion's share of our adjustment and we've got a long history of understanding those elements. It's just a unit cost adjustment. So pretty simple and easy to estimate and adjust for. The second element inside those practices was some outpatient prior authorizations that we also suspended. Those were a smaller element inside this quarter. Those will play out a little bit more in next quarter as you think about that lag between notice and actual incurral date. But again, pretty easy for us to estimate. These are practices we've had in place for a very long time and feel comfortable about the adjustment that we made."
},
{
"speaker": "Andrew Witty",
"content": "Brian, thanks so much. And just again to confirm, as you heard from John, we brought those processes back into play in the last few days. Next question."
},
{
"speaker": "Operator",
"content": "We'll go next to A.J. Rice with UBS."
},
{
"speaker": "A.J. Rice",
"content": "Thanks. Hi, everybody. Congratulations on working through all this. Maybe just to make sure I understand a little more, the $800 million reserve that you're holding out and you did comment, you didn't take any prior period development to the bottom-line. I guess it sounds like you've used the word prudent several times in describing that. How much -- just maybe to follow-up on the last question, how much of that is things that either from which you get insight from Optum Health or from your own ability to look at prior year claims versus what you've seen so far is what you really think is going to happen and how much of that is sort of add-on just because of the moving parts out there? And then it sounds like you're basically saying that the care dynamics are similar, is there anything you call out outpatient, inpatient that suggest any variance relative to your MLR assumptions for the year when you started out?"
},
{
"speaker": "Andrew Witty",
"content": "So I'm going to ask John just to comment on the $800 million more specifically. I mean, I think as we said a couple of times, A.J., really not seeing anything stand out in terms of care pattern differentiation from what we really expected. I mean, as we mentioned earlier, that kind of pressure we saw at the end of Q4 and rolling into the very beginning of the year around some kind of winter syndrome vaccination dynamics, we talked about a lot last time. As expected that did subside. Beyond that, I would -- which was what we were anticipating. Beyond that, I wouldn't say there's anything really to call out within all of that. John, could you maybe go a little deeper on the $800 million?"
},
{
"speaker": "John Rex",
"content": "Yeah, good morning, A.J. Yeah, so picking up on comment Andrew had made earlier, so what you're really doing there is estimating what you didn't see. So claims receipts that you may have not received in the quarter and trying to make an accommodation for that, as you said, a prudent accommodation for that. Just to acknowledge, that there clearly had to be some disruption in the quarter in claims patterns and so you're trying to make some estimation in that zone to anticipate that. So you need to put it somewhere in the zone, it's not zero and it's not 800, somewhere in between, probably as you think about those elements and where you might -- where you might land and so as we look out. And you should expect that we'll probably continue with a judicious view over this, over the next several quarters actually also. We want to make sure that we've got full visibility into this that the claims are flowing and as we sit here on April 16th, it does. We see at UHC. We see a fairly normal claims receipts and payments flows going on at this point, but we really want to be careful on that because we know there are certain care providers out there that may have been left out a bit, and so we'll continue to be very judicious next quarter also in terms of assessing that."
},
{
"speaker": "Andrew Witty",
"content": "Thanks, John. Thank you, A.J. Next question."
},
{
"speaker": "Operator",
"content": "We'll go next to Justin Lake with Wolfe Research."
},
{
"speaker": "Justin Lake",
"content": "Thanks. First, I just wanted to quickly follow-up on A.J.'s question here around $800 million. Can you just be specific around, is that conservatism related to 2023, meaning you would have had up to $800 million of development that would have benefited the quarter or are you saying that you just took extra reserves that actually impacted Q1? Because we're looking at an MLR that's 50 basis points above where you kind of expected it and if you're saying trend is in line, so we're trying to figure out, was there a 50 basis point miss or are you saying that really that's just the conservatism here. And then any -- my question was really around the relative visibility on cost trend, right? Last year, it was somewhat opaque. You kind of told us that there was some uncertainty and then if that uncertainty turned to certainty around, hey, trend is higher in Q2. How do you feel about your visibility this year? Do we have to wait till 2Q to kind of be able to declare that, hey, we're kind of through this and you're not seeing what the rest of the industry is seeing or do you do you think we probably have to get that updated again in second quarter? And lastly, any commentary on Q2 MLR and where you think you end up in the full year range for MLR would certainly be helpful if you could provide? Thanks."
},
{
"speaker": "Andrew Witty",
"content": "Okay, Justin. Thanks for those questions. Let me -- I'm going to ask John in a second just to go back and again just give you a little bit more definition around the $800 million as you asked. Just in terms of -- and just in terms of cost trend and let me make a couple of comments and ask Brian maybe to go a little deeper as well and then come back to John. As I look at the cost trend this year versus last year, some big differences. So last year, really I think the core of the story of what led to that sort of step shift, if I can put it that way, in early Q2 -- Q2 of last year. I think that was really -- and the hindsight tells us that was really around a kind of post-COVID or end of COVID story playing out in terms of capacity coming on stream most importantly and to some degree of pent-up demand. I actually think the capacity coming on stream was as much an issue driver of that as anything else. So I think to some degree a one-off. We don't see anything like that. We've seen much more stabilization. We haven't seen a step down from that trend. We'd be super clear about that. We haven't seen it kind of go back down again, but we've certainly seen that kind of sustained activity without aggressive acceleration. And then the other thing, I would say to you is, as you would expect, given that shift we saw last year in the intervening year, we've put in a lot of sensing mechanisms across our organization, both in UAC and Optum, to look for early warning signals of changes, quite a low granularity in terms of trying to figure out how this pattern plays out. Now as all our actuaries and any actual will tell you that the gold standard of knowledge on trend is a paid claim, but nonetheless, we've tried to put in place a lot more prospective sensing capability. And again, that's kind of consistent with what we're sharing with you. So we're not really anticipating a big change there. I mean, obviously, the future is the future, but as we sit today, everything looks pretty much as expected. Brian, you may want to give a bit more from a UHC perspective."
},
{
"speaker": "Brian Thompson",
"content": "Yeah. Thanks, Andrew. And I think you summarized it well. I'll reiterate what you heard from John, which is what we're seeing in these underlying service types, inpatient, outpatient, et cetera, are in line with what we had planned for, so I'll reiterate that. Just to add to that level of improved visibility this year over last, certainly COVID being the biggest driver, but also re-determinations. Last year, we were at the beginning of that. This year, we're nearing the end of that. So two key unknowns a year ago I think that contributed to perhaps a little less visibility, both of which I think we've really got a better view to this year. And the last thing I'll just point out is, as we've paced through one-one, I also feel good about our business mix. Again, early in the stages of evaluation of that, but how our growth has changed and what we've seen in those profiles from the growth that you're seeing in our Commercial business to the growth in our Medicare business as well, really feel good about all those elements. So, yes, optimistic about the rest of the year and how it's playing out against what we had planned for."
},
{
"speaker": "Andrew Witty",
"content": "Great. Thanks, Brian. And John?"
},
{
"speaker": "John Rex",
"content": "Yeah, Justin, good morning. So I think the way you look at it, so overall the net view being, so we didn't let any earnings or medical care ratio impacting development flow-through into the quarter. And when you look at it, so you can come at it, as to the normative course of assessments would have indicated some potential for favorable development in the quarter. We would -- we took a position also that there was likelihood that there were claims we didn't receive. And so in terms of the claims completion factors and such and so how that may have impacted and so you're really netting that all off in the course of the quarter to try to just normalize that out, not having any impact from any of those -- from those elements, and taking a pretty prudent view of where you might be in terms of the claims you received. In terms of your question here on the Q2 MCR, at this distance, I put it in a similar zip code to 1Q, including similar impact from the cyber effects that we had also, and as I noted in response to A.J.'s question, we'll be continued to be very judicious as we look at those patterns also on claims receipts. So we'll continue with the judicious view of how we think about -- how we think about development and those impacts as we step out here in the next couple of quarters to make sure we're getting our claims receipt timings fully incurred here."
},
{
"speaker": "Andrew Witty",
"content": "Great. John, thanks so much. Next question."
},
{
"speaker": "Operator",
"content": "We'll go next to Stephen Baxter with Wells Fargo."
},
{
"speaker": "Stephen Baxter",
"content": "Yeah, hi, thanks. The business disruption costs you've projected beyond the first quarter are, I think, smaller maybe than most had expected despite the fact we've heard commentary from stakeholders reducing their dependence on Change Healthcare during the quarter. I guess, what are you seeing from customers on that front? I guess, how much of that recovery do you have on the revenue line? Do you have line-of-sight to versus you have to drive throughout the balance of the year to get to that no impact to 2025 that you seem to expect? Thank you."
},
{
"speaker": "Andrew Witty",
"content": "Yeah, Stephen, thanks so much. So I'm going to ask Roger Connor, who runs Optum Insight to give you a little detail on this. First off, so I just want to -- I just want to take a moment to pay credit to the teams for the speed in which they brought back the overwhelming majority, the functionality of Optum -- of Change Healthcare after the attack. It's been extraordinary example of really the resources of UHG, and frankly, the support of many of the biggest companies across America in the tech environment coming in to help recover from this particular attack, which was straight out an attack on the US Health System, and designed to create maximum damage I think. We've got through that very well in terms of the remediation and the build back to functionality, and Roger, maybe you could share a little bit of what you're seeing and expect in terms of customer dynamics over the next few months."
},
{
"speaker": "Roger Connor",
"content": "Yeah, we'll do. Stephen, thanks very much for the question. So the way that we're thinking about the whole cyberattack response is two key areas of focus. First of all, as Andrew mentioned, good progress on system restoration. If you look at the biggest areas where we have the largest number of customers, that's pharmacy, claim, and payment, we're up to 80% functionality and that's continuing to improve day-by-day. Now we've still got work to do. We've got another set of products coming online in the number in the coming weeks, but pleased with that progress. I think your question is really about our next focus, which is recovering the business and this is about bringing those products back, but actually bringing them back stronger where we can. We're adding functionality where we can too. But then also bringing back customers, who because of the outage have to go elsewhere to get things like their clearance house support. Now we are confident in our ability to do that. Why? Well, first of all, the portfolio and the differentiation we have, which is good. But also, as you can imagine, we're talking to those customers all the time and they want their functionality back. They like what they've got or they had with Change and they want to get that back. So we're working with them to ensure that we can actually do that. Also, we provided financial support to a number of our clients and they appreciate that. They have said to us that they appreciate it. That's a signal that we are committed both to them, but then also to this marketplace as well. So when you add those elements up, Stephen, that's where we're confident. We've got more work to do. This has been a heavy lift and we're going to continue that work. But that's why we're confident in getting back to that baseline performance in 2025."
},
{
"speaker": "Andrew Witty",
"content": "Roger, thanks so much. And I think, Stephen, what you heard in Roger's response there is a couple of really important features of the character of UnitedHealth Group, super high resilience and we will always stand by our customers and clients, and when an attack like this happens, which puts our customers and clients at risk, we will do whatever it takes to make sure they get through that, whether it's technical fixes or financial support, we are going to stand by our clients, who in this case are the providers and the systems across America who look after American patients and we will do that. And I think that means a lot to a lot of people and it's an important capability to have running through the backbone of American healthcare. With that, Stephen, thanks for the question. Next question."
},
{
"speaker": "Operator",
"content": "We'll go next to Kevin Fischbeck with Bank of America."
},
{
"speaker": "Kevin Fischbeck",
"content": "Great. Thanks. Just want to go more -- a little bit more into the visibility that you guys think that you have into claims today. It sounds like you feel like you're largely back, but I guess, where would you say today that you are from a percent visibility into claims versus the same time last year? And I know that there's forecasted improvement, but I think there's a lot of focus on the ability to price 2025 correctly. So by the time you're submitting your MA bids, how much back to normal? What percentage back to normal do you think you'll be from a claims perspective at that point? And then finally, I'm used to hearing you guys reiterate 13% to 16% long term EPS growth, but I didn't hear that in the prepared remarks. I just wasn't sure if that was due to time or whether there was anything that you were trying to say there. Thanks."
},
{
"speaker": "Andrew Witty",
"content": "All right. So I'm going to ask John to comment on your substantive question, Kevin, and I'm going to ask you just to stay on the line for my last paragraph for closing comments for the second part of your question. John?"
},
{
"speaker": "John Rex",
"content": "Good morning, Kevin. So as we sit here today on April 16th, I would say, UHC is pretty much back to normal levels in terms of claim submission activity. We view it as normalized now. That we're seeing claims slowing like they -- we'd expect them to be flowing and moving along. So that's all progressing quite well, which assists a lot with the piece that you were just describing here in terms of where we think that is and as we move forward and look over the next month plus to finalize our bid submissions and such. So feel good about that in terms of our visibility and insights."
},
{
"speaker": "Andrew Witty",
"content": "Yeah. Thanks so much, John, and thanks so much, Kevin. Next question."
},
{
"speaker": "Operator",
"content": "We'll go next to Nathan Rich with Goldman Sachs."
},
{
"speaker": "Nathan Rich",
"content": "Hi. Good morning. Thanks for the question. I wanted to ask on the reported DOJ investigation. I'd be curious, has the company had kind of dialogue with the DOJ and do you have a sense of timeline for what the next steps might be as we look about what -- for what the possible outcome of this process could be?"
},
{
"speaker": "Andrew Witty",
"content": "Hey, Nathan, thanks so much for the question. Listen, I think you'd probably expect we don't comment on these sorts of matters and I don't think it would be appropriate to do so today, and certainly, we never have done in the past. So it's not something we're going to get into in the call, but I appreciate the interest. Thanks. Next question."
},
{
"speaker": "Operator",
"content": "We'll go next to Andrew Mok with Barclays."
},
{
"speaker": "Andrew Mok",
"content": "Hi. Good morning. Commercial risk and ASO membership both came in above the high end of your initial guidance, can you help us understand what drove the membership -- a better membership results for each segment? Thanks."
},
{
"speaker": "Andrew Witty",
"content": "Thanks so much for the question. I'll ask Dan Kueter, who runs our E&I business from UHC to respond to that. Dan?"
},
{
"speaker": "Dan Kueter",
"content": "Yeah. Hi, Andrew, and thanks for the question. Certainly encouraged with the broad based growth, share gaining growth, I would say, in our Individual segment, our Local Market segment, and our National Accounts business. Some of the key drivers underlying that, about a third of our Group growth gains were attached to our most innovative products and the expansion of those into 37 states now, on a fully-insured basis, to be -- and also fully available nationally on an ASO fee-based business. Specifically inside the risk business, our individual and family exchange-based plans were a significant driver of the growth. We've seen some latency. From membership, we expected that would have come in from re-determinations into the final portions of 2023, now begin to emerge into 2024. That's been a significant contributor to that risk-based growth in the first quarter. As a punchline, I like our growth, I like the pricing, very much like the profile of both the groups and the consumers that we're attracting. And finally, I'm really pleased with the consumer experience that our teams are delivering to those that we serve. Thanks for the question."
},
{
"speaker": "Andrew Witty",
"content": "Great. Thanks so much. And as you saw, Dan's organization delivered an extraordinary two million member growth in the first quarter, one of the highest growth rates we've seen for many, many years. And I think that really comes down to relentless focus on modernization of service offer and then delivery of that service offer, and I'm very proud of the whole team in the UHC Commercial businesses domestically for what they've done. Next question."
},
{
"speaker": "Operator",
"content": "We'll go next to Lance Wilkes with Bernstein."
},
{
"speaker": "Lance Wilkes",
"content": "Thanks. Question on Optum Health. As we're looking at outlook there, we've been really focused on capacity growth in the systems, do you guys have any insights for your capacity growth in Optum Health? Obviously, you've been taking some cost actions there, so interested in hiring trends. And then second, have you been renegotiating risk deals? I know that there was likely some of that for '24. What's the outlook for that and the impact of that in '24 and the outlook of that for '25? Thanks a lot."
},
{
"speaker": "Andrew Witty",
"content": "Yeah, Lance, thanks so much. And I'm glad you've asked about Optum Health. I'm going to ask Dr. Desai to respond to that. Amar runs our Optum Health business. He has been doing a great job of continuing to mature that business for us, which for me, I think is one of the great headlines of Optum Health. Its continuous maturation as a sophisticated value-based care delivery organization, and Amar, maybe you could respond to Lance's question."
},
{
"speaker": "Amar Desai",
"content": "Yeah, thanks for the question, Lance. I'll take the first one in terms of hiring trends. We continue to work with more providers in a deeper way continuing to grow across a range of arrangements. As you know, physicians across the country work with us in contracted affiliated arrangements as well as employed arrangements and we continue to have strong partnership and growth, both organically and also through some of our inorganic M&A activity. We don't see a capacity constraint there. In fact, we've continued to see incredible growth with our payer partners to the second part of your question. The risk partner growth continues to increase across multiple payers. It's being driven by some of the funding and benefit dynamics that are out there. Folks are looking for a real stable partner to be able to grow with. We have worked with them continuously in terms of our contracts, both looking at the benefit and funding changes and ensuring that the funding level is appropriate for the risk that we're taking on, and to be able to provide very high quality care across our membership. So we're very proud of the growth we've had and we'll continue to do so. Thanks."
},
{
"speaker": "Andrew Witty",
"content": "Great. Amar, thanks so much. Next question."
},
{
"speaker": "Operator",
"content": "We'll go next to Sarah James with Cantor Fitzgerald."
},
{
"speaker": "Sarah James",
"content": "Thank you. We wanted to understand a little bit better the $3 billion in IBNR. So just our back-of-the-envelope math suggests if 15% to 20% of claims from UHC run-through change, post-event that would be like assuming a third of the change-related claims are delayed, is that in the ballpark of where your change completion factor assumptions were? And keeping that conservative assumption of a claims like throughout the year, what does that imply for the seasonality of the remaining $0.41 to $0.61 GAAP impact from change?"
},
{
"speaker": "Andrew Witty",
"content": "Sarah James, thanks so much. John?"
},
{
"speaker": "John Rex",
"content": "Yeah. So I don't know if I'd kind of go right with some of those stats that you pulled out in terms of where those fell, but here's some insights I can offer on that. So, one of the elements we wanted to break out on the IBNR component is, so, as you know, what we report on the balance sheet you received this morning, medical costs payable is a combination of IBNR and medical claims payable. And so we're hoping to provide some more transparency for you as you looked at the quarter and such, and a $3 billion increase in IBNR is significant. And then offsetting that on the -- on that line item would have been the -- really the funding advances. The component where we just made sure that as soon as the claim was in-house processed, we were speeding it out-the-door to get it to providers. That was one of the components in addition to the interest-free loans we made that we were helping the provider community -- the provider community with. As you talked -- as you discussed kind of where we were, let's say, today, we feel that UnitedHealthcare is essentially at normalized levels in terms of -- in terms of claims receipts. As we sit here, we're going to be super prudent in how we look at that because we know there are providers out there that could still be having trouble submitting claims, and still having troubles with payment flows and such, and so we're going to be very appropriately constrained in how we think about that dynamic playing out here over the next -- over the next couple of quarters. But really, those are the kind of mechanics of what's going on between the IBNR component that you spotlighted and the full line of medical costs payable."
},
{
"speaker": "Andrew Witty",
"content": "Right. Thanks, John. Next question."
},
{
"speaker": "Operator",
"content": "We'll go next to Gary Taylor with Cowen."
},
{
"speaker": "Gary Taylor",
"content": "Hi. Good morning. Just wanted to follow-up on that point, John. My understanding is, on the IBNR that you report in your Qs and Ks includes unprocessed claims, inventories, so the $3 billion, is that just going to tie to the number we see when the Q comes out? Are you saying the $3 billion really is true unreported claims at this point?"
},
{
"speaker": "Andrew Witty",
"content": "Thanks so much, Gary. John?"
},
{
"speaker": "John Rex",
"content": "$3 billion is IBNR directly, that is to your point. That is the IBNR component of it, Gary."
},
{
"speaker": "Andrew Witty",
"content": "Okay. Thanks, John. Next question."
},
{
"speaker": "Operator",
"content": "We'll go next to Erin Wright with Morgan Stanley."
},
{
"speaker": "Erin Wright",
"content": "Okay, thanks. On capital deployment, you didn't change your expectations for share repurchases, but how should we think about the priorities more broadly, whether it's M&A or otherwise in your ability to be opportunistic on that front? Thanks."
},
{
"speaker": "Andrew Witty",
"content": "Erin, thanks so much. I'll ask John to comment on it."
},
{
"speaker": "John Rex",
"content": "Yeah, Erin. Yeah, we didn't update any of those components here. We continue to take a very balanced view in terms of how we think about our opportunities. You saw, certainly, that we had activity in the quarter from -- in terms of both share repurchase and dividends. Also, we continue with robust opportunities in the marketplace in terms of other capabilities that we are looking at. So that all continues strong. So you'll see us continue to balance those out nicely in terms of -- in terms of the opportunities that are out there and with capacities really to approach all those elements strongly."
},
{
"speaker": "Andrew Witty",
"content": "Yeah, and I continue to see very interesting diverse pipeline of M&A opportunity across the marketplace in terms of business areas that we have interest in. As I think you see some of the funding changes play out across the -- across the next few years, I suspect that may also create new opportunities for us as different companies assess their positions. I think how we look at this situation is we have a good strong strategy for how we navigate through this dynamic. You're seeing that play out super well in the first quarter performance of Optum Health and UHC and I think it gives us a sense of real confidence as we look not just in terms of our performance, but potentially how we might think about M&A opportunity. And as you rightly said, be somewhat opportunistic if those moments arrive. Next question."
},
{
"speaker": "Operator",
"content": "We'll go next to Whit Mayo with Leerink Partners."
},
{
"speaker": "Whit Mayo",
"content": "Thanks. Good morning. Just back on the 2025 rate notice, I think you're -- if I'm hearing you correctly, it sounds like you're framing this as modestly disappointing, but perhaps manageable. Just any more color on growth expectations for next year? And then if you could elaborate on the broker agent changes, what this could potentially mean for your strategy seems like a meaningful change. Don't know, if you think about investing more into captive broker strategies, just any color would be helpful. Thanks."
},
{
"speaker": "Andrew Witty",
"content": "Thanks so much for the question. I mean, obviously, we're not going to get into give kind of '25 numbers or expectation just yet, but Tim Noel, who runs our M&R business, certainly give you some good perspective on the rest of your question. Tim?"
},
{
"speaker": "Tim Noel",
"content": "Yeah, good morning, Whit. Thanks for the question. So on the final notice and some of the distribution elements of that, we continue to believe that there's opportunities to improve the distribution environment in Medicare Advantage and have been in a dialog with CMS for several years on how to do that. Some of the elements of the final notice that were published recently are directly in line with some of our recommendations and some of them are relatively consistent, but not totally as we had conceived them. I would also say right now, it's a little bit early to comment on how this might rebalance some of the channel mix, as still some questions on how some of the key elements of that will be rolled out. So we're still waiting for a little bit more detail before we can get more specific on how it impacts go-to-market in '25."
},
{
"speaker": "Whit Mayo",
"content": "Great. Thanks so much, Tim. Next question."
},
{
"speaker": "Operator",
"content": "We'll go next to Ann Hynes with Mizuho Securities."
},
{
"speaker": "Ann Hynes",
"content": "Hi. Good morning. So, I would say your commentary on care patterns is definitely more positive than what investors feared. And you referenced several times that trend came in line with your expectations, can you actually tell us what growth rates you're assuming like the major trend categories in guidance, whether that's inpatient and outpatient, and maybe some year-over-year growth versus historical averages? And within that, can you specifically talk about what you're assuming for MA? That'd be great. Thank you."
},
{
"speaker": "Andrew Witty",
"content": "John, would you like to start that?"
},
{
"speaker": "John Rex",
"content": "Yeah. Ann, good morning. So the components that I would call outliers are the similar components that we've talked about for a while here in terms of trend outlooks. So in particular, still go back to outpatient care for senior, what we've seen in orthopedic, cardiac, those kind of categories primarily have been the big factors. I think you brought up a really important point though. So the percentage growth in those was much bigger last year. You're coming off an environment where both the supply side had been constrained and the willingness of seniors, in particular, consumers to access that environment had been constrained for a couple of years. So those percentage factors were quite significant. You heard us talk about very significant levels on those double-digit levels of last year as we looked at those. The way we look at those really though is because you would expect that to start normalizing in terms of the percentage change. So you really look at that in terms of the number of units consumed per patient served. And so you look at those levels, that's what we're talking about and we're seeing those kind of continuing at those levels. They're continuing at those levels in terms of the number of units consumed, delivered, and -- but those percentage levels, of course, would start normalizing out a little bit in terms of what you'd seen. So that continues to be the area. It's outpatient care for seniors. It's those categories that we'd call real outlier areas versus our historical levels of trend factors. The other -- the other historical levels of trend factors remain much closer to kind of our traditional views that we've always had as a company. In the quarter, other things you look at just to get indications, and by the way, we kind of vastly expanded all those areas. First fills, you've heard us talk about that a lot. Also, first fills in the quarter, an indication of outpatient care, physician visit activity, it's kind of normalized in there also in terms of stabilizing for us and many -- the many other factors of the company historically looked at. Thank you."
},
{
"speaker": "Andrew Witty",
"content": "Thanks, John. And maybe ask Brian maybe to give you a little bit more from a UHC perspective, and then maybe Heather also from a Optum perspective in a second, just maybe reflect a little bit on the work you're doing in terms of how we -- obviously, medical trend is one thing, then there's a question of how well we're able to engage with folks to actually help them manage their cost and maybe come to you in a second, Heather, on some of the word that you're leading at Optum. So Brian, first?"
},
{
"speaker": "Brian Thompson",
"content": "Sure. I think John said it well. The first headline is what we're seeing is what we plan for. But as he alluded to, some of those elements, we plan for them to be elevated year-over-year. And I don't want to lose sight of unit costs. We've talked for some time that multi-year provider group and hospital contracts renew a little later than perhaps the inflation we've seen and that is up year-over-year. The biggest driver was the outpatient. We're really pleased to see that in line with as John explained. But also, we've been able to see increases in Specialty Rx. We've planned for those. Those are in our pricing appropriately, et cetera. And we've certainly worked hard to create more access in the behavioral space. So all of those elements are modestly up, but up as we had planned for and they'll hopefully sound familiar to you because we spoke to all of these at our investor conference as we ended the year. So I think that's what I would summarize or add to John's commentary. Heather?"
},
{
"speaker": "Heather Cianfrocco",
"content": "So, I would say, incredibly consistent on the Optum side. So maybe just focusing on the medical first. So I mean, I think you've heard us say this, when you look, when we came out of last year, looking into this year, our focus was on the behavioral health, those outpatient sides consistent with UnitedHealthcare. And what was very important for Optum Health was using that capacity that Amar explained in our physicians, as well as those wrap-around services and our investments to ensure that we were looking at those care patterns. So, we feel really good about coming into this year. That work we've done, John referenced engagement with particularly those most complex numbers, 75% already engaged. And that PCP engagement, that member engagement is incredibly important, whether it's with their PCP directly or it's with some of our care -- our own care management wrap-around services. Because it identifies affordability opportunities incredibly quickly. It also identifies chronic disease that needs to be managed and it gets them connected to primary care quickly. So that's our focus for the year and that's why we feel good about that our ability to control utilization on the medical side particularly. And again, what we'll remind you is a reduced funding environment as we go into this year. So that's what brings us -- that's what brings that value-based care proposition, incredible value to all of our payers. On the pharmacy side, I call it, same things. For our clients, that specialty trend is a focus and we bring those products and solutions and that's why we've seen growth on the PBM side and our pharmacies around our clinical model and the continued innovative products that we're bringing to bear. So you're seeing that pull-through in the diversified growth and strength of the performance on the Optum Rx side as well."
},
{
"speaker": "Andrew Witty",
"content": "Great. Thanks so much, Heather. Just one number Heather just shared with you there, which I'm very pleased of and it's a significant improvement year-over-year is that 75% engagement of the most complex members in Optum Health. And just for that, that means three out of every four most complex, most disadvantaged folks in the country have had a direct engagement with us in the first three months of the year. That's a great rate of touch. Opens the door then for us really getting to know those folks, helping the system, helping bring the system to support that many of these people, particularly those who are trapped in their homes have just not had access to that kind of care opportunity. That engagement is the first step of doing that. We have -- we really believe that is a key to how we not only deliver an effective care delivery from a cost point of view, but also make sure they get the very best quality that they deserve. So really pleased to see that step up year-over-year. I think we have time for one last question. If we could take that question, please, Jennifer."
},
{
"speaker": "Operator",
"content": "Yes, we'll go to our last question from Jessica Tassan with Piper Sandler."
},
{
"speaker": "Jessica Tassan",
"content": "[Technical Difficulty] A few more details maybe on the --"
},
{
"speaker": "Andrew Witty",
"content": "Sorry, we missed the beginning of your question."
},
{
"speaker": "Jessica Tassan",
"content": "Hi. Sorry about that. I'm interested in a few more details maybe around the launch of Change 2.0. If you could talk a little about what payer receptivity to reconnection has been? Whether Change retains its legacy data rights post breach? And then just any change or updated thoughts on kind of the long-term thesis on Change for something like a real-time transparent payments and decision support network? Thanks so much."
},
{
"speaker": "Andrew Witty",
"content": "Thanks very much for the question. Let me ask Roger to kick that one off."
},
{
"speaker": "Roger Connor",
"content": "Yeah, Jessica, thanks very much for the question. First of all, on your first part about Change 2.0. Again, we're just confident in terms of our ability to reconnect. I mentioned the level of functional restoration that we have. You can imagine now the next stage of this is working with payer and provider to reconnect them in a safe way and an appropriate way, and all of the conversations that we're having with them are positive as we work through it. As I mentioned, there's still work to do and that's going to take us a little bit of time, but we're continuing to work through that functionality. I think it's important also to recognize, where Change sits in the overall Optum Insight portfolio. Change Healthcare was about 15% of our projected revenue for this year and when you look at -- that means I've got thousands of people who are continuing to work on other products outside of Change, not impacted by this and their underlying performance this quarter has been strong. If you adjust for the Change out, that business' earnings actually grew by around 10%. But what we haven't slowed either, as you mentioned, is our innovation agenda. The excitement of the Change portfolio across the Optum Insight portfolio is what we can bring to this market to transform it from an innovation point-of-view. And the real-time settlement work that we're doing, plus work that we've been doing with Optum Health on value-based care and provider risk enablement, that's all still going ahead. So in terms of our innovation agenda and the performance of the underlying business within Optum Insight, we're very positive."
},
{
"speaker": "Andrew Witty",
"content": "Roger, thanks so much. And yeah, absolutely, Change Healthcare, the important acquisition for the group and I think important for the country that we own Change Healthcare. Without UnitedHealth Group owning Change Healthcare, this attack would likely still have happened and it would have -- it would have left Change Healthcare, I think, extremely challenged to come back because it was a part of UnitedHealth Group, we've been able to bring it back. We're going to bring it back much stronger than it was before. And secondarily, all of the reasons that we were interested in bringing the Change Healthcare capabilities and customer connectivity closer to UnitedHealth Group still absolutely holds fast in terms of the potential innovation around things like real-time settlement, clinical decision support capabilities, all of those products are the future services of the future, which ought to be characteristics of a modern healthcare environment. Those are all the reasons why we believe Change and Health -- and UHG were better together. This cyberattack has unfortunately created another true validation of why that was the right thing to do because it meant UHG was in position to resolve this much more quickly than I think would ever have been imaginable in a standalone situation."
},
{
"speaker": "Andrew Witty",
"content": "Thanks, everybody, for all of your questions this morning. It's been a bit more of a complex quarter for sure this time around, but one that's also showed the depth and breadth of our company's capabilities. We're recovering quickly from the Change Healthcare attack and are a stronger, more capable company as a result. We're continuing to build our business based on the five strategic growth pillars that we're relentlessly focused on, and we're steadfastly confident in our ability to achieve our 13% to 16% long-term growth objective as we look to the years ahead. We very much appreciate all of your time and attention this morning. Thank you."
},
{
"speaker": "Operator",
"content": "This does conclude today's conference. We thank you for your participation."
}
] |
unp | 2,024 | 4 | [
{
"speaker": "Operator",
"content": "Greetings, welcome to Union Pacific's Fourth Quarter 2024 Earnings Conference Call. [Operator Instructions] As a reminder, this conference is being recorded and the slides for today's presentation are available on Union Pacific's website. At this time, it's my pleasure to introduce your host, Mr. Jim Vena, Chief Executive Officer for Union Pacific. Thank you, Mr. Vena. You may now begin."
},
{
"speaker": "Jim Vena",
"content": "Thank you very much, Rob, and good morning, everyone. Pleased to have you with us this morning. Little bit of winter in some parts of our company, even lots of snow in the Southeast part, but love the way the operating team has worked through it and we are in way better shape already. So great recovery by everybody, but lots of hard work by the men and women of Union Pacific. Why don't we get started. So I'm joined here this morning in Omaha by Chief Financial Officer, Jennifer Hamann; our Executive Vice President of Marketing and Sales, Kenny Rocker; and our Executive Vice President of Operations, Eric Gehringer. Let's dig into 2024. It was a very successful year for the Union Pacific team, and we really finished the year on a high note in the fourth quarter to put up an adjusted 58% operating ratio, removing the impact of a new regional Brakeperson Agreement is really excellent work. It shows that the team is executing our strategy to lead the industry in safety, service and operational excellence. Now why don't we move over to discuss the fourth quarter results, starting on Slide 3. This morning, Union Pacific reported 2024 fourth quarter net income of $1.8 billion and earnings per share of $2.91, both 7% improvements. Fourth quarter revenue, excluding the impact of fuel surcharge grew 4%. Our ability to generate strong volume growth and core pricing gains more than offset an unfavorable business mix. Reported expenses year-over-year improved 4%, while lower fuel prices led the way, the team demonstrated strong productivity utilizing 3% fewer employees to move 5% more volume. This led to operating income growth of 5% and the operating ratio outcome that I mentioned earlier. This is the result of the team's commitment to build a safer, more durable and more efficient network. Just a fantastic way to end 2024. Throughout the year, we built momentum behind our strategy and you see that in the financial results we delivered. While internally, we've already turned the page to work on further improvements in 2025, we need to pause and celebrate the team's success in 2024. We set a goal to achieve industry leading results and when the dust settles, I'm confident that's where we'll be. So with that, I'll let the team walk you through the quarter and the year in more detail and then come back for a wrap up before we go to Q&A. We'll start with the fourth quarter and full year financials. Jennifer, it's all yours."
},
{
"speaker": "Jennifer Hamann",
"content": "All right. Thank you, Jim, and good morning, everyone. Let's begin with our fourth quarter income statement on Slide 5. Operating revenue of $6.1 billion decreased 1% versus 2023 against strong volume growth, while our fourth quarter freight revenue finished flat at $5.8 billion, breaking down the drivers of freight revenue, increased volume in the quarter added 525 basis points. Fuel surcharge revenue of $588 million declined $207 million as lower year-over-year fuel prices reduced freight revenue 450 basis points. Similar to our third quarter results, strong core pricing gains were more than offset by business mix, reducing freight revenue 100 basis points with our 16% intermodal growth driving that mix dynamic, of significance, our price dollars met the long-term commitment of exceeding inflation dollars, while also being accretive to fourth quarter operating ratio. Wrapping up the top line, other revenue decreased 7% as a result of lower accessorial revenue from the second quarter intermodal equipment sale and reduced revenue from the ongoing transfer of metro operations. As a reminder, we see offsets against this revenue decline in operating expense. Switching to expenses, our appendix slides provide more detail, but let me share some highlights of our strong cost control as total operating expense declined 4% to $3.6 billion against a 5% increase in quarterly volume. Looking closer at the expense line, compensation and benefits expense increased 8% compared to fourth quarter 2023, driven by the $40 million Brakeperson Buyout Agreement, which Jim mentioned and wage inflation. This is the second Brakeperson Agreement that we have reached in the last couple of years, both of which have enabled more efficient car handling. Quarterly workforce levels decreased 3%. Our train service employee workforce was flat against the 5% volume growth as we effectively handled the additional volume. All other workforce areas decreased to 4%. These efforts resulted in record workforce productivity, demonstrating our strategic focus on delivering operational excellence. For 2025, we expect our all in cost per employee to be around 4% as we continue to find ways to be more productive with our workforce through process improvements, technology and investment. Fuel expense decreased 23% on a 24% year-over-year fall off in fuel prices from $3.16 to $2.41 per gallon. Our fuel consumption rate improved 1% in the quarter as we more than offset the impact of moving a less fuel efficient business mix. Equipment and other rents expense increased 8% due to inflation and volume related growth in our intermodal business. Finally, other expense declined 22%. As you'll recall, in the fourth quarter of 2023, we highlighted elevated casualty costs due to the catch up of case backlogs. In the fourth quarter of 2024, we benefited from lower casualty expenses as well as a reduction in bad debt expense. Operating income improved 5% to $2.5 billion and was a fourth quarter record. Below the line, other income decreased $40 million on lower real estate gains, while interest expense declined 6% or $19 million as a result of lower average debt levels. Altogether, these results total a record fourth quarter net income of $1.8 billion and earnings per share of $2.91, both up 7% versus 2023. Our fourth quarter operating ratio of 58.7% improved 220 basis points year-over-year. And as Jim noted, when you adjust for the Brakeperson Agreement, our quarterly OR came in at 58%, a great outcome, reflecting very strong quarterly performance by the UP team as we work to safely and efficiently serve our customers. Moving to Slide 6, let me quickly recap full year 2024. Operating revenue of $24.3 billion grew 1% on a 3% volume increase, core pricing gains, partially offset by lower fuel surcharge revenue and business mix. Excluding fuel surcharge, our freight revenue grew 4% versus 2023. Operating income totaled $9.7 billion, a 7% increase and our full year operating ratio of 59.9% improved 240 basis points, both great indicators of how good railroading produces solid operating leverage and cost control. Earnings per share of $11.09 increased 6% versus 2023, while our return on invested capital improved 30 basis points to 15.8%. Let's turn then to shareholder returns in the balance sheet on Slide 7. Full year 2024 cash from operations totaled $9.3 billion, up almost $1 billion from 2023. Our cash flow conversion rate improved to 87% and free cash-flow increased from $1.5 billion to $2.8 billion. These year-over-year improvements reflect the change in year-over-year labor agreement payments as well as the growth in our operating income. We rewarded our shareholders returning $4.7 billion in 2024 through dividends and share repurchases. Our adjusted debt-to-EBITDA ratio finished the year at 2.7 times as we maintain a strong balance sheet and continue to be A-rated by our three credit agencies. 2024 proves that our strategy of safety, service and operational excellence leading to growth also generates strong cash returns for our shareholders. With that, let me turn it over to Kenny."
},
{
"speaker": "Kenny Rocker",
"content": "Thank you, Jennifer, and good morning. As Jennifer mentioned, we had a strong fourth quarter. Freight revenues totaled $5.8 billion for the quarter, which was up 4% excluding fuel surcharges due to increased volume. This also reflected strong core pricing gains as a result of our deliberate focus on maximizing price. Let's jump right in and talk about the key drivers for each of our business groups. Starting with our Bulk segment, revenue for the quarter was down 4% compared to last year on a 4% decrease in volume, while Average Revenue per Car remained flat, even with decreased fuel surcharges. Coal continued to experience the same challenges seen throughout the year as demand remained soft due to the high inventory levels and the competition from low natural gas prices. Grain volumes increased for the quarter as there was strength in export grain to Mexico, coupled with UP service during -- strong UP service during the harvest. Lastly, grain products grew in the fourth quarter as our work to locate renewable diesel plants on our railroad is paying dividends in the form of increased demand for feedstocks and we expect that growth to continue with the startup of two new facilities, one in Nebraska and one in Kansas that came online in the fourth quarter, bringing the current count of UP accessible plants to 15 with more expected this year. Turning to industrial, revenue was up 1% for the quarter as volume remained flat. Strong core pricing gains were mostly offset by lower fuel surcharges and a negative mix in volume. Business development in our Petrochemical and Petroleum commodity segments drove growth. Demand improved for plastics -- for our plastics business in both export and domestic markets. However, these gains were offset by softer demand for Metals, Sand and Rock. Premium revenue for the quarter was up 3% on a 13% increase in volume and a 9% decrease in Average Revenue per Car, reflecting increased intermodal shipments and lower fuel surcharges. Intermodal volumes remained strong due to international West Coast import demand and positive domestic growth driven by business development efforts. International volumes were up 26% in the quarter, outpacing the growth rate of the West Coast imports by utilizing our buffer resources, which includes people, locomotive and railcars, our operating team efficiently moved the traffic and maintained fluidity in the supply chain. Automotive volumes were flat due to unplanned downtime, partially offset by business development wins with Volkswagen and General Motors. Now, let's focus on 2025. Here are some of the key macroeconomic indicators that we're watching this year on Slide 10. These are S&P Global's forecast from their January report. And you'll notice that it shows a mixed picture for 2025, which is not materially different than what we shared back in September at our Investor Day in Dallas. The forecast for industrial production shows a slight increase, while GDP growth slows from 2024. Housing starts are expected to remain challenged, but with December sharp uptick, we are closely watching the situation. Now turning to Slide 11. Here is Union Pacific's 2025 outlook as we see it today for the key markets we serve. Starting with Bulk, we anticipate coal to continue to decline, though not to the levels we've seen in 2024. We expect coal demand will be met from existing high inventory levels. However, a new contract win with the Lower Colorado River Authority, also known as LCRA will help offset losses from 2025 coal retirement. While it's premature to predict grain export demand, domestic grain demand is expected to remain steady through the first half of 2025, driven by strong grain yields from a good harvest in 2024 as well as our efforts to serve both new and expanding facilities. Lastly, we expect continued strength in grain products, driven by intense business development and the expanding markets for renewable fuels and the associated feedstocks. We will continue to monitor potential changes in renewable diesel incentives and tax credits. Moving on to industrial, while the forecast for industrial production in 2025 remains muted, our diverse business mix, strong service and robust franchise will help us grow in some markets. The metals market is expected to remain soft. However, our industrial chemicals and plastics markets will remain favorable based on plant expansions with multiple strategic customers and our strong focus on business development. This strong focus is all about unleashing what's possible by empowering the commercial team. They are leveraging our Gulf Coast franchise and strong service to win. And wrapping up with premium on the intermodal side, we expect growth in domestic intermodal with over the roll conversions. Strong international intermodal volume experienced in 2024 creates tough year-over-year comparisons for us. And the mix issue continues as international volumes remain strong at the start of the year. Additionally, we are keeping a watchful eye on potential tariff changes that could further impact volumes. Even though we are early in the year, we are seeing automotive OEMs curtail production to better manage high inventories. However, consistent with S&P Global's outlook and our conversations with customers, we expect a positive trend with output increasing as the year progresses. Overall, we anticipate a soft economic environment and face difficult comps in 2025, but I'm excited about onboarding LCRA, the new coal customer mentioned earlier, and I'm encouraged by the incremental volume we will gain from new and expanding facilities across multiple business segments. In fact, we currently have over 200 track construction projects in progress with a potential revenue of $1.5 billion, and our business development pipeline is just as strong as it was this time last year. We continue to invest in intermodal, which Eric will touch on. You heard me discuss new unit train facilities added to our network and we are bullish on industrial development projects in the Gulf Coast with a mix of large and small customers. I'm proud of the commercial team. They continue to hustle and we will maintain our strong pricing posture in 2025. And with that, I'll turn it over to Eric to review our operational performance."
},
{
"speaker": "Eric Gehringer",
"content": "Thank you, Kenny, and good morning. Moving to Slide 13. Before diving into our results, I want to express my appreciation to the team for their hard work. Historically, vast surges in volumes such as those we witnessed in 2024 significantly disrupt rail operations. However, the team bucked that trend and was able to improve our service product while also driving growth and network efficiency. It's proof our relentless focus on operational excellence is working and I'm excited we are carrying that momentum into 2025. Safety also improved in 2024 and continues to be at the forefront of everything we do. For the year, both our derailment and personal injury rates improved significantly, a strong step towards becoming the safest railroad. We remain committed as well to enhancing safety as we strive to send every employee home safe each day. Moving to our results this quarter. Freight car velocity improved 1% versus last year. A favorable business mix coupled with continued improvements in terminal dwell drove the performance. Notably, 2024 marked an all-time record for terminal dwell, a meaningful improvement in our service, which reduces customers' fleet costs through improved cycle times. Exceptional work by the team as they continue our focus on the fundamentals to drive terminal fluidity and capacity for future growth. On the service front, our intermodal service performance index declined 7 points year-over-year, while manifest improved 5 points. Intermodal SPI specifically improved month-by-month through the quarter as December ended with our second highest level of the year at 97%. The team continued to deploy buffer resources and adjust trip plans to minimize the impact of the quarter's 26% surge in international intermodal shipments. Now let's review our key efficiency metrics on Slide 14. Our full year locomotive productivity metric improved 5% versus 2023, while the deployment of buffer resources to handle higher volume levels drove a 3% decline in our fourth quarter results. Workforce productivity, which includes all employees improved 6% in both the fourth quarter and full year versus 2023. Further, 2024 marked a fourth quarter and full year record for workforce productivity. We continue to remove unneeded work and automate operations, while improving the safety of how we work. Train length improved 1% versus 2023, marking our sixth consecutive quarter year-over-year improvement. All in, 2024 set an all-time record for train length. We have made great strides in this area. However, there are still opportunities to adjust the transportation plan and leverage targeted investments as we push to generate mainline capacity in the pursuit of growth. To wrap up, let's review our capital outlook for 2025 on Slide 15. In 2024, we invested approximately $3.4 billion across the railroad as we continue to reduce capital intensity while still delivering value to our shareholders. In 2025, we are targeting capital spending of roughly $3.4 billion, flat versus last year. As always, our first capital dollars will support safe and productive operations as we invest in our infrastructure and renew older assets. This includes modernizing our locomotive fleet and acquiring freight cars to support replacement and growth opportunities. Also, we will continue to invest in capacity projects that support our growth initiatives, while enhancing productivity. This includes siting construction and extension projects such as those in the Pacific Northwest and the Southwest along our Sunset Route. Furthermore, terminal investments supporting our manifest network such as those in and around our Houston Gulf Coast region aim to improve fluidity and increase capacity. On the intermodal side, we will continue to invest for growth in areas like Kansas City, Inland Empire and Lathrup to name a few. At the end of the day, it's about ensuring we have the right resources in the right place to support growth and drive efficiencies. Wrapping up, I'm encouraged by the progress we made in 2024, but our work is not yet done. Continuing to focus on the fundamentals of railroading and leveraging new innovative technologies, we will further improve our service product and build a more resilient, efficient network in 2025 and beyond. So with that, I'll turn it back over to Jennifer to lay out our initial financial thoughts for 2025."
},
{
"speaker": "Jennifer Hamann",
"content": "Thanks, Eric. If you turn to Slide 17, I do want to start by pointing out that in the appendix, we have a modeling slide that contains several 2025 assumptions that should be helpful in framing our current expectations. And as we talk about the year, all of our guidance is within the context of the three year targets we provided at our Investor Day in September. Our team understands those commitments, we are focused on achieving them and our 2025 performance is the first step. As you heard from Kenny, economic indicators for this year are a bit muted and mixed, some growth, some contraction. Add to that outlook, questions around possible tariffs, interest rates, regulatory changes, et cetera and our ability to forecast only gets more challenging. As we see the year ahead, there are positives on the volume front. First, we're starting the year with a bang. Volume is growing and the network is running well. Mother Nature has certainly taken a couple of early shots and will likely fire a couple more, but our resiliency is strong as we focus on meeting our customer commitments. And you heard Kenny talk about how that service product has helped us secure new business for 2025 as well as the continuing pipeline of opportunities that span our entire portfolio. We also acknowledge there are some tough spots, namely from reduced coal demand and the year-over-year international intermodal comparison we'll face in the second half of 2025 as today's mix impact turns into a volume challenge. So while there are puts and takes on the volume side, we are confident that we will continue to drive operational and financial improvement in 2025. We will achieve that goal by continuing to control the controllables by generating pricing dollars that are accretive to our operating ratio, gaining further technology, productivity through technology and by empowering every UP employee to drive asset efficiency. We expect the combination of our activities to drive volume, price and productivity will deliver earnings per share growth for the full year that is consistent with attaining our three year Investor Day CAGR of high single to low double-digit growth. Finally, with the capital allocation, as you heard from Eric, this year, we plan to invest $3.4 billion back into the railroad. We remain committed to our industry leading dividend payout ratio of around 45% of earnings and we plan to return excess cash to shareholders through share repurchases of $4 billion to $4.5 billion during the year. The team has done an excellent job to position ourselves for whatever environment we face this year. We are on target to achieve our long-term goals while maintaining our industry leading position. We are excited for this new year and we're ready to deliver. With that, I'll turn it back to Jim."
},
{
"speaker": "Jim Vena",
"content": "Thanks, Jennifer. Before we get to your questions and I'm looking forward to the questions, I'd like to summarize what you've heard. First, you heard from Jennifer in the fourth quarter, we leveraged the network to handle volume growth and drive strong quarterly results. Similar to the third quarter, our business mix profile presented a margin headwind. So it was imperative that we generated strong productivity and pricing to offset that impact, and that's exactly what we did. Kenny gave an overview of fourth quarter volumes and laid out initial thoughts for 2025. Look, there are a lot of unknowns, but in my 48 years of railroading, I've never entered a year without some economic question mark. It is what it is. As you heard from Kenny, our team will focus on outperforming our markets and generating strong pricing for the value we provide. Importantly, I believe our 2024 performance demonstrates that our strategy to operate with a buffer and connect more closely to our customers is paying dividends, both in terms of meeting our customer commitments and as a direct result winning new business. Eric provided an update on our progress to improve safety, service and operational excellence. From a safety perspective, we made great strides, but we still have work to do. On the service front, we're showing our customers what's possible while at the same time driving productivity. What's exciting for me is that I know we're not done. There are more opportunities ahead and we have clear line of sight of how we drive further improvements in 2025. Lastly, you heard from Jennifer, our expectations for the upcoming year. Key for me is that we're on target to achieve the long-term guidance that we laid out at the Investor Day in September. We operate the largest, most complex rail network in North America and with it comes challenges and opportunities. The team understands our goal is to deliver what's possible from this franchise. We intend to do that as an industry leader that keeps rates in the bar as we drive value for our shareholders. Let me finish with one of my favorite quotes from a mentor. \"It's the fundamentals stupid, do what you say and commit to it and deliver\". And that's who we are at Union Pacific. And with that, I'll turn it over back to you, Rob, and let's start the questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Thank you. And our first question today is from Scott Group with Wolfe Research. Please proceed with your questions."
},
{
"speaker": "Jim Vena",
"content": "Good morning, Scott."
},
{
"speaker": "Scott Group",
"content": "Hi, thanks. Good morning. I just want to start on the guidance. The comment consistent with attaining the long-term CAGR that seems carefully chosen language, just so we're all on the same page, like does that just mean you expect to be in that high single-digit to low double-digit range on earnings this year? And then I just want to understand also, Jennifer, the pricing starting to become accretive to margin, is that -- does that start right away in Q1? I don't know if there's any sort of Q1 color you want to give us. Thank you."
},
{
"speaker": "Jim Vena",
"content": "So let me start, Scott, with the question of where we are. We were clear that we had a three year and when we commit, just like I said from my favorite quote from my mentor early, we committed and you never know exactly what's going to happen this year, what are tariffs going to do, what are the regulatory changes that the administration is going to put in. But our goal is, just as we showed in 2024 with the 7% increase that we think that -- that's where we're going to be. We are going to be high single-digit, low double-digit. Now if there's things outside of our control, then we're going to have to work harder. But this is not a change from what we said before and I would expect that every year we deliver high single-digit to low double-digits. That's the win for us. So that's what we committed to and that's what we look forward to delivering. Jennifer, on the accretive piece."
},
{
"speaker": "Jennifer Hamann",
"content": "Yes, Scott. So just going back for a second. So fourth quarter, we were accretive. So we actually, I would say, outperformed ourselves a little bit there because we did not think we would achieve that here in 2024, but we did in the fourth quarter. And so I'm not going to parse out the quarters in 2025, but I don't see us taking a step back and we're going to be accretive throughout 2025."
},
{
"speaker": "Scott Group",
"content": "Thank you."
},
{
"speaker": "Jim Vena",
"content": "Thanks, Scott."
},
{
"speaker": "Operator",
"content": "Our next question is from the line of Jon Chappell with Evercore ISI. Please proceed with your question."
},
{
"speaker": "Jim Vena",
"content": "Good morning, Jon."
},
{
"speaker": "Jon Chappell",
"content": "Thank you. Good morning. Eric, in Jennifer's comments at the start, you noted the record workforce productivity also said all in cost per employee of 4% in '25 as you continue to find ways to be more productive. You've done a lot of volume with a lot less resources. Is it still a labor productivity or what are some of the other initiatives you're looking at '25 to kind of maintain or manage that cost inflation?"
},
{
"speaker": "Jim Vena",
"content": "Yes, thank you for the question, Jon. And let me be clear, there is more opportunity and we're working to capitalize on that. Let's go back to our Investor Day and kind of level set from that perspective. First thing I said at Investor Day was that we focus on productivity because it puts Kenny and the team in the best position to grow in the markets and that's still and will always be true. The second thing that we focused on was our culture, our mindset here at Union Pacific, which is to be perpetually dissatisfied with ourselves when it comes to productivity, to keep pushing to find additional opportunities. So specifically to your question about what are those opportunities, it's going to be some of the same things you've heard in the past and a lot of new things that I'm excited about. The fundamentals, they always stay true. Those are the things in the past that we continue to focus on. The improvements we made in the fourth quarter regarding our recruit rate. Even moving that just a single point has a significant productivity driver for us. The work that we did to reduce our people starts in our yards and locals approximately 2% and 4% respectively in the fourth quarter. That's about the technology we're putting in the yards and being able to be even more productive with it. On the technology front, the work that we do and have continued to do and will continue to do on the automation of our terminals and pushing to reduce dwell. Then when you get outside of the terminals and the transportation side, you mentioned a couple of them and the engineering team as they work to continue to automate inspections, maintenance tasks, distribution of materials. And then of course, you have the whole bucket of purchase services and I see great opportunities in that. And we capitalized on those in 2024, but there's more. When you start to think about the technology we have to automate some of our vans across the system and when you're using hundreds of thousands of van starts per year, a 10% improvement in that is really meaningful for us. So here's the bottom line. There's more than 75 initiatives up against how we think about driving productivity across this company. And I really do mean across the company. It's not just operating. I'm very confident about our plan in '25, and I'm encouraged that we'll be telling you about those results as we go through '25."
},
{
"speaker": "Jon Chappell",
"content": "Thanks."
},
{
"speaker": "Jim Vena",
"content": "Thank you very much."
},
{
"speaker": "Operator",
"content": "Our next question is from the line of Stephanie Moore with Jefferies. Please proceed with your question."
},
{
"speaker": "Jim Vena",
"content": "Good morning, Stephanie."
},
{
"speaker": "Operator",
"content": "Stephanie, perhaps you're on mute. Your line is live for a question."
},
{
"speaker": "Joe Hafling",
"content": "Sorry, I was on mute. This is Joe Hafling on for Stephanie Moore. Thanks for taking our questions and congrats on the good results. I wanted to talk about, one of the things you've mentioned over the last couple of months has been maybe a reduction in regulatory burden. Maybe consistent with what you talked about on the second question here, what are some sort of specific areas maybe that you've seen additional red tape or what areas do you think you guys could particularly benefit if there is reduced regulatory burden on you guys in particular? I know you guys had mentioned a lot of things on the Investor Day. So if there's any specific examples, that would be very helpful. Thank you."
},
{
"speaker": "Jim Vena",
"content": "Well, I think the largest thing is that we've applied for a lot of waivers that would help with the technology that we've implemented to make the railroad more efficient, provide better service to our customers. Those are the things that are out there that we hope with the turning of the page and how regulations are being talked about at the federal level that we get those improvements will allow us to be able to provide better service and of course, be more productive. So those are just to name a few and there's a lot of waivers that we've applied for that are being outstanding for years now that we're looking forward to it. So I could go on here for about 45 minutes on things that the regulation wise, I think would help the industry, make us safer, provide better service and be more productive, but that's a good way to look at it as those waivers that we've applied for over the last number of years."
},
{
"speaker": "Joe Hafling",
"content": "Got it. Thank you."
},
{
"speaker": "Jim Vena",
"content": "You're welcome."
},
{
"speaker": "Operator",
"content": "The next question is from the line of Brian Ossenbeck with JPMorgan. Please proceed with your question."
},
{
"speaker": "Jim Vena",
"content": "Good morning, Brian. How are you this morning?"
},
{
"speaker": "Brian Ossenbeck",
"content": "Hi, good morning, Jim. Good morning, team. Thanks for taking the question. I'm doing well, thanks. I hope you're as well. I wanted to come back to the -- I guess there's a second Brakeperson rules. Wanted to hear a little bit more about that because you mentioned there was one earlier. So thanks for pointing out. And then also, Jennifer, on the comp per employee for the full year, you're still rolling out, last we heard storing out some of the predictable work schedules for the engineers because I understand there's still some negotiation going on with the conductors for something similar. So maybe can you just give us a little context in terms of the other Brakeperson Agreement, how it's different than the first one? And then how you see those other two factors or agreements, I guess, for the engineers and conductors rolling out for the rest of this year and what you expect in the numbers there? Thank you."
},
{
"speaker": "Jennifer Hamann",
"content": "I'll let Eric talk about the Brakeperson Agreement and what that really does. But just as a reminder, we did one in the second quarter of 2023 and now this one here in the fourth quarter, and we actually have one more region that we're working on there. In terms of the rollout of work rest, we continue to rollout on the engineer side and we continue to work with our conductor Smart-TD in terms of coming to an agreement. And that's all really part of the mix as we think about the statement that I made about the all-in 4% comp per employee in 2025."
},
{
"speaker": "Eric Gehringer",
"content": "Yes. And Brian, I'll just add to that. If you think about on the engineer side, there's 28 hubs across Union Pacific and 20 of the 28 are already cut over. So we're nearly 75% cut over. Now thinking about the Brakeperson, the way to really think about it is you kind of got to go back in time a little. So go back in the days when you had five people on every single train. And that's the context you got to think about this Brakeperson deal. As the technology has improved over the last 40 years, including the technology that we're still implementing to this day, you just have less demand for some of those five people. And we've demonstrated that, right. At most a crew today has three. That third person is the Brakeperson and we have that in some parts of our railroad. In Jennifer's prepared comments, she referred to it as a regional Brakeperson Agreement and that's because not every single area of the Union Pacific has it. So this is very similar to the first agreement that we reached in almost every single regard and the goal is still the exact same, right. It's to utilize who was in those Brakeperson positions as conductors and our normal crew base to be able to provide the service that we sold to our customers."
},
{
"speaker": "Jim Vena",
"content": "The only thing I'd like to add is the whole discussion about where we are on implementing with SMART and with the BLET and Eric just said that 20 out of the 28 hubs we've implemented. What you always, Brian, when you do those things is you make sure that you still end up with the same number of starts per week per employee. And that's real important. And I sat down very first few weeks I was here, came back to work what, 16 months, 17 months ago with the union leaders and they committed that it made sense that that goal had to be there. And what we wanted to do was provide that time off and that scheduling. But they also understand, because they want us to succeed also, is that we have a workforce that works. What -- we expected them to work on a weekly basis. And what we found results so far is we have to work hard to find ways to make sure that the schedules are set up. And we've had a little degradation, but nowhere near as much as some people write about. I'm always surprised when people write about those things without the detail. But at the end of the day, I'm very comfortable that we have figured out a way to move ahead and do this right, so that we don't add incremental cost to the company when we provide and the unions have agreed that it is going to be cost neutral for us or start neutral, wages still went up 4.5%. So the wages are the wages that we've agreed to. But that's the way to look at it is that we're very comfortable. And with SMART, we'll get to the right place that's good for our employees. We want our employees to have regular ships. I'm one of the guys who is a CEO in this industry that's actually worked on the ground as a locomotive engineer and conductor and to have schedules that help you plan your life so that you can balance the demands of working and also everything else, your family and everything else is real important to me. So we'll come to the right place. But we're also being smart about how we get to it. You can't have a deal that's all one sided. So I'm looking-forward to working with SMART to finalize the deal and working with the BLET to implement the last eight terminals that we have. But I think it's a real positive for both of us and it will help us to become even more efficient in the long run because people with schedules will not take as much time off as they did before once they get used to what's -- what their work schedule is. So sorry for the long answer, but I just needed to sort of clarify because I know there's some noise out there about what the effect is for us. Okay?"
},
{
"speaker": "Brian Ossenbeck",
"content": "Understood. Thank you, Jim."
},
{
"speaker": "Jim Vena",
"content": "Thanks, Brian."
},
{
"speaker": "Operator",
"content": "Our next question is from the line of Jason Seidl with TD Cowen. Please proceed with your question."
},
{
"speaker": "Jason Seidl",
"content": "Thank you, operator. Good morning, Jim and team, and nice job on the quarter. You briefly touched about some of the unknowns that are out there. There's obviously been a lot of talk about potential tariffs with two of our largest trading partners, Canada and Mexico. Clearly, you guys have a big position in Mexico with your access to the Mexican interchanges as well as a partial ownership of Ferromex. I guess if we do get that tariff on February 1, sort of what are the expectations on volume and then I guess what potentially could have an impact if cross border business with you guys would decline because of that?"
},
{
"speaker": "Jim Vena",
"content": "Listen, let me start and then I'm going to pass it over to Kenny, who knows our markets and what the different business mix would be. If something happens South of the border, does it give us more business out of origination in the U.S., I'll leave that to Kenny. But let me talk in general, the way I think about this. I have never, for all the years, I've been railroading and I just about hate to say that number because I think it's -- I've been railroading longer than most people on this call have been alive. But at the end of the day, I have always -- there's always something and this is the way I see it. We have the capability at Union Pacific to react to anything that's thrown at us. Good strong balance sheet, real good focused marketing team operations that's looking to be more efficient. And I look at the entire package, if we get tariffs but we also get the regulatory changes and we get the tax changes that we're talking about by the President with how depreciation is going to work on capital and how our corporate tax rate works that could be a lot of positive. Now I don't expect any of that. That's not what we plan. We plan for the worst if something really bad happens, make sure that we are in a good position to handle that. So I think that with the puts and takes of where our business is, we'll deal with it, and we're waiting to see what actually happens. I'm hoping that it's a negotiating position by the President and because I don't think anybody, the consumers in the U.S. would love to have increase in prices because of dispute unless there's some strategic reason that the President needs to do that for security of the country. But overall, I'm very comfortable that we're going to be in a good position as we move forward and we'll just react on how we see things happening. Kenny?"
},
{
"speaker": "Kenny Rocker",
"content": "Jim, I'll tell you, you covered a lot. So all I'll say is, and we've seen this before, it's really about being prepared. And what generally happens is maybe the origin location shifts from Asia to Mexico or Canada and that commodity is priced in, that tariff is priced in. But being prepared is a critical thing. Eric and his team have demonstrated that, especially in the second half of this year when we saw it happen on the West Coast. Same is true with exports. We saw that on the grain side where it may shift from P&W or go to the Gulf or go to Mexico, regardless, it's all about preparedness. And I'm telling you, as we're humming along here from an operating and service perspective, I feel good about our posture going in regardless of what happens."
},
{
"speaker": "Jim Vena",
"content": "Thank you very much. Good question."
},
{
"speaker": "Jason Seidl",
"content": "Appreciate the time."
},
{
"speaker": "Operator",
"content": "Our next question is from the line of Chris Wetherbee with Wells Fargo. Please proceed with your question."
},
{
"speaker": "Jim Vena",
"content": "Good morning, Chris."
},
{
"speaker": "Chris Wetherbee",
"content": "Good morning. Thanks for taking the question. I guess, I wanted to maybe pick up on the West Coast and get some perspective about how you think about sort of the shifts. I know international intermodal has got some pretty challenging comps, particularly as you move into the second half of the year. But Kenny, any sort of perspective you can give what you're seeing from your customers, maybe how real-time any of those shifts may occur? I know we kind of have a tentative agreement on the East Coast, so potentially there could be some business moving around a little bit. And then just, maybe in terms of the pricing piece, I know we're getting back into sort of accretive pricing. How do we sort of think about the opportunity and pricing as we move forward over the course of the next year or maybe longer in terms of the service recovery in the network, ultimately the inflation that we've seen across the, sort of the broader market outside of transportation and maybe what your opportunity is to try to tap into that? Just want to get a sense of maybe how that plays out."
},
{
"speaker": "Kenny Rocker",
"content": "Yes, Chris, on the International intermodal side, we are seeing some pull ahead taking place. And whether it's the hangover from some of the strikes on the East Coast or whether it's just the idea of the tariff, you can see our numbers and they're pretty strong here as we are walking into January. We'll see how that plays out for the rest of the quarter before I can really tell you what will happen. We've got the tough comps and I've talked about that. Those are in the second half. But sitting here on January 23rd, I think it's premature to go out and make a strong forecast about what will happen there. Now, on this whole thing around prices, I just want to reiterate what Jennifer said. We were price accretive in 2024 and we expect to be price accretive in 2025. Eric and the team have really done a great job of providing a strong service product. Our commercial team sells it and we're providing the service that we sold to our customers. I want to hit that hard. We're sharing the investments that we're laying out to support the growth. Our commercial team is crystal clear on what's acceptable going in from a pricing standpoint based on the service that we sold. With that, we're going to take some risk, but it's all about aligning the service we've sold with maximizing price."
},
{
"speaker": "Chris Wetherbee",
"content": "Got it. That's helpful. Thank you."
},
{
"speaker": "Jim Vena",
"content": "Thanks, Chris."
},
{
"speaker": "Operator",
"content": "Our next question is from the line of Ravi Shanker with Morgan Stanley. Please proceed with your question."
},
{
"speaker": "Jim Vena",
"content": "Good morning, Ravi."
},
{
"speaker": "Christyne McGarvey",
"content": "Hi, great. Thanks for taking -- good morning. This is Christyne McGarvey on for Ravi. Thanks for taking our question. I just wanted to circle back to some of the service comments. It sounds like you guys have pretty good confidence going into 2025, but I wanted to touch on kind of what's underpinning that? And maybe particularly in the context of perhaps a better environment than you guys are currently thinking about, if the volumes do snap back a little bit more aggressively, how you guys feel that kind of capacity is there to meet that without much service disruptions or customers?"
},
{
"speaker": "Jim Vena",
"content": "Well, I love the question that says what happens if we have more business? I think I like that question. That would be a great outcome for all of us if the U.S. consumer stays strong and grows the demand for us. We operate a railroad and we keep on talking about buffer and I think we showed it with the large increase in international. And that's the way we look at it. We want to have our assets in place, operating them efficiently, but we carry a buffer, especially the assets that we can't inbound into the company if we need them in a quick manner. So locomotives, railcars, we do that. Capacity on the railroad, we operate our railroad with the capacity because we need to recover from events like we just had in the Southeast part of our network, we need to have a buffer. So we run with a 20% to 25% buffer on our capacity, rail capacity because our business goes up and down. Customers don't release cars seven days a week. There's a big drop in the weekends. So we have that buffer. That's the way we look at it. Listen, the best thing that could happen is a 10% increase in volume across the Board. I think we're set-up to handle that and we'd onboard the people to be able to handle that in a very quick manner. So that would be the best problem I would have in 2025. Thank you very much for the question."
},
{
"speaker": "Christyne McGarvey",
"content": "Thanks. Appreciate the color."
},
{
"speaker": "Operator",
"content": "Our next question is from the line of Ariel Rosa with Citigroup. Please proceed with your question."
},
{
"speaker": "Jim Vena",
"content": "Ari, good morning."
},
{
"speaker": "Ariel Rosa",
"content": "Hi, good morning, Jim, and congrats on a nice results here in fourth quarter. So I wanted to ask about the operating ratio. You mentioned this expectation of industry leading operating ratio. Just wanted to understand a little bit more what gives you confidence in that target? And if you could talk about kind of how you perceive the structural advantages that UP relative to some of your competitors, especially given the context of BN maybe having some challenges in fourth quarter that maybe held up some of their intermodal partners. So if you could just give a little more color on that outlook, both kind of short-term and longer-term, how we should think about that? The OR evolution?"
},
{
"speaker": "Jim Vena",
"content": "Yes, Ari, I don't -- I'm not going to comment about any other railroad. We have a position that -- it's a complicated network that we have. It truly is. It's not linear, it's complicated. But I think we've fundamentally figured out a way to operate it and be as efficient as possible. We want to be the leaders when it comes to operating ratio and that's what we're delivering. And I'm not sure what the other railroads are going to because we're first up. I'm assuming that we will have the best operating ratio. That's an outcome of everything we do. That's the important piece is Ari. what do we do with -- do we provide good service, so we can maximize price so our customers could win and grow in the marketplace. That's real important for us, that triangle. Is that operationally -- do we look at our assets, how we operate, the number of people and do we use technology? We're excited about net control and how we were going to be able to quickly change our operating plan faster than we've ever been able to do before to operate the railroad more efficiently. So with all those things, I personally, and I've said this publicly and I'll say it again, all the railroads should be very close when it comes to operating ratio. There's no reason for the Class 1s not to be. And I know some -- I'll probably get some notes from some of the other CEOs and I'd appreciate the call or the text. But at the end of the day, we want to be in the best position and you can see what happens when we have a little bit of volume, we price smart, we operate the railroad efficiently, we end up with a 58.0%. Are we always going to be at a 58.0%? No, we might go up a little bit depending on what the market conditions are. But we're going to drive that to be the best and stay tuned, okay. I don't think anybody thought we were going to be able to deliver a 58% and hang on and watch us go. That's the win for us. Anybody else want to comment anything further? No, nobody else wants to say anything after that. Thanks for the question."
},
{
"speaker": "Ariel Rosa",
"content": "All right. Thank you, Jim."
},
{
"speaker": "Jim Vena",
"content": "You're welcome."
},
{
"speaker": "Operator",
"content": "Our next question is from the line of Bascome Majors with Susquehanna. Please proceed with your question."
},
{
"speaker": "Jim Vena",
"content": "Good morning, Bascom."
},
{
"speaker": "Bascome Majors",
"content": "Good morning, Jim. In one of the earlier questions, you talked about some opportunity with the FRA waiver backlog potentially beginning to clear and opening up some efficiency. But this week, we also had Patrick Fuchs take over as STB, Chairman. Can you talk about that side of the regulatory fence? What have you learned from working with him as a Board member over the last six years? And over the next several years, what opportunities does UP or the industry have that might not have been on the table under Primus or Oberman's leadership? Thank you."
},
{
"speaker": "Jim Vena",
"content": "Yes, listen, there's always changes in who leads. And I've had a number of meetings with Mr. Fuchs, okay. Very smart individual. And the rest of the Board is very strong. So at the end of the day, the way I look at it is we have the same goal. We want to provide good service to our customers. And if we can provide good service to our customers, they win in the marketplace and we both win. And the STB deals with those things. Now, at the end of the day, there's a lot of other things that the STB does. They look at mergers, they look at acquisitions. And I'm absolutely sure that everybody, the STB and the railroads would like quick decisions, quicker movement on what's happening. And I'm hoping that that's how we move ahead. But I'm very comfortable that the relationship will be strong and we'll continue to have a strong relationship with all the regulators. There is a position to have regulators there. There is a need and I'm very comfortable that we'll work with them and be very transparent about what we're doing at Union Pacific. Anybody else have any comments on that, any further? Because you've all met with the STB, Kenny?"
},
{
"speaker": "Kenny Rocker",
"content": "No, I mean, we're looking forward to it as a commercial leader. We want quicker outcomes so that we can service the marketplace. So it's encouraging."
},
{
"speaker": "Jim Vena",
"content": "Eric, anything from you? You deal with them lots."
},
{
"speaker": "Eric Gehringer",
"content": "I think that's the exact same comment. I mean, even in the engagements that we've had with them on even service things, right, continuing to move faster. I know Patrick in the past has had really good perspective on how we think about service. So looking forward to working with them."
},
{
"speaker": "Jim Vena",
"content": "I know, Jennifer, you don't meet with them as often, but maybe we should get you there more often because you've got a better personality for it than me, maybe. But anything to add?"
},
{
"speaker": "Jennifer Hamann",
"content": "No, I think your point about our goals being aligned is the important one. They want a strong rail franchise. It's the best thing for the nation, our national security, our economy, and we want to grow with our customers. And I think working together to fulfill that purpose is what everybody wants."
},
{
"speaker": "Jim Vena",
"content": "Perfect. Great question. Thank you very much."
},
{
"speaker": "Bascome Majors",
"content": "Thank you all."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question is from the line of Ken Hoexter with Bank of America. Please proceed with your question."
},
{
"speaker": "Jim Vena",
"content": "Good morning, Ken."
},
{
"speaker": "Ken Hoexter",
"content": "Hi, great. Good morning, Jim and team. Congrats on the solid OR and results. But maybe digging in a little bit on that. Jen, you guided in the appendix the other expense to $325 million, $350 million. Maybe can you delve into what happened in the fourth quarter? I think you mentioned the bad debt expense. Can you talk about a scale of the one-timer or the scale of casualty expense that we should see bounce back? And I guess maybe I'm just ultimately getting at, kind of, trying to think about the cadence to first quarter. Can you talk about seasonality and what we should -- I know you don't delve into quarterly specific, but maybe just normal historical seasonality, how we should think about the move given the improved performance here in the fourth quarter?"
},
{
"speaker": "Jennifer Hamann",
"content": "Yes. I mean, when we look at other expense for the fourth quarter, I mean, casualty was really the driver there. I did call out the bad debt expense, but the bigger piece was the casualty, both in terms of looking at it year-over-year because we did have a pretty big step-up in fourth quarter of 2023 as well as the fact that we're starting to see some better performance here in 2024. That's a little slower to come through on the expense side, but you heard Eric and Jim both talk about the fact that we're continuing to drive better safety performance. So that's really where I'd focus in terms of the driver for fourth quarter. In terms of looking out into 2025 within that category, it's probably one of the least seasonal categories we have, quite frankly. State and taxes -- state and local taxes is the biggest component of that. And then you do have some of the other things like the casualty, like bad debt, travel, all those fun things. So I wouldn't think about that in terms of a lot of seasonality on that expense line."
},
{
"speaker": "Ken Hoexter",
"content": "Well, I didn't mean, just on the expense line, I meant the cadence into first quarter of kind of the OR, do you normally see 150 basis point deterioration? Is that -- would you see that given all the backdrop that you're talking about in a big picture way?"
},
{
"speaker": "Jennifer Hamann",
"content": "Yes. I mean, obviously I'm not going to give you a guide, Ken, for the quarter, but I think in terms of seasonality, you understand it. There is a difference, when you start out the year, you have some beginning of year costs. If you think about some of the payroll taxes that kick back in for us, our business is a railroad. You generally see some of the lowest volumes of the year in the first quarter and then you tend to have some more weather expenses. I mean, I'm not used to paying for snow removal in New Orleans, but I think I'm going to this year a little bit. So you have some of those things happening. So pleased to see the way the railroad started in terms of the volume demand and the fluidity. But from a seasonality perspective, I wouldn't look for anything unusual there."
},
{
"speaker": "Ken Hoexter",
"content": "Appreciate the clarification. Thanks for the time."
},
{
"speaker": "Operator",
"content": "Our next question is from the line of David Vernon with Bernstein. Please proceed with your question."
},
{
"speaker": "Jim Vena",
"content": "Good morning, Dave."
},
{
"speaker": "David Vernon",
"content": "Hi, good morning and thanks for the time. So Kenny, I got a couple of questions for you. First is, in the intermodal business, can you give us a sense for where utilization is in the box pool fleet for you guys right now? Obviously, there's a lot of the channel inventory that's been built up by the intermodal marketing companies through the pandemic taking too many boxes. I'm just wondering where your utilization is kind of running right now on railroad owned equipment? And then the second question would be whether this recent uptick in natural gas prices that we're seeing may have some benefit for you on the pricing side with some of your utility coal contracts? Thanks."
},
{
"speaker": "Kenny Rocker",
"content": "Yes. So the first question. Thanks. We certainly did deploy our rail fleet in the second half. We saw it grow and really do really well in our portfolio of fleet. When I say portfolio, I'm talking about the private asset folks, IMCs. So we saw shrink there. It wasn't fully deployed. So there's upside there. And so we'll see what happens as we move throughout the year. Switching to natural gas, I tell you, it's one of the most volatile things to do. And I've been in this role now for seven years and I've gotten out of that game of trying to forecast what's going to happen with natural gas. But bottom line, you asked a direct question. We should see some benefit if natural gas prices increase. Absolutely."
},
{
"speaker": "David Vernon",
"content": "And is there any way to quantify how many more boxes kind of are stacked today versus maybe you would have had normally pre-COVID?"
},
{
"speaker": "Kenny Rocker",
"content": "No, I would just say that if you look at the overall market again, I mean, the overall market is still not where it should be. There's still upside. And so we still feel good about deploying those boxes as the market comes back."
},
{
"speaker": "Jim Vena",
"content": "Thanks for the question."
},
{
"speaker": "David Vernon",
"content": "All right, thanks for the time."
},
{
"speaker": "Operator",
"content": "The next question is from the line of Jordan Alliger with Goldman Sachs. Please proceed with your question."
},
{
"speaker": "Jim Vena",
"content": "Good morning, Jordan."
},
{
"speaker": "Jordan Alliger",
"content": "Good morning. Just coming back to intermodal, if the trends hold up that international facing those tough comps, maybe volumes would be tough to grow in the back-half of the year, does the domestic intermodal offset, can that provide -- even if volumes are perhaps down, can that provide a favorable net positive in terms of mix, margin, EBIT dollars, et cetera? Thanks."
},
{
"speaker": "Jennifer Hamann",
"content": "Yes, I mean everything depends on magnitude, right, Jordan. So I think it's unfair to really kind of focus in on one commodity line like international intermodal. You're right the comps are going to be extremely tough in the back-half, but there's a lot of other businesses that we move and that's really what's going to ultimately play into what our financial results will be. So maybe domestic intermodal offsets some of that, but we've got a lot of other business lines that we're going to move and we're going to try to maximize those. So I don't know that we want to get into the game of trying to make a prediction about how the back half actually looks. There's a lot to happen between now and then."
},
{
"speaker": "Jim Vena",
"content": "The bottom line is we feel confident and we're bullish on the domestic intermodal market going into 2025. That's the key."
},
{
"speaker": "Jennifer Hamann",
"content": "We've had some great franchise wins there that we still haven't seen the full benefit from."
},
{
"speaker": "Jim Vena",
"content": "Thanks for the question, Jordan."
},
{
"speaker": "Jordan Alliger",
"content": "Okay. Thank you."
},
{
"speaker": "Operator",
"content": "Our next question is from the line of Daniel Imbro with Stephens. Please proceed with your question."
},
{
"speaker": "Jim Vena",
"content": "Good morning, Daniel."
},
{
"speaker": "Daniel Imbro",
"content": "Hi, good morning everybody. Thanks for taking the question. Maybe to follow-up on the volume outlook, if we look on the outlook on Slide 11, on a headline, there's more pluses than minuses. But how should we think about the mix impact on revenue per carload? You just talked about intermodal in the previous question. But I guess any visibility into changes of mix within mix within these categories that we should be aware of when we think about the market share wins? And Jennifer, understanding you don't want to guide each quarter, but how should we think about volume growth through the year given the more difficult back-half compared? Can we grow volume each quarter? Would that be kind of a base case expectation? Just any color there would be helpful. Thanks."
},
{
"speaker": "Jennifer Hamann",
"content": "Hi, Daniel, thanks for the question. So, I mean, we specifically aren't giving volume guidance either for full year or on a quarterly basis. I think you've laid out, as we laid out kind of what some of the puts and takes are through the year. I think the important thing is that we're very well positioned. The service product is good. Kenny and his team are out there winning new business. And so we're going to do all we can to push that curve upward. But there's also market forces out there that we're going to be playing against and we'll just see how that all plays out. From a mixed perspective, and I did say this in my comments. When I look to the back-half of the year with what we expect to happen from International intermodal, that will alleviate that mix pressure that we had in the back-half of 2024. How that ultimately shapes out kind of similar to my answer to Jordan, will depend on what the rest of the business is doing at that point in time. But I think you're thinking about the different components correctly. It's just a matter of what else layers in along with those as we go ahead. Certainly, mix will continue to be a challenge here at least in the first part of the year as international intermodal stays strong. I don't know, Kenny, if you want to add anything else?"
},
{
"speaker": "Kenny Rocker",
"content": "You hit it all, again the credo here for the management team is we're going to have volume outpace the markets and we expect the revenue to outpace volume."
},
{
"speaker": "Jim Vena",
"content": "I guess the only thing I would say is this. Our business mix actually is we've got a broad range of customers and a broad range of markets that we play in. So of course, we want to maximize all of them in a smart way that fits our network, makes our customers win, and it's service that we can provide at a high level. So puts and takes international, we don't see it being able to stay at that. Nobody -- if I go back to the early part of 2024, nobody thought the international intermodal for the Western railroads was going to grow in for Union Pacific as much as it did, but it did. But we also have products across, whether it's industrial products, whether it's sand for fracking, you name it. And that's the nice part about our franchise is the different types of customers that we handle. We move every day, products that America needs for finished products, consumer goods and inputs to the economy. So I'm very happy. It's great to have this franchise that was built by a lot of people before I came to Union Pacific. So that's the way we look at it. And of course, Kenny's job is to maximize it. Otherwise, why do you have a marketing department, right? So I'm looking forward to another great year, Kenny. Thank you very much for the question."
},
{
"speaker": "Daniel Imbro",
"content": "Yes. Thanks for all the color."
},
{
"speaker": "Operator",
"content": "Our next question is from the line of Walter Spracklin with RBC Capital Markets. Please proceed with your question."
},
{
"speaker": "Jim Vena",
"content": "Good morning, Walter. How is it in Canada?"
},
{
"speaker": "Walter Spracklin",
"content": "Yes. It's pretty cold, but my backyard rink is in good shape, Jim. That mentor quote, it sounds like it was a quote from Hunter, am I right?"
},
{
"speaker": "Jim Vena",
"content": "Well, it was a little earlier, but I think Hunter would have -- might have said it in a different way. He might have not called me stupid."
},
{
"speaker": "Walter Spracklin",
"content": "We're excited about."
},
{
"speaker": "Jim Vena",
"content": "But at the end-of-the day, yes, he would have said something very similar. Don't worry about all these things that you can't control. It's the fundamentals. If you operate a strong railroad, if you look at your cost, you make sure you're very efficient, don't lose sight of what's important, you end up on the winning side of the game. You end up on the winning side of the hockey game. You know, Walter, good strong defense, right, in hockey always wins the Stanley Cup. Not that classic person in the front. It's that strong four core defensemen that make a difference and a strong goalie. So that's what we're all about."
},
{
"speaker": "Walter Spracklin",
"content": "Well, my son will be happy to hear that comment for sure. Speaking of those fundamentals, Jim, you talked a bit about guidance and its predicate on a mixed economic outlook. And I know you like that kind of scenario analysis where we look at the upside. And I know a few of your trucking peers have spoken pretty constructively here today about that potential for an improvement in the economy. So if we do see that, where do you see the most opportunity for leverage, if we get a better macro? And more importantly, is this type of operating leverage that you're engineering here, Jim. Excuse me, is this setting you up for potentially coming in above the high end of that low double-digit band or is the low double-digit capture? If the economy gets better, then we will do low double-digit. Just curious to hear how that sensitivity works out for you."
},
{
"speaker": "Jim Vena",
"content": "Well, Walter, if I didn't have a few hundred people on the call, maybe I would say something different. But bottom line is you know what we talk about. But you know what, you always hear from me. But I've got a strong team with me and Eric does a fantastic job about how we operate every day. And Kenny does a fantastic job. I rib him every so often about why do we need a marketing department. So why don't I let them talk about what they see and what we have operating leverage and what we see customer leverage as we move ahead and what that would mean. So Kenny or Eric?"
},
{
"speaker": "Kenny Rocker",
"content": "I'll kick off, Eric, and then you take over. I mean, look, we laid out the slide, but I'm very bullish on what we're seeing in our grain products area with renewable diesel and I'm bullish from a number of reasons. One is structural, we've talked about these facilities that are on our line. Eric's service product has given us flexibility on the grain side to move anywhere in the world, whether it's going out of the Gulf, whether it's going to Mexico, whether it's going to the P&W and we'll see where coal ends up. I got a coal question a little bit earlier. It started off pretty solid here and we've got a win that's coming off. On the industrial side, our Petrochem business has been strong, we've had some wins. We've been investing in that area to help us grow. We'll see that in terms of expansions coming on this year. And then we got to look at some of these other macro indicators, what's going to happen with housing starts that has a really, I'll call-it a step function impact on us from a lot of different commodities. And then on the premium side, we should see automotive market improve as we move throughout the year. Domestic intermodal, I mentioned I'm high on and should be positive. And on the international side, I'd be remiss if I didn't say we've gone out and tried to minimize those comps by winning some business last year and trying to retain portions of it, not all of it, obviously. So we'll see how that plays out."
},
{
"speaker": "Eric Gehringer",
"content": "And then Walter, if you pick it up from there, then the question becomes, are there proof statements in Union Pacific's recent history that demonstrate that we can do exactly what Kenny just said that we can support him as he's out there in the market and there are a number of them. We talked about international intermodal and I think we've talked about that one enough, a massive accomplishment for the team. But think about it, if we were sitting here a year ago, nobody would have expected the shift on the grain side away from the Pacific Northwest as much into Mexico. But you didn't hear any noise about that. Instead, you saw us pivot, use some of those buffer resources we have, leverage our strong relationship with FXC to be able to grow that market share. You also see it in the example that I mentioned in my prepared comments about the Houston Gulf Coast projects. Sometimes when people think about capital investments and we say projects, they think, well, it's one location and we must be building just a siding. That project collectively is a massive undertaking and it's a very strategic undertaking to say where do we have to make just small adjustments, small investments in many different terminals to make sure that we can support exactly what Kenny said. And then finally, one of the most exciting ones for me and certainly for all of us, I tell you, every single expansion we do at Inland Empire, Kenny's team just keeps filling it up. And so we have many proof statements that say we can support exactly what Kenny is setting out to do in 2025."
},
{
"speaker": "Walter Spracklin",
"content": "I appreciate the color, Eric, Kenny. Thanks very much."
},
{
"speaker": "Jim Vena",
"content": "Walter, thank you very much. And listen, it's time for one of the Canadian teams to win the Stanley Cup, okay."
},
{
"speaker": "Walter Spracklin",
"content": "Agreed."
},
{
"speaker": "Jim Vena",
"content": "It's been a long time."
},
{
"speaker": "Walter Spracklin",
"content": "Agreed."
},
{
"speaker": "Jim Vena",
"content": "And I think the Edmonton Oilers are going to do it. I've been following them for a long time and I've been suffering for many years, Walter. Not as bad as you in Toronto, but that's okay. Don't worry about it."
},
{
"speaker": "Walter Spracklin",
"content": "We'll get it done."
},
{
"speaker": "Operator",
"content": "Our next question is from the line of Jeff Kaufman with Vertical Research Partners. Please proceed with your question."
},
{
"speaker": "Jeff Kaufman",
"content": "Thank you very much and congratulations on just a terrific execution quarter. Kenny, I want to come back to you, if I can. I liked your answer to Jason Seidl's question, be prepared in terms of dealing with these known, unknowns. But I want to dive a little bit deeper. When I think about what could be at risk on the tariff side, I'm not talking about the tax change or regulatory benefit. You would think obviously export grain South, you would think beer imports North, you would think auto parts. What elements of your traffic mix either have maybe a Canadian end to it that we might not see as obviously or a Mexican import, export end that might not be as obvious to us on the outside."
},
{
"speaker": "Kenny Rocker",
"content": "Well, first of all, I just want to say it's all fluid. And I'm not aware when I look across our commodity groups where, maybe there is one specific commodity I can think about. But most of these commodities have different entry points and different origin points, different destinations. That's why I talk about preparedness, because we have just a great franchise to be able to capture that. So whether it's finished vehicles that have to come in through the Gulf, whether it's finished vehicles that have to come in through Mexico, whether it's finished vehicles that we move out of the P&W, we have different entry points and destination points to move in and out. That's why I harp so much on preparedness. The end consumer is going to consume these products. It may be a few pennies more. They're going to consume the products. It's just how it's going to get there and our commercial team is all over this to make sure it moves Union Pacific."
},
{
"speaker": "Jeff Kaufman",
"content": "So maybe to your point, I guess maybe the thing we should be thinking about is maybe the way it gets to where it's going changes, but your feeling is that the team will find a solution if that has to be."
},
{
"speaker": "Kenny Rocker",
"content": "So I hit that point. I thought I hit it hard earlier. That's exactly what I'm saying. Our job, our commercial team and we are, and we're dialed-in on where these changes will be and then coming up with solutions with Eric team to make sure we can deliver."
},
{
"speaker": "Jim Vena",
"content": "Yes, good morning. I forgot to say that. And thanks for the question. I think you summarized it well."
},
{
"speaker": "Jeff Kaufman",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Our next question is from the line of Tom Wadewitz with UBS. Please proceed with your question."
},
{
"speaker": "Jim Vena",
"content": "Good morning, Tom."
},
{
"speaker": "Tom Wadewitz",
"content": "Hi, yes, good morning. I wanted to -- I think you've had some pretty positive and convicted views on pricing and focus on price, which is great. How do you think about the truck, your assumptions on truckload market? And do you just think, well, we'll get a little help from some modest contract increases in truck and that helps us and or how do you think about that? And also just on intermodal revenue per unit, is that something that's been pretty meaningful drag for a while? I know some of that can refuel surcharge and mix and everything, but that's been a pretty big drag. How do you think about revenue per unit in intermodal in 2025 as well?"
},
{
"speaker": "Kenny Rocker",
"content": "So the last couple of years, we -- I have resisted from going out and forecasting and seeing back-half, back-half, back-half. We want to look at the data points and the market data points will tell you whether you're looking at DAC, whether you're looking at FTR that it should improve as we move throughout the year. Customer sentiment is the same as we're talking to a number of our IMCs and private asset folks. We'll let that market play out, the timing of it. We'll see where that goes, the extent of it, we'll see where that goes. And yes, if that improves, we should see some uptick there based on how we position things in terms of that revenue per box."
},
{
"speaker": "Jennifer Hamann",
"content": "Yes. And Tom, I think you really nailed it in terms of what you see as the drivers there. I mean, it's one of those categories where we have mix within mix. We talked at our Analyst Day about how our international intermodal has our lowest revenue per unit of any commodity that we haul. And so when that's growing strong within that group, you see that impact. And of course, fuel coming down is another thing. So both of those are really what you see happening there as well as the tougher competitive environment."
},
{
"speaker": "Jim Vena",
"content": "The only thing I could add, Tom, is just on the productivity side of the way we've been able to change the way we operate our lowest revenue movements. And no if, ands or buts, there's a big difference between some products that we move because we don't price the same for every commodity. But at the end of the day we've done a lot of work on terminal dwell, car speed, car velocity, how many boxes we can put on a train to be able to make it more efficient for us so that we handle that difference in the revenue that we make. And Eric's team works every day, every minute on that commodity to see how do we optimize the railroad and the cost structure that we have against the revenue that we make on it. So it's a challenge. But at the end of the day, I think we've done a pretty good job of it and we still love that business. It's good for us and it moves through our whole network. And the more efficient we can get, the better we are on being able to handle more of it in an efficient manner and maybe put a little less pressure on Kenny. Well, I guess not, to price it up. So thanks for the question, Tom."
},
{
"speaker": "Tom Wadewitz",
"content": "Okay. Great. Thank you."
},
{
"speaker": "Operator",
"content": "The next question is from the line of Oliver Holmes with Redburn Atlantic. Please proceed with your question."
},
{
"speaker": "Jim Vena",
"content": "Good morning, Oliver."
},
{
"speaker": "Oliver Holmes",
"content": "Good morning, thanks for having me on. Just a question on CapEx if I may. It looks like your locomotive [technical difficulty]"
},
{
"speaker": "Jim Vena",
"content": "Oliver, you're breaking up. I can't understand it. I don't know if anybody else around the table can."
},
{
"speaker": "Jennifer Hamann",
"content": "No, all I heard was something about CapEx."
},
{
"speaker": "Jim Vena",
"content": "Yes, can you maybe just get into a little better spot or something and see if you can get through to us, please."
},
{
"speaker": "Oliver Holmes",
"content": "[technical difficulty]."
},
{
"speaker": "Jim Vena",
"content": "No, still breaking up, Oliver. Can we go to the next question and then see if we can get Oliver in a different spot because I know we're down to the last couple. Operator?"
},
{
"speaker": "Operator",
"content": "Sure. Yes. The next question is from Brandon Oglenski with Barclays."
},
{
"speaker": "Jim Vena",
"content": "Good morning, Brandon."
},
{
"speaker": "Brandon Oglenski",
"content": "Hi, good morning all. Thanks for getting my question in here. I know it's been a long call, and I was off for the front part of it. So apologies if I'm replicating something here. But I guess, Jim or Kenny, we've heard about better service and I think what investors are looking for at Union Pacific and other railroads is to finally see real volume growth. So on the back of those service gains that you guys have made in the network, Kenny, within the context of your comments about volume outpacing the market this year, I mean, is this incremental wins? Is it business development efforts that are driving this? And finally, leveraging that service product?"
},
{
"speaker": "Kenny Rocker",
"content": "Yes, absolutely. I mean, if you look at our network minus the business development wins, especially in markets like the automotive that I highlight, in markets that are challenged where we have structural decline like coal and markets that are emerging and we're ahead of it in renewable diesel in a market that we expect to grow from an export perspective on the Petrochem side and industrial chemical side, absolutely. The business development wins matter and it does help us outpace the market. So no other way to really say that than to just hit that one head on."
},
{
"speaker": "Brandon Oglenski",
"content": "Thank you all."
},
{
"speaker": "Jim Vena",
"content": "Brandon, thank you very much. Operator, did we get Oliver back on or not?"
},
{
"speaker": "Operator",
"content": "No, it did not, Mr. Vena, I'll turn it over to you for closing comments."
},
{
"speaker": "Jim Vena",
"content": "Okay. Well, listen, Oliver, call in Brad and team are always willing to answer the question, so I apologize if it didn't work out. But listen, I'm very proud of the team. I'm very proud of the focus, I'm proud of every -- today, right now, we have 15,000 people out there moving, touching and working to move the products that we sell. And the rest of us are in a nice warm office and they're out there working. I can't be more appreciative. Great quarter for all of them, great quarter for us and looking forward to speaking to all of you, if not at some conference or at some other time at the end of the first quarter. So thank you very much. Have a great day and let's enjoy the day as we go forward. Thank you."
},
{
"speaker": "Operator",
"content": "Thank you, Mr. Vena, and thank you to everyone for joining us today. You may now disconnect your lines at this time. We thank you for your participation and have a wonderful day."
}
] |
unp | 2,024 | 3 | [
{
"speaker": "Operator",
"content": "Greetings, and welcome to Union Pacific's Third Quarter Earnings Call. [Operator Instructions] As a reminder, this conference is being recorded, and the slides for today's presentation are available on Union Pacific's website. It is now my pleasure to introduce your host, Mr. Jim Vena, Chief Executive Officer for Union Pacific. Thank you, Mr. Vena. You may now begin."
},
{
"speaker": "Jim Vena",
"content": "Good morning, Rob, beautiful morning in Omaha, nice fall day. So good morning, and thank you for joining us today to discuss Union Pacific's third quarter results. I'm joined in Omaha, by our Chief Financial Officer, Jennifer Hamann, our Executive Vice President of Marketing and Sales; Kenny Rocker, and our Executive Vice President of Operations, Eric Gehringer. As you'll hear from the team, our third quarter results do an excellent job of capturing the progress we've made under our strategy to lead the industry in safety, service and operational excellence. And you're seeing how that leads to financial success. I'm very pleased with where we sit today compared to where we started a little over a year ago. Now let's discuss third quarter results, starting on Slide number 3. This morning, Union Pacific reported 2024 third quarter net income of $1.7 billion, a 9% improvement and earnings per share of $2.75, a 10% improvement. Third quarter operating revenue gained 3% of strong volumes and core pricing gains were impacted by our business mix and less fuel surcharge revenue. Excluding fuel, freight revenue increased 5% versus 2023. Reported expenses year-over-year improved 2%, while fuel prices were a driver. The team did an excellent job generating productivity to control costs as we successfully handled a 6% increase in volume. Our third quarter operating ratio of 60.3% improved 310 basis points versus last year, further demonstrating our ability to be operationally excellent while maintaining a resource buffer to handle unforeseen events. Look, it was another really good quarter. I'm pleased with how we flex to handle the 33% increase in international intermodal volume during the quarter, while improving service metrics across our network. And yes, that mix of business pressured margins a bit. But at the end of the day, it's about operating as efficiently as possible to drive increases in net income and free cash flow. And as Jennifer will walk you through, we did an excellent job of delivering in those areas. It's another proof point that our strategy is working. I'll let the team walk you through the quarter in more detail and then come back for a wrap up before we go to question and answers. So we'll start with the third quarter financials. Jennifer, over to you."
},
{
"speaker": "Jennifer Hamann",
"content": "Thank you, Jim, and good morning. Let's begin on Slide 5 with a walk down of our third quarter income statement, where operating revenue of $6.1 billion increased 3% versus 2023 on a 6% volume increase and third quarter freight revenue totaled $5.8 billion, up 4% compared to last year. Breaking down the freight revenue components, increased volume in the quarter added 550 basis points. Strong core pricing gains were more than offset by business mix, reducing freight revenue 75 basis points. As I mentioned at Investor Day, International Intermodal's average revenue per car is significantly lower than our system average. And lastly, fuel surcharge revenue of $635 million was flat versus last year as lower fuel prices impacted freight revenue 75 basis points. Wrapping up the top-line, other revenue declined $73 million or 18%, driven by several factors: lower access oils resulting from the second quarter intermodal equipment sales reduced demand for auto part shipments at our subsidiary, the ongoing transfer of metro operations and a onetime contract settlement of $12 million during the quarter all contributed to the decrease. As a reminder, there are cost savings across our expense lines associated with the ongoing revenue impact from the equipment sales and metro transfer. Switching then to expenses, third quarter operating expense of $3.7 billion improved 2%, driven by strong productivity and lower fuel prices that more than offset volume-related expenses. There are more details in the appendix, but let me highlight some of the performance drivers. Compensation and benefits expense increased 2% versus last year as wage inflation, including the July 1st, 4.5% increase and volume costs were partially offset by 5% lower workforce levels and record workforce productivity. Trained service employees were flat year-over-year, as we used our buffer resources to handle increased quarterly volume. All other workforce areas decreased 8%, reflecting our continued focus on operational excellence. Cost per employee in the third quarter increased 8% as a result of higher incentive compensation as well as additional wage inflation related to the work rest labor agreements. Purchased services and material expense improved 4% as cost to maintain a lower active locomotive fleet, and decreased subsidiary drayage expenses were partially offset by inflation and volume related expenses. Fuel expense in the quarter declined 13% on a 17% decrease in fuel prices from $3.12 to $2.60 per gallon. Our fuel consumption rate increased 1%, related to the significant growth in less fuel-efficient intermodal traffic, which offset our year-over-year productivity gains. Finally, other expense was better by 6%, reflecting the impact of write-offs in 2023 that more than offset inflation and volume costs. The result of solid revenue growth and strong cost control was third quarter operating income of $2.4 billion, up 11% versus 2023. Below the line, other income decreased $19 million from lower real estate income, while interest expense declined 6% or $20 million on lower average debt levels. Income tax expense increased 23%, driven by higher pre-tax income and state income tax reductions in 2023. Third quarter net income of $1.7 billion, increased 9% versus 2023, which when combined with a lower average share count resulted in double-digits earnings per share growth to $2.75. Our quarterly operating ratio of 60.3% improved 310 basis points year-over-year with nearly half of that coming from core operational improvement. As we discussed in Dallas at our Investor Day, operating ratio is an outcome of our strategy and not the goal. Our goal is to grow earnings and generate more cash for our shareholders, which we achieved even as our revenue growth and margins were impacted by mix. Looking now at cash, shareholder returns in the balance sheet on Slide 6. Year-to-date cash from operations totaled $6.7 billion, up $700 million versus last year. Our cash flow conversion rate improved to 83% and free cash flow has almost doubled versus 2023, up over $900 million. These improvements are driven by 2023 labor agreement payments and growth in operating income, partially offset by higher cash taxes. Year-to-date, our shareholders have received $3.2 billion through dividends and share repurchases, including third quarter repurchases of $738 million. Finally, our adjusted debt-to-EBITDA ratio finished the quarter at 2.7x, as we maintain a strong balance sheet and remain A rated by our three credit rating agencies. So wrapping up on Slide 7, with just over two months left in the year, the majority of 2024 story has been written and it's been a good one. We are executing on the fundamentals of railroading, which is critical to achieving the full financial potential of this franchise. We are affirming our prior 2024 guidance, most importantly that we will continue to improve profitability through our strategy of safety, service and operational excellence. Pricing dollars will exceed our inflation dollars. We will purchase $1.5 billion of shares and invest roughly $3.4 billion of capital and our capital allocation strategy is unchanged. We also are going to put a slightly finer point on how we expect to close the year. At this time, we'd expect fourth quarter results to closely mirror the third quarter, while improving on a year-over-year basis. This level of performance will mark our fifth consecutive quarter of year-over-year gains, again demonstrating the positive results of our strategy. Throughout the year, we've shown our ability to pivot and flex to handle the various challenges of railroading, from weather of all types to the significant West Coast traffic spike, and we navigated them successfully, improving service, while maintaining cost discipline. We continue to generate strong pricing and productivity, positioning us well to finish 2024 with momentum and on a path to achieve the long-term targets we laid out last month. I'll now turn it over to Kenny to provide an update on the business environment. Kenny?"
},
{
"speaker": "Kenny Rocker",
"content": "Thank you, Jennifer, and good morning. As Jennifer mentioned, we had a solid third quarter. Freight revenues totaled $5.8 billion for the quarter, which was up 5%, excluding fuel surcharges, due to increased volume and strong core pricing gains. Let's jump right in and talk about the key drivers for each of our business groups. Starting with our Bulk segment, revenue for the quarter was up 2%, compared to last year on a 3% decrease in volume and a 5% increase in average revenue per car based on a positive mix in traffic and solid core pricing gains. Coal continued to face difficult market conditions in the quarter, resulting from reduced coal demand due to high inventory levels and competition from low natural gas prices. Grain products volumes increased for the quarter due to business development wins and new facilities supporting renewable diesel and associated byproducts, as we highlighted last month at our Investor Day. Lastly, export grain business was up for the quarter, primarily driven by corn and wheat. We continue to win business moving to Mexico, as their domestic consumption outpaces production. Moving to Industrial. Revenue for the quarter was up 3% for the quarter, on a 2% decrease in volume. Average revenue per car increased by 5% due to strong core pricing gains and a positive mix in traffic. Petroleum shipments increased for the quarter due to strong business development efforts in various markets like asphalt and lube oil. Petrochemicals volumes continued to grow due to domestic demand in plastics and new business wins in our industrial chemicals market. However, those gains were more than offset by the softer demand for rock against last year's record shipment. Premium revenue for the quarter was up 7% on a 14% increase in volume and a 6% decrease in average revenue per car, reflecting increased international intermodal shipments, lower fuel surcharges and truck market pressures. Automotive volumes were down due to unplanned production adjustments, partially offset by business wins with Volkswagen and General Motors. Intermodal volumes continue to remain strong. Our international intermodal volume was up 33%, significantly outpacing growth seen in West Coast imports. Import strength also drove increased domestic volume, which we were able to capitalize on due to our diverse IMC network. Now turning to Slide 10. Here is our outlook for the balance of 2024 for the key markets we serve. Starting with Bulk. Coal is expected to remain challenged, as inventories remain high, and we see competition from low natural gas prices. Moving to Grain. We are optimistic due to a strong supply in UP's franchise areas, and we have secured additional new facilities that will ensure domestic growth, generating long-term ratable grain demand. We expect ongoing strength in the Mexico export market as the UP continues to increase its share south of the border. Additionally, we expect continued growth in the grain products tied to renewable fuels and their associated feedstocks. The team is focused on capturing business as production continues to ramp up at new facilities brought online, such as Bartlett's crush facility in Cherryvale, Kansas. Turning to Industrial. As we mentioned earlier, we expect the rock market will not match last year's record volume. For petroleum, we have tougher comps but are building on our success with business development. Petrochemicals is expected to outperform the market, based on the strength of our Gulf Coast franchise, and we are excited to see incremental volume from Shintech's expansion at Plaquemines, Louisiana. And wrapping up with Premium. On the intermodal side, the surge of West Coast import volumes will continue to drive for both our international and domestic markets for the remainder of the year. In Automotive, we are seeing softness in the market, which will be partially offset by business development wins. In summary, I'm proud of the commercial team. We're going to see the strongest volume year since 2029. Our diverse portfolio allows us to see positive momentum, and our resource buffer puts us in a great position to manage increased volumes on the West Coast. The team is focused on our key growth markets, collaborating with our customers and the operating team to find innovative solutions to grow and win together. With that, I'll turn it over to Eric to review our operational performance."
},
{
"speaker": "Eric Gehringer",
"content": "Thank you, Kenny, and good morning. Moving to Slide 12. As I mentioned at our Investor Day in September, we always believe there's a better way to do things, even the things we're doing well today. And that culture has manifested itself in our results, as we continue to make great progress in our safety, service performance and efficiency metrics. Starting with safety. We remain intensely focused on our four pillar strategy to prevent injuries and drive down derailments. As a result, year-to-date both derailment and personal injury rates improved year-over-year. While we are not there yet, we are clearly on the path to become the safest railroad. Freight car velocity improved 5% to 210 miles per day compared to third quarter 2023. Additionally, throughout the last several weeks, we have maintained a freight car velocity near 220 miles per day. A favorable business mix coupled with continued improvements in terminal dwell has driven the performance. Notably, we achieved a third quarter record in terminal dwell, a 5% improvement versus last year. Intermodal and Manifest Service Performance Index saw a 1 and 5 point improvement year-over-year respectively. As demonstrated by our results, the team took quick action throughout the quarter to deploy buffer resources and adjust trip plans minimizing the impact of a 33% surge in international intermodal shipments. These swift actions not only allowed us to effectively absorb the increased volumes, but also mitigated the impact on our broader network. Now let’s review our key efficiency metrics on Slide 13. In addition to our service product, the team remains hyper-focused on driving productivity throughout the network. The more productive we are, the better we put ourselves in a position to compete and you can see we did that in the third quarter. Locomotive productivity improved 5%, compared to third quarter 2023. While increased fluidity of the network has enabled our performance, the team also continued its focus on reducing locomotive dwell. In fact, this quarter our locomotive dwell results tied for the best ever quarterly performance, a 5% year-over-year improvement. Workforce productivity, which includes all employees, improved 12% versus 2023. Impressively, both the month of September and the third quarter marked all-time records for their respective periods. Our continued work to leverage technology and automate operations across our transportation, mechanical and engineering team is paying dividends. Not only is it driving efficiencies, but it's also improving the safety of how we work. Train length was flat for the third quarter. After experiencing the impacts of Hurricane Beryl in July, we've made steady sequential improvement throughout the quarter and ended September with a monthly record over 9,600 feet. These improvements are a direct result of targeted transportation plan changes and capital investments, such as siding extensions and technology. While we have made great strides this year to improve train length, there are still opportunities to safely improve, as we strive to generate mainline capacity for current and future growth. To wrap up, great work by the team, as they efficiently leverage our buffer resources to handle the influx in volumes. However, as I opened with, there is always opportunity to get better and I'm confident the team will continue pushing in our pursuit of industry leading safety, service and operational excellence. Jim?"
},
{
"speaker": "Jim Vena",
"content": "Thank you, Eric. Turning to Slide 15. Before we get to your questions, I'd like to quickly summarize, what you've heard from our team. First, as you heard from Jennifer, we did a great job of adding volume to our network in an efficient manner. And given the margin profile of that volume, it was imperative that we did so. We also continue to generate strong pricing that reflects the value we're creating for our customers. Again imperative to mitigate the mix dynamic in the quarter. Kenny gave an overview of third quarter volumes and laid out thoughts for the remainder of the year. The team is making no excuses and going after every available carload. While international intermodal gets a lot of attention these days, there are plenty of additional markets, where the team is winning to bring new customers to the railroad over the short-term and long-term. Lastly, Eric updated our progress to improve safety service and operational excellence. Year-to-date our safety metrics continue to show great improvement, but they're just the initial steps toward being industry-leading. On the service front, the operating team did a great job of improving service, while we handled more business. That was possible due to the efficiency of our network and our ability to maximize asset utilization. While the business of railroading can be unpredictable, it's the fundamentals of how you operate the company anticipating and reacting to change that ultimately matters. I said it earlier and I'll say it again, I'm very pleased with where we sit today. When I joined the company, I said, we had pressures that were going to take us a couple of years to get by some of the inflationary pressures. But, as you heard at our Investor Day last month, we have the right team and the right strategy to make take this company to new heights. This is just the beginning of the journey. So with that, we're excited, we're ready and we're ready to take your questions. Rob?"
},
{
"speaker": "Operator",
"content": "[Operator Instructions] The first question today will be coming from the line of Ken Hoexter with Bank of America."
},
{
"speaker": "Ken Hoexter",
"content": "Good morning, Jim and team. Thank you for the question. I guess, two things. One, can you just clarify, when you talk consistent with last quarter, are you talking on an operating ratio level? Are you talking on a revenue or op income level? Just want to clarify that. And then, I guess, Kenny, it seems coal has taken a big step down lately. Can you talk about what puts and takes about what's built into the full year target that you're targeting there?"
},
{
"speaker": "Jennifer Hamann",
"content": "I'll start with that then, Ken. Thanks for the question. Yes, I mean, when we say consistent, and we say results, we're being pretty broad there. But, yes, I mean, I think we see are the as we look at what's going to happen in the fourth quarter. We see the outcomes being very similar across all of those categories in terms of our fourth quarter results. So consistent is consistent."
},
{
"speaker": "Kenny Rocker",
"content": "Yes. On the coal side, no surprises with coal. We'd expect what you're seeing in the public numbers, those volumes to continue through the rest of the year. That's why I made a point to focus on if you look at that bulk line, doing everything we can to counter some of those challenges on the coal side with renewable fuels and with the grain network."
},
{
"speaker": "Operator",
"content": "The next question is from the line of Chris Wetherbee with Wells Fargo."
},
{
"speaker": "Chris Wetherbee",
"content": "Good morning, guys. I guess I just maybe wanted to understand a little bit about how you think about the intermodal outlook and maybe how that influences that comment around the fourth quarter. So we came off of what has been a remarkable sort of preloaded peak season potentially in the third quarter, particularly for international. Do you see the mix start to change a little bit, but maybe sort of work that into a little bit of the drivers of that consistency in the fourth quarter? It would be helpful."
},
{
"speaker": "Jennifer Hamann",
"content": "Yes. I'll start with that, Chris, and then Kenny can weigh in relative to the volume. I mean, we believe the mix pressures are going to continue into the fourth quarter. You also see just kind of that normal seasonality. You have a little bit lower volume, you've got the holidays, tend to have a little bit of weather. There's those things. The other thing that I think folks need to pay attention to is fuel on a year-over-year basis and even sequentially, because you have a much different dynamic from fuel. We think our fuel surcharge is probably going to be $200 million or so less in the fourth quarter. And when you're looking at how it contributed positively in the third quarter and as a drag on fourth quarter, there's a lot of puts and takes there that I think you need to pay attention to that, I think help maybe fill in some of those blanks as well as just the mix impact. Kenny?"
},
{
"speaker": "Kenny Rocker",
"content": "Yes. On a year-over-year basis, I think we could expect international intermodal to be elevated. Although, as we go throughout the quarter and you can see that in some of the numbers now, you're seeing it start to step down a little bit. One of the things that I just want to highlight again is the preparedness for the team to be able to accept and anticipate that 33% increase. And so, we're very encouraged by that."
},
{
"speaker": "Operator",
"content": "Our next question is from the line of Walter Spracklin with RBC Capital Markets."
},
{
"speaker": "Walter Spracklin",
"content": "Yes, thanks. Good morning, everyone. Jim, in your prepared remarks, you kind of alluded to margins that perhaps weren't what you were hoping. Is that to say that kind of the prior margin improvement that you achieved in your first few years ago is not possible in the current environment or is it just taking longer? And I think, I'm just curious whether your mention of an industry-leading OR. Do you think that that is in effect for next year? In other words, can you have an industry-leading OR as early as next year?"
},
{
"speaker": "Jim Vena",
"content": "I think we have an industry leading OR for the last number of quarters including this one. I think we're the last ones to report and I'm pretty safe to say that. Walter, let's back up a little bit. People are in different positions of where and what we started. I remember back in 2019 where I joined, we parked 1,000 plus locomotives closer to 1,500. We adjusted the number of people that took to operate the railroad and those were big changes and we did those already. I think I was here and then I went on sabbatical and now I'm back. And am I done? Absolutely not. But, it's a lot different place to start where I came back 13, 14 months ago, than it was if I would have come, if we were in the same situation as 2019. We will be the best margin operating ratio company this year and I don't see any reason for us not to continue that and we will look at ways. Now inflationary pressure and I said it from the very first call I was on is, it's not going to be an easy one to get over. We are pushing price, but also being cognizant that we only get, the customers have to see value in that. They have to understand that we're giving them a product that allows them to win in the marketplace. And we've done that with the revenue coming in and pricing higher than what inflation is. So what I see is exactly what we laid out in our Investor Day. We see EPS growth high single-digits to low double-digits. We have the opportunity with the cash that we're providing that if we don't come up with another use for that we can buy back $4 billion to $5 billion versus shares. And we are absolutely online to set operating ratio improvement at the Union Pacific. So that's the way I see it Walter. Hopefully I answered your question."
},
{
"speaker": "Operator",
"content": "Our next question is from the line of Jordan Alliger with Goldman Sachs."
},
{
"speaker": "Unidentified Analyst",
"content": "Good morning. This is Andre on for Jordan. Thanks for taking my question. With headcount down 5% year-over-year and carload growth up nicely at 6%, you achieved strong incremental margins in the quarter both year-over-year and sequentially. Could you just talk a little bit more about the productivity opportunity set that you guys are taking and the actions there and how that sets up for 2025, incremental if industrial production can actually accelerate from here?"
},
{
"speaker": "Eric Gehringer",
"content": "Absolutely, Andre. Let's start by level-setting on what we did. So you start thinking about locomotive dwell. In my prepared comments, I talked about we've tied the best quarterly results that we've ever had before. Workforce productivity 12% monthly and quarterly record. TrainLink September best month ever in the history of Union Pacific and certainly a quarterly record in 2Q. But as we look at that, productivity is not new for us. Since 2019, we've driven approximately $1.4 billion in productivity and you're going to see us continue to find opportunities. We work on it every single day. Let's talk about what some of those are. When I start talking about workforce, I always break it down for my team, it's fundamentals, it's agreements, it's technology. On the fundamentals, I still see opportunities for us to be able to improve our recur rate. We've done improvement. There's still more opportunity there. When you look at the number of people that we use in our yard and local, you heard Jim talk about the inflationary pressures of a 4% wage increase to start the year and a 4.5% at July 1st. Yet, if you look at our wages that we're paying, we've actually been able to offset some of that inflation through productivity. That's technology, that's process. You're going to continue to see us do that. Fuel is going to still be a big opportunity for us. Whether you're talking about process or whether you're talking about technology, it's a huge expense for us and it's one we got to continue to work through. Our work with EMS, which is Energy Management, our work on how we think about filling our locomotives, where do we fill the most locomotives at the lowest cost, we've driven that compliance now north of 90%, where we started the year significantly lower. That's still an opportunity for us. I'll tell you the list goes on, and on, and on. When I say we work on it every day, I really mean that. It's safety, it's service, it's productivity."
},
{
"speaker": "Operator",
"content": "Our next question is from the line of David Vernon with Bernstein."
},
{
"speaker": "David Vernon",
"content": "Hi. Thanks for the time. Eric, I had a question for you on the intermodal train speeds. The data we're looking at from the outside looking in, those numbers are trending kind of as low as they've been. We've seen some issues on dwell at the West Coast ports as well. How do I reconcile some of those external data points with the performance that you guys are driving in the results today in terms of talking about the best ever TrainLink, best ever improvements in intermodal customer service? I'm just trying to square that circle, because it's come up in a couple of client conversations."
},
{
"speaker": "Eric Gehringer",
"content": "Yes. Thank you for the question, David. Here's how I reconcile it. It tells you that 220 is not as good as we can be, because to your point, we've seen dramatic improvements in both the manifest and bulk side and we've seen improvements on some lanes in intermodal, we've continued to work to be able to improve that. Now let's be really frank, 33% increase in international intermodal without much advance notice, if any advance notice, I'm very proud of what the team has accomplished to be able to handle that. Now what do we have to continue to do to build back that intermodal speed that you're talking about? Well, it's the things we're doing right now. So when we talk about deploying our buffer resources, that's taken the form of locomotives and cars into the LA Basin. We've staged our trains across the system, so that we take every train, excuse me, every car that we can into the ports and we take every car that they can give us back. We work closely with the CSX and the NS to ensure that our interchange points remain fluid. These are the things we need to continue to execute, as we continue to capture that volume and I expect in short order that, that intermodal speed will turn the other way and that will continue to add on top of the excellent performance we have already."
},
{
"speaker": "Jim Vena",
"content": "David, I need to sort of add on a little bit from what Eric said. I followed up with both LA and Long Beach Board here earlier this week and we both came to the same conclusion. No one told us first or second quarter that we were going to see a 33% increase and it was an event that happened because of East Coast ports issues, the Canadian issues. The big question is, how did we handle it, and you know that when something happens that is thrown on you, you start moving intermodal equipment and you don't get the same speed and you don't get the same velocity and we knew we were not going to be able to maintain that. But let's see where the success is or failure by the supply chain. Ships are not being held out at LA and Long Beach. They are arriving and going on the way they normally do with that kind of increase in business. As far as the fluidity of our terminals, we're in great shape. We've been able to turn the containers and the customers have done a fantastic job of pulling those containers off and delivering. The only place that we'd love it, if we have been able to plan it is, we'd have faster velocity if we could have been told that, it was coming and seen it a little sooner so we could place cars in the right place, work on the terminals we have at the West Coast a little differently and be able to speed it up. I'm very proud. I think the customers have seen what LA and Long Beach can do and I think that they it will be part of their decision making as they move ahead to say can LA and Long Beach handle an increase of business and I think it can and we've proven that point. It's a heck of a success story for us. I love the story. I love that you look at our metrics real good, and I'm sure that you've seen that, we're running over 220 miles per day for our cars and that's what's really important to us as we keep the place fluid. Thank you very much. Great question, David."
},
{
"speaker": "Operator",
"content": "Our next question is from the line of Tom Wadewitz with UBS."
},
{
"speaker": "Mike Triano",
"content": "Hi, Jim. This is Mike Triano on for Tom. If we look at workforce productivity and locomotive productivity, they're both up mid-single-digits through September and they've been a driver of OR improvement this year despite the volume and the mix headwinds. If we look out to next year, the volume backdrop is still kind of murky, but volumes are kind of flat to up. Do you think you can get another mid-single-digits improvement in those productivity metrics?"
},
{
"speaker": "Jim Vena",
"content": "We're sticking to our guidance for next year, which I think that's it. We've set it out, we thought about it. It's very, very definitive about what we want to deliver next year. So unless the economy implodes in the United States, we're very comfortable that it's that we're going to be able to deliver that. So I'm very proud of when you get that kind of productivity number that we delivered this last quarter and we don't see any reason for us not to be able to take a look at what we're doing on the railroad to continue to improve productivity. We know that, we're carrying extra people, because of some of the collective agreements that we still have to implement from the last round. We're being very prudent on that side, but you could see on the non-operating side, what we've been able to do to still operate the railroad in a very efficient manner. We do that every day, take a look at it and I'm very comfortable that we're headed the right way. Jennifer, anything to add?"
},
{
"speaker": "Jennifer Hamann",
"content": "No. I just would reiterate and it's really kind of what Eric talked about too. When we look at all the areas of expense and on the capital side, we have areas to improve our productivity and we have action plans against that for the rest of this year and going into 2025 and beyond. That's what really gives us the confidence to say, there's certainly great runway ahead of us and we're very confident in our ability to perform."
},
{
"speaker": "Operator",
"content": "The next question is from the line of Daniel Imbro with Stephens."
},
{
"speaker": "Daniel Imbro",
"content": "Yes. Hi, good morning, everybody. Thanks for taking the questions. Maybe wanted to ask a broader one, just from a competitive standpoint, I know it's hard to know, but your Western peers have been more vocal, but wanted to improve it. I'm curious if you're noticing anything different when you're out there bidding on business or going head-to-head with them in the market. And then, in your prepared remarks, you mentioned merchandise pricing was positive. Just curious how you're seeing core merchandise pricing out there in the market, if it's changing at all? Thanks."
},
{
"speaker": "Kenny Rocker",
"content": "If you look at the size of the pie, we're really competing against truck. We're putting together a service product to go out there and compete against truck, against sourcing, to a lesser degree against barge. So we're doing what we can do to go out there and grow and win share and focus on Union Pacific and what we can control. That's that. The second part of your question, look, I'm proud of the team to be able to go out and lead with the capital investments that we put into the network for our customers, to lead with the inflationary pressures that we can have, the buffer resource that Jim and Eric talked about, and now we talked a little bit about the velocity. We tie it all to the service and we're aligning those pricing with the service product that's there. So, yes, the team has been able to go out there and secure some strong pricing on that merchandise business of the freight."
},
{
"speaker": "Jim Vena",
"content": "Kenny, the only thing I would add is this and I think it's a valid point to make. I want the entire industry to operate very efficiently. I want the entire industry to be able to operate in a manner that allows us all to grow. We interchange a lot of traffic not quite 50%, but around 40% touches another railroad, whether it's a short line or one of the other railroads in the United States. The more we can all be efficient, when we interchange traffic, when we move it across the Mississippi, when we move it with our Western competitor. We love to compete, but there's a lot of traffic, if we're both efficient on, we get to be able to move that from other modes of transportation. Now I've worked with people, if I was smiling last night when I was thinking about this, how many people that I've worked with that are at other railroads, whether it's CPKC now even Burlington Northern Santa Fe, whether it's CSX or whether it's Norfolk Southern. So we come from a culture all of us that have worked together that we operate railroads in an efficient manner and we move ahead so that we want all of us want growth. I'm not speaking for the rest of them, I'm speaking for us at Union Pacific. Now given all that, listen, I can control what we do, not what everybody else does. I'm very comfortable with where we are and what we can do in the kind of business mix that we have. And you could see at this last quarter and what we've been able to deliver and what we see moving forward. I'm excited. I think the industry is in a better place now than it was 10 years ago and 5 years ago, and I'm sure better than we were in 2022. It's a wonderful place to be and we'll even continue to get better. That little competition with all the people you know is the best thing you can have. Nothing better than beating all the people that you know and that's what we want to do."
},
{
"speaker": "Operator",
"content": "Our next question is from the line of Jon Chappell with Evercore ISI."
},
{
"speaker": "Jon Chappell",
"content": "Good morning, Jim. Kenny, I was going to ask this anyway, maybe a pretty well-timed follow-up to the last one. So the arc up 5% in both bulk and industrial obviously points to your pricing. Jim says that, customers have to see value in the service and you're seeing that. But with inflation conceptually coming down a little bit, the volume headwinds remaining, to keep that type of pricing momentum despite the good service, do you need a little bit of help from the volume side, from the macro, from demand to continue to push price or at a certain point is that kind of cap out without getting some volume tailwind?"
},
{
"speaker": "Kenny Rocker",
"content": "Yes. The macro is the macro, and those are things that are out of our control, Jon. We focus on the network. We focus on the service that Eric is providing us, the investments we're making, and we link that to the value of the pricing. We're very crystal clear in how we articulate to our customers. The way we look at it, we see it as something that will definitely continue to happen."
},
{
"speaker": "Operator",
"content": "Our next question is from the line of Brian Ossenbeck with JPMorgan."
},
{
"speaker": "Brian Ossenbeck",
"content": "Good morning. Thanks for taking the question. Jim, maybe just to come back to the one of the initial comments you had earlier here, and then also something you said when you first came on board. Just to take a little while to get over the labor challenges that you sort of inherited on the network. Obviously, we've seen mix in coal not help and then just the broader inflationary trend. Maybe just to help level set things a little bit, you said it's going to take a while. Can you offer any sort of context in terms of what the timing should be, if it's going to be gradual or if there's some step change that we could be thinking of, as we look more broadly to getting over some of these hurdles and probably to a better place than what you started off with?"
},
{
"speaker": "Jim Vena",
"content": "Brian, thanks for the question. If we -- I don't like to look backwards too much, but I think we've done a great job at Union Pacific, all 30,000 of us, to be able to deliver where we are comparatively to everybody else. Now growth is real important to us and we've done a great job of providing service at a high level. Remember service is what we sold the customer not other measures that are out there to talk about what service is, is we measure individually to every one of our customers about what level of service that we sold them. We put that in the mix and we had inflationary pressure. That's why we are very clear on what our three year expectation is, Brian, of what our results should be and what we think we can deliver. I'm very comfortable where we are and I think we'll see improvements in our operating ratio. We'll see improvements over time over our net income and improvements in our EPS that drives value for our shareholders. Very comfortable. This was always at the very start, I said it was going to be a couple of years. It's still a couple of years. It was not going to be easy and it's not easy to get to overcome some of the things. But I think we've done a good job with pricing growth and coal. Coal is coal, like coal is down 20%. At the end of the day, if it wasn't down 20%, but that's not the way I look at the world. There's always challenges. If there was no challenges, then I would have stayed retired and enjoyed myself in Scottsdale, Arizona this morning going for a hike to Camelback. I'm here because I think there's something to do and we can get this company moving forward. I'm very excited, Brian. Thanks for the question."
},
{
"speaker": "Operator",
"content": "Our next question is from the line of Ben Nolan with Stifel."
},
{
"speaker": "Ben Nolan",
"content": "Thanks a lot. The service performance index for both intermodal and manifest has been trending up higher. I'm just curious, if you think there's a point where if you arrive at a certain level or if at a certain range where you can really lean more heavily into pricing than maybe you already have or and maybe also just share gains versus competitors, or versus trucking, is that -- is there like a magic number or at least a magic range where you feel like really you have a strong or much stronger competitive advantage?"
},
{
"speaker": "Kenny Rocker",
"content": "Yes. Jim hit it a little bit earlier and what do we sell to our customers, and how do we translate that into pricing and those discussions. No. There's not a magical number. But clearly, as the service improves, that gives us a better environment to maximize price. Same is true on growth, more consistent, reliable product and better service product. We go in and we ask for more business when we're talking to customers. We ask to look at their truck files. We ask to look at talk to more of their receivers. Clearly, as we improve and we've done a great job here in the third quarter on the service product. It creates our own capacity. It creates our own opportunities regardless of what happens in the macro environment."
},
{
"speaker": "Ben Nolan",
"content": "Do you think you're there now? Just, as a follow-up."
},
{
"speaker": "Kenny Rocker",
"content": "I hope not. I mean, we always want to improve as a management team. So no, we're going to always strive to improve. There's no time where we're going to yell out we arrived."
},
{
"speaker": "Operator",
"content": "Next question is from the line of Brandon Oglenski with Barclays."
},
{
"speaker": "Eric Morgan",
"content": "Hi, good morning. This is Eric Morgan on for Brandon. Thanks for taking the question. I just wanted to come back to the mix discussion in the fourth quarter. I think you mentioned mix headwinds continuing in the quarter, maybe with some international intermodal volume growth moderating somewhat. But, can you just talk about some of the mix effects from other commodity groups outside of intermodal? In particular, maybe how you view margin contribution from coal would be helpful, I think."
},
{
"speaker": "Jennifer Hamann",
"content": "I'm going to pass on that last part of your question. But, if you just look at our business teams, industrial is the group that has our highest average revenue per car, has very strong contributions to our bottom line, and that business has been down all year. Now, there's always mix within mix, but with the continued pressures in the industrial economy and the continued outlook that those volumes are down year-over-year, that's an impact and that certainly contributes to the mix, in addition to obviously seeing the growth come in some of the lower average revenue per car, kinds of businesses like the international intermodal. On the Bulk side, yes, there's coal, set that aside. Grain, strong grain into Mexico, which is great for us. We really enjoy that business. That's a little bit shorter length of haul than if we're taking it to export out through the West Coast. Again, you have some of that what I'll call mix within mix. Kenny, I don't know if you want to add anything else?"
},
{
"speaker": "Kenny Rocker",
"content": "Yes. I just want to say we're not going to apologize for accepting the increase. Yes. We'd love the 33% increase. What I'd tell you is that, the management team here did a good job of preparing for it. That's what we did with Phoenix to take trucks off the road, what we did to expand Inland Empire. All these things set us up for success for this unexpected amount of volume that's come on."
},
{
"speaker": "Jennifer Hamann",
"content": "That's really why it's so important goes back to Jim's point on the fundamentals. That's why we need to be just diligent about how we're using our resources, our workforce productivity and how we run this railroad, so that we can absorb shocks from mix and still produce a very good quarterly result."
},
{
"speaker": "Operator",
"content": "Our next question is from the line of Stephanie Moore with Jefferies."
},
{
"speaker": "Stephanie Moore",
"content": "You talked a lot about the strength in export grain to Mexico, but can you also talk a little bit more broadly about your Mexico business? How do you see that going forward? And any thoughts on geopolitical and administration changes as well would be helpful."
},
{
"speaker": "Kenny Rocker",
"content": "Yes. First of all, I just want to step back as we're talking about our grain business and our grain network and differentiate renewable fuels and the actual facilities that we've landed there that we've discussed. The same thing with our grain network, the facilities, meaning the 20-plus facilities that have come on and the fact that Cherryvale Kansas facility will help supply grain into Mexico. So let me just kind of break that apart to let you know how we look at it. But then, yes, broadly, as we look at Mexico, Clearly, there's a lot of opportunity with over-the-road trucks. There are some markets like finished vehicles and also auto parts. We have a strong service product coming out there. What differentiates us, Stephanie is, again, the fact that we have multiple partners that can get in that market. We have our own rail box that we can get into that market. And we have daily service into and out of Mexico, which we know we're the only one that has that. So clearly, again, a strong growth area for us. We laid it out in Investor Day. And as far as the administration, we see that it's an environment that they're going to be certainly pro-business and support the freight environment, so we're excited about that."
},
{
"speaker": "Operator",
"content": "Our next question is from the line of Scott Group with Wolfe Research."
},
{
"speaker": "Scott Group",
"content": "Jennifer, any color on that comp for employees up 8% and how to think about that going forward? And then I know someone else asked already about like what that sort of flat Q4 comment made. But I just -- I guess I'm not sure if that was -- still not sure if that was an earnings or margin or revenue comment. So I don't know any color?"
},
{
"speaker": "Jennifer Hamann",
"content": "Okay, Scott. So we'll start with the comp for employees. So if you look at the 8% increase, call it, rough numbers, half of that was from the July 1 wage increase. The other half is a combination of higher incentive comp year-over-year as well as higher guarantee payments. That's really associated with the work rest agreements as we've cut over more hubs through the year and also graduated more TE&Y employees from training. So those are all the drivers that we see in there. And for 4Q, it's probably going to look pretty similar, maybe even up a little bit more as we continue to carry some of the extra resources support the implementation of the work rest. And so that's really why you've heard us stress the productivity piece today because we do have inflationary pressures, and that's why that workforce productivity is just absolutely critical for us as well as how we're approaching labor going forward and making sure that we are getting good agreements in place that can help us serve our customers in a very efficient manner while compensating our employees fairly. Going back to your other question about the consistent -- we said results. That's a fairly all-encompassing words. So you could call that any number of measures. But you know what the key ones are that you all look at EPS, operating ratio, operating income, we think it's going to look very similar in 4Q versus 3Q."
},
{
"speaker": "Operator",
"content": "Next question is from the line of Elliot Alper with TD Cowen."
},
{
"speaker": "Elliot Alper",
"content": "This is Elliott on for Jason Seidl. I believe this is the first quarter this year where your domestic intermodal volume outlook is positive. Can you talk about what you're seeing in the domestic intermodal market in Q4? And I know you already talked about kind of the mix headwinds in international growth and fuel, but we see domestic intermodal growing into the quarter. Could that maybe partially offset intermodal rev per car in Q4? Just trying to gauge the magnitude."
},
{
"speaker": "Kenny Rocker",
"content": "So we've been encouraged on the domestic intermodal front, even as late as the second quarter, we saw that line be positive. It's been positive in the third quarter. Now some of that has benefited from the international in a most side. And that's why I keep harping on these products that we have, having a product like Inland Empire helps us capture some of that domestic intermodal, and we've seen some strong demand there. I'll tell you as it looks at -- we look at it for the fourth quarter. Again, we think we'll see a little bit more of a benefit for what's taking place on the international intermodal side, and we'll see what happens as we continue throughout the quarter."
},
{
"speaker": "Operator",
"content": "Our final question is from the line of Ariel Rosa with Citigroup."
},
{
"speaker": "Ariel Rosa",
"content": "I just wanted to -- I know some other people have spoken about this already, but I wanted to ask about is the target to price above rail inflation. Could you give us color, just to be clear, is that something that's being achieved currently and that we can expect for 2024? And then kind of given the looser capacity environment, would you say that you've kind of gotten more pushback from customers as you have those pricing discussions? Or do you think service is sufficient currently to kind of compensate for whatever the loose truck environment might be doing or the kind of the softer demand environment might be?"
},
{
"speaker": "Jim Vena",
"content": "Ari, good question. Kenny?"
},
{
"speaker": "Kenny Rocker",
"content": "Yes. So I think you're talking specifically and only about domestic intermodal, you'll have to clear it up, if you can. We've got -- and we've talked about this, we've got price mechanisms for our customers that are in place to keep them competitive. Again, I talked to you about the fact that second quarter, third quarter, we were up in domestic intermodal. So we look at that as a positive outcome for us. We've gone from a trucking environment really since 2022, that's really been stagnant to downward and it's flattish now. We'll see what happens in the next few months, but we feel good about where we're positioned and the ability as it capacity tightens, we're going to see more value on the pricing side. ."
},
{
"speaker": "Jim Vena",
"content": "Jennifer, do you want to talk about the inflation."
},
{
"speaker": "Jennifer Hamann",
"content": "Absolutely. So to that point, in terms of your question, absolutely, our pricing dollars today are exceeding our inflation dollars, and they have throughout this inflationary period, whether you're talking about 2024, you've been going back 2023, 2022. We have been committed to that and we have achieved that. I think the important point really is going forward, and we talked about this at Investor Day, is that not only will we continue to have our price dollars exceed our inflation dollars that it will become accretive to our margins next year. So I feel very bullish on that front."
},
{
"speaker": "Jim Vena",
"content": "Ari, good question. Why don't I just wrap it up real quick and then looking-forward to the call in 3 months and looking-forward to finishing off this year just the way we set it up and also delivering on what we said last year? If we look at what we've been able to deliver as a team, 10% increase in earnings per share, 11% up in operating income, 9% up in net income, productivity, up 12%. Those are all numbers that make us very comfortable of how we are operating the railroad and how we're driving business. We think that if we get the service level, and it's very close to where we are right now to the right level, then the discussion is how do we work together with our customers to win in the marketplace and not worried about what the -- whether the service is holding them back from winning in the marketplace. So with that, let me just close off by thanking everybody for joining us this morning. I know there was competing calls, and nice to have you guys all with us this morning and looking-forward to more discussions as we move ahead. Thank you very much."
},
{
"speaker": "Operator",
"content": "Ladies and gentlemen, thank you for your participation. This does conclude today's teleconference. You may now disconnect your lines at this time, and have a wonderful day."
}
] |
unp | 2,024 | 2 | [
{
"speaker": "Operator",
"content": "Greetings, and welcome to the Union Pacific Second Quarter Earnings Call. At this time, all participants are in listen-only mode. A brief question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded and the slides for today’s presentation are available on Union Pacific’s website. It is now my pleasure to introduce your host, Mr. Jim Vena, Chief Executive Officer for Union Pacific. Thank you, Mr. Vena. You may now begin."
},
{
"speaker": "Jim Vena",
"content": "Thanks, Rob. And, good morning, and nice to come to you all from a beautiful morning here is Omaha. And, thanks for joining us today to discuss Union Pacific’s second quarter results. I’m joined by our Chief Financial Officer, Jennifer Hamann; our Executive Vice President of Marketing and Sales, Kenny Rocker; and our Executive Vice President of Operations, Eric Gehringer. As we dive into the discussion of the second quarter, you’ll hear that operating outdoors these past few months has not been easy, but I’m pleased with how we manage those challenges to drive strong financial results. It provides another proof point that our strategy is the right one to drive success. Now, let’s discuss second quarter results starting on Slide 3. This morning, Union Pacific reported 2024 second quarter net income of $1.7 billion or $2.74 per share. This compares to 2023 second quarter net income of $1.6 billion or $2.57 per share. Second quarter operating revenue was up 1% as solid core pricing gains and slightly increased volume were reduced by a negative business mix and lower fuel surcharge revenue. And, if you’re normalizing for the yearly change in fuel, freight revenue was up 2% versus 2023. Reported expenses year-over-year were down 4%. This is very impressive work by the team to offset the high inflationary pressure we’ve experienced in a flattish volume environment, even when you adjust for one-time items and fuel. Our second quarter operating ratio of 60.0% improved 300 basis points versus last year and despite some challenges, we still showed sequential improvement. Overall, this quarter was another solid step toward our goal of leading the industry in safety, service and operational excellence. I’ll let the team walk you through the quarter in more detail and then come back for a wrap up before we go to Q&A. So, we’ll start with Jennifer and the Q2 financials. Jennifer?"
},
{
"speaker": "Jennifer Hamann",
"content": "Thanks, Jim, and good morning, everyone. Let’s start on Slide 5 with a walk-down of our second quarter income statement, where operating revenue of $6 billion increased 1% versus last year on slightly positive volume. As Kenny will highlight, this strong topline performance was supported by solid pricing gains and business wins against the backdrop of weak coal demand. Second quarter freight revenue totaled $5.6 billion, a 1% gain. Digging into the revenue components, strong core pricing gains partially offset by an unfavorable business mix added 150 basis points to freight revenue. Double-digit growth in international intermodal volume was the primary contributor to the negative mix dynamic and further compounded by an overall decline in our higher average revenue per car industrial business. Slightly positive volumes in the quarter added 50 basis points to freight revenue. And lastly, fuel surcharge revenue of $669 million declined 5% as lower fuel prices impacted freight revenue 75 basis points. Excluding fuel surcharge, freight revenue grew 2% as the team continues to pace revenue growth faster than volume. Wrapping up the topline, other revenue declined 6% as a result of lower intermodal accessorials and less demand for auto parts shipments at our Loup subsidiary. Switching to expenses, second quarter operating expense of $3.6 billion decreased $152 million versus 2023 as we drove productivity across most cost categories. We have more details in the appendix, but let me highlight some of the performance drivers. Compensation and benefits expense declined 6% versus last year as we reduced headcount 5% and generated positive productivity. Although our training pipeline is significantly reduced compared to 2023, train service employees increased 1% as we continue to carry more train service employees as a buffer for our operations and to offset the impact of new labor agreements. The remainder of the workforce decreased 9% as we continue to focus on delayering and pushing work down in the organization. And, as you’ll recall, last year’s expenses included a $67 million one-time ratification payment. Following up on an item we highlighted at our first quarter report, last month we completed the transfer of around 350 mechanical employees to Metro in Chicago. Going forward, this transfer will lower both other revenue and our expenses by roughly $15 million a quarter. Excluding last year’s one-time labor payment, cost per employee in the second quarter increased 4% as we continue to drive for better overall efficiency. Fuel expense in the quarter declined 6% on a 5% decrease in fuel prices from $2.86 per gallon to $2.73 per gallon. We overcame a challenging operating environment and less fuel efficient freight mix to improve our fuel consumption rate 1% largely by locomotive productivity. Equipment and other rents declined 12%, reflecting improved cycle times and lower lease expense, partially offset by business mix. Finally, other expense decreased 4% as we recorded a couple of one-time items in the quarter. On the positive side, we added a $46 million gain from an intermodal equipment sale. Conversely, we recognized $23 million of additional environmental expense at a legacy California remediation site. Second quarter operating income of $2.4 billion increased 9% versus last year. Below the line, other income increased 11% as a result of interest received on tax refund claims, while interest expense declined 6% on lower average debt levels. Second quarter net income of $1.7 billion and earnings per share of $2.74 both improved 7% versus 2023. Our quarterly operating ratio of 60% improved 300 basis points year-over-year. As I just discussed, there were several puts and takes in the quarter. Key here is that our core operations drove 160 basis points of OR improvement and $0.21 of EPS growth year-over-year. This is a great continuation of the momentum we’ve created these past three quarters. Turning to shareholder returns in the balance sheet on Slide 6, second quarter cash from operations totaled $4 billion up $175 million versus last year. Growth in operating income and 2023 labor agreement payments partially offset by higher income tax payments resulted in the increase in cash from operations and our free cash flow improvement, up 43% to $853 million. As stated back in April, we restarted share repurchases late in the second quarter. Although we plan to ramp up repurchases through the year, we started slowly with just over $100 million repurchased in June. Combined with our dividend payments, we’ve returned $1.7 billion to shareholders year-to-date. Finally, our adjusted debt to EBITDA ratio finished the quarter at 2.8 times and we continue to be A rated by our three credit rating agencies. Wrapping up on Slide 7, as we’ve reached the midway point of 2024, there remains some uncertainty about the second half recovery that many were forecasting. As Kenny will detail, there are definitely markets where we’re seeing growth and much of that growth is being driven by our business development efforts. There also are some challenge markets, particularly coal. Operationally, the team is making great progress towards our long-term goals to be the best in safety, service and operational excellence. This is reflected in the progress in our safety and performance metrics, including our margins. Importantly, we believe the trend is indicative of where we can get to long-term and each successive quarter is a step on our way to winning. We are highly confident in our ability to generate price dollars in excess of inflation dollars and still expect freight revenue to pace ahead of volume in 2024. We also remain committed to our long-term capital allocation strategy. This includes last week’s announcement of a 3% increase in our dividend as we drive higher returns to our owners. This increase represents the 18th year in a row of annual dividend increases. With share repurchases, we expect to repurchase around $1.5 billion in 2024 as we maintain our current leverage. Before I turn it over to Kenny, I’d summarize our second quarter financial performance as strong and our confidence in the future stronger as we continue to unlock the potential of our great franchise. We’re excited to execute on our strategy in the second half and lay out more of our long-term thoughts at our Investor Day in September. Kenny?"
},
{
"speaker": "Kenny Rocker",
"content": "Thank you, Jennifer, and good morning. As Jennifer mentioned, we had a solid second quarter, especially if you put aside the lower volume from coal. Freight revenues totaled $5.6 billion for the quarter, which was up 2% excluding fuel surcharges due to strong core pricing and a slight increase in volume. Let’s jump right in and talk about the key drivers in each of our business groups. Starting with our Bulk segment. Revenue for the quarter was down 2% compared to last year on a 5% decrease in volume and a 3% increase in average revenue per car driven by solid core pricing gains and a positive mix in traffic. However, if you exclude coal, Bulk revenue for the quarter was up 4% year-over-year and volume grew by 6%. Coal volume was down 23% in the quarter due to ongoing secular decline of the market along with continued challenges from lower natural gas prices and higher inventory levels. Fertilizer volumes increased for the quarter due to strong export demand for Canpotex potash and easier comps from a 2023 customer outage. In addition, grain products business was favorable due to increased demand for renewable diesel, strong demand for ethanol and new business wins. Moving to Industrial, revenue was up 2% for the quarter on a 3% decrease in volume and a 5% increase in average revenue per car. Strong core pricing gains and a positive mix in traffic were partially offset by lower fuel surcharges. Our strong business development efforts in petroleum allowed us to capitalize on opportunities. Petrochemicals volume continued to grow due to improved domestic demand in plastics and strong business development wins in our industrial chemicals markets from customers located along the Gulf Coast. However, challenges with high inventories and rainy weather in the South negatively impacted our rock volumes. Premium revenue for the quarter was up 4% on a 6% increase in volume and a 2% decrease in average revenue per car reflecting negative mix, lower fuel surcharges and truck market pressure. Automotive volumes were positive due to business development wins with Volkswagen and General Motors, but offset by unplanned decreases in production impacting auto parts shipments. Intermodal volumes continue to remain strong due to West Coast import demand and positive domestic growth despite market conditions especially within our Parcels segment. Now, turning to Slide 10. Here’s our outlook for the balance of 2024 for the key markets we serve. Starting with Bulk, coal is expected to remain challenged as inventories remain high and natural gas futures stay at levels that make coal less competitive. For grain, as we sit here today, the markets look stable and healthy although global export sales are off to a slow start. Crop conditions look good and we’ll have a better read over the next several weeks. In addition, we expect grain products to remain positive as we see incremental renewable diesel production coming online in California and continue to capture new business. Turning to Industrial. Our outlook remains the same as we laid out during our last earnings call. We expect our rock market will not match last year’s record volume. However, both petroleum and petrochemical markets will remain favorable due to our focus on business development supported by our investments in the Gulf Coast. And, wrapping up with Premium, on the intermodal side, we expect to see continued strength for imports in the near-term. And, while we have seen imports drive pockets of increased demand, on the domestic side, the overall market remains soft. But, our improved service product, along with our diversified set of private asset owners and IMCs provide Union Pacific more at bet when opportunities present themselves. And for automotive, we’re still expecting year-over-year growth due to business development wins despite some softening in the market. In summary, I’m proud of the commercial team and their focus to fill the volume gap we’re seeing from coal. On the price side, we’re achieving solid price results to overcome inflation and delivering the consistent and efficient service that we sold to our customers. As we head into the second half of the year, I am confident that our great franchise, along with the diverse product offerings we provide, gives our customers the ability to compete and win in the marketplace. Our commercial leaders are actively working with customers and the operating team to convert more over the road business to rail that allows us both to win and grow. And with that, I’ll turn it over to Eric, to review our operational performance."
},
{
"speaker": "Eric Gehringer",
"content": "Thank you, Kenny, and good morning. Moving to Slide 12. As you heard from Jim, Mother Nature delivered many powerful weather events throughout the quarter as we experienced impactful flooding across both our northern and southern regions. But, we’re not here to make excuses. Leveraging our intense focus on operational excellence and detailed contingency plans the team quickly acted to mitigate the impact by adjusting trip plans and deploying temporary buffer resources to safely restore operations. I’m very proud of our frontline employees who worked tirelessly to repair our infrastructure to minimize the customer impact. There are countless examples highlighting their efforts as they repaired miles of damaged track, restored bridges and cleared countless trees and debris. That being said, versus 2023, service levels and network performance for the second quarter remained strong, demonstrating our recoverability in the wake of major weather disruptions. Starting with our foundation of safety, we continue to drive improvements building on the momentum of the first quarter. For the second quarter, both derailment and personal injury rates improved year-over-year. While I am proud of the team for making this progress, we will not rest until every employee goes home safe to their loved ones every day. Freight car velocity was flat in the second quarter compared to 2023 as improvements in terminal dwell were offset by weather impacted train speeds. The opportunity here is to drive even stronger terminal dwell performance by removing unnecessary car touches across the network. On the service front, intermodal SPI improved four points as manifest and auto SPI remained flat. Although we worked hard to minimize impact on weather on our service product, we know customers felt the impact, particularly those located in the affected areas. Now, let’s review our key efficiency metrics on Slide 13. The team remains highly focused on cost control, leveraging technology and other investments to drive productivity throughout our operation. As I mentioned last quarter, it is imperative to our strategy as it enables Kenny and the team to compete in the marketplace. Similar to the first quarter, we saw year-over-year improvements across all of our metrics. Locomotive productivity improved 6% compared to second quarter 2023 driven by improved network fluidity and asset utilization. Throughout the year, we have been able to efficiently flex our locomotive fleet with units readily available to adjust to varying volume levels. Workforce productivity, which does include all employees, improved 5% versus 2023. While overall employee levels decreased, our active train, engine and yard employees increased as we implement new labor agreements. Train length improved 2% compared to second quarter 2023 and 3% sequentially due to increased intermodal volume combined with the usage of safety technologies like Precision Train Builder. In fact, our second quarter result was a quarterly record and June marked the first month ever with train length over 9,600 feet. This is a remarkable achievement by the team as they continue to generate mainline capacity for future growth. Wrapping up, it’s important to note, as we continue to implement new technology throughout our operation, we are also building new processes. These processes powered by automation and real-time analytics open new capabilities for Union Pacific and our customers. I’m looking forward to sharing such examples at our Investor Day in September. So with that, I’ll turn it back to, Jim."
},
{
"speaker": "Jim Vena",
"content": "Thank you, Eric. Turning to Slide 15. Before we get to your questions, I’d like to quickly summarize what you’ve heard from our team. First, as you heard from Jennifer, despite a challenging environment, we achieved strong financial results in the quarter. We continue to drive efficiency into the network and the commercial team has done a good job generating price for the value we provide our customers. Kenny provided you with an overview of the second quarter volumes and laid out some updated thoughts for the remainder of the year. I think it’s worth stating that when you remove coal, our total volume was up 3% in the second quarter. This demonstrates that even in a tough freight environment, we are winning with our customers to bring new business to the railroad. Lastly, Eric walked you through the progress we’re making across safety, service and operational excellence. In the first half of the year, our safety metrics improved, but we still have a way to go. Our service was challenged in the quarter, but I’m pleased with our ability to recover and we’re continuing to do things more efficiently making good improvements in operational excellence. Look the quarter presented its challenges, but I’m very pleased with the results we achieved. From the beginning, I said improvement wasn’t going to be a straight line. There are just too many variables when you operate an outdoor factory, but I expect the trend line will be in the right direction and we demonstrated that again this quarter. Over the past 12 months, we’ve put this company on the right path to redefining what’s possible for Union Pacific, a theme we’ll build on at our Investor Day in mid-September. With that, now we’re ready to take your questions, Rob."
},
{
"speaker": "Operator",
"content": "Thank you. We’ll now be conducting a question-and-answer session. [Operator Instructions] Thank you. And, the first question today is from the line of Brandon Oglenski with Barclays. Please proceed with your question."
},
{
"speaker": "Jim Vena",
"content": "Good morning, Brandon."
},
{
"speaker": "Brandon Oglenski",
"content": "Hey, good morning. Good morning, and thanks for taking the question. So, Jim, if I recall, it was almost a year ago that you got appointed CEO and I think you said publicly like give me a year then let’s look back and judge how things went. I think you just clearly articulated the coal headwinds in the quarter. But I guess, how would you look at the past year in terms of operational improvement, network performance? And then maybe most importantly customer growth, which I think you were alluding to?"
},
{
"speaker": "Jim Vena",
"content": "Yes, Brandon, I appreciate the question and you’re right on. I think they announced me last year on 26th, we agreed that I was going to join this company and the announcement came up. So, guess what it’s a year. Now, I actually didn’t start work till the 14th of August, but that’s okay, couple of weeks doesn’t make a difference. Bottom line is, if I look at the quarter Brandon, I’m very, very, very happy with how we’ve progressed on this railroad. If you start above the line and Kenny and the entire team have done a great job of, we knew we had an inflationary pressures with the contracts that were signed and we knew that we had to do something above the line and I think we’ve done a great job and you can see that where the revenue comes in against our volume growth and we continue and we will continue to see that as we go through the year. So, I’m very comfortable with that. Business development, we have been, I have personally spent a lot of time, Kenny and his entire team spends a lot of time and the entire leadership group with customers looking for opportunity and we’ve spent capital and developed new facilities and expanded facilities across our network to be able to handle more business. But, the best part about it is our service level is to the point where the first discussion isn’t, are you providing the service that we agreed to, it’s more of how do we work together to move ahead. Operationally below the line very comfortable to be able to present today the numbers that we are on car velocity, dwell, locomotive and things that you all don’t see, how fast our crew changes are, how well we’re able to and the number of people it takes to operate the terminals, we see those numbers every day and I’m very comfortable of where we are. And, I’m also very happy that we continue to improve our operating ratio and I don’t see that stopping. We’ll have, I never give a number for operating ratio, because it’s a result of everything you do, but to have a 160 basis points improvement this last quarter, year-over-year operating ratio and sequentially a small is a greater testament with what we can do with everything that we were impacted with this customer. We are not a team that makes excuses. You won’t hear us complain about coal. We just say that coal is a problem, but to be able to when we had 20% plus drop in our coal volume to actually increase goes to show you the strength of our network. We’re going to leverage what we’re doing in Mexico with our 26% ownership of the FXE and we think that’s going to lead to more growth as we move ahead and we’re going to leverage this network we have. So, Brandon, I’m in a real good place. So, hopefully you guys aren’t the toughest marketers in the world, because sometimes some of you are. But overall, I’m very happy with where we are today and I look forward to how this next few years while I’m leading this company and show everybody what we can do."
},
{
"speaker": "Brandon Oglenski",
"content": "Appreciate the answer, Jim. Thanks."
},
{
"speaker": "Jim Vena",
"content": "You’re welcome, Brandon."
},
{
"speaker": "Operator",
"content": "Our next question is from the line of Scott Group with Wolfe Research. Please proceed with your question."
},
{
"speaker": "Jim Vena",
"content": "Good morning, Scott."
},
{
"speaker": "Scott Group",
"content": "Hey, thanks. Good morning. So, I know, Jennifer, mix can swing on you positive negative. Any thoughts on mix based on your volume outlook in the back half of the year? And then, I just want to bigger picture, right? Even if I adjust for mix, the yield growth is still relatively muted in the context of higher inflation. And so, I know I’ve asked this before, I keep asking because I just think it’s so critical like when do you guys think we truly get back to inflation plus pricing? And, I don’t mean like dollars versus dollars, I mean like margin accretive inflation plus pricing because I think that’s sort of like the, in my opinion, the key to like having confidence in like sustained margin improvement. So, I don’t know, any thoughts? Thank you."
},
{
"speaker": "Jennifer Hamann",
"content": "Well, so a couple of things there, Scott. On the mix side of things, as we look ahead, a lot of the drivers that were present in our volumes here in the second quarter are going to be present at least into the third quarter. International intermodal is staying strong, coal is weaker, the industrial portion of our portfolio, while we’ve got great business development opportunities, there’s just a little softness there. And so, if you assume that, that dynamic continues, that’s going to continue to have an impact on our mix, probably to the negative side. So, I mean, you guys get our volumes every week, you’ll be able to see that, engage that, but that’s kind of our going in expectation as we look at what’s ahead of us, particularly into the third quarter and we’ll see how some of those intermodal trends move into 4Q. In terms of the question relative to price and price accretion, the team is doing, I think, a very good job of driving price in the areas where they can touch it and actively work with the customers. Jim mentioned the service aspect of it, that’s critical when you’re sitting in front of customers and driving the price. And so, the thing that I’m very encouraged by is we know we’ll get to that point. I’m not going to give you a date by which we’ll get to that point. But, what’s encouraging is without that, we’re still driving very solid margin improvement and looking for more going ahead. So, that’s what I would focus on. And, as we continue to get more access to contracts, that’s just going to give us more upside and more ability going forward."
},
{
"speaker": "Scott Group",
"content": "Thank you."
},
{
"speaker": "Jim Vena",
"content": "Thanks for the question, Scott."
},
{
"speaker": "Operator",
"content": "Our next question is from the line of Jason Seidl with TD Cowen. Please proceed with your question."
},
{
"speaker": "Jason Seidl",
"content": "Thank you, operator. Jim and team, good morning. Nice to see you guys recover from some of the weather in the quarter. I want to focus in a little bit on something, Kenny, that you say, you mentioned there was some weakness on your rock business. We’ve been hearing some of the infrastructure projects that were planned are sort of really not getting off the ground. Is that part of the weakness that’s behind that or what are you looking at in the marketplace?"
},
{
"speaker": "Kenny Rocker",
"content": "Yes, Jason, you’re right, on. We’ve seen some NLG products down in the Gulf that have been delayed or slow roll. And, a lot of it also is just overall demand and we haven’t had the best weather, haven’t seen that in that second quarter. So yes, it is. I will tell you this though, Jason, Eric’s team is doing everything they can to capture the volume that is out there. We’re looking at adding every car to every train that we can to maximize efficiency. So, as the opportunities are there we’re taking advantage of it."
},
{
"speaker": "Jason Seidl",
"content": "Well, that makes sense. And, Kenny, on the delayed projects, is there any expectation for these things to sort of be lifted as we look into ‘25 or it’s just sort of a wait and see?"
},
{
"speaker": "Kenny Rocker",
"content": "I think, it’s wait and see. It’s hard for us to go out and forecast what a lot of the customers will do and how the contractors will play out. Our best bet is just to be prepared, which we are."
},
{
"speaker": "Jason Seidl",
"content": "Sounds good. Appreciate the time."
},
{
"speaker": "Jim Vena",
"content": "Thanks for the question."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Jon Chappell with Evercore ISI. Please proceed with your question."
},
{
"speaker": "Jon Chappell",
"content": "Thank you. Good morning. Jim, do we get to a point in your new tenure here where some of these productivity improvements that you’ve made start to hit a ceiling without volume? And, clearly what you’ve been able to do on locomotives and workforce, in a flat volume environment and of course we understand what’s happening with coal, is pretty impressive, but do you hit the ceiling without a volume tailwind at some point?"
},
{
"speaker": "Jim Vena",
"content": "No, I don’t see that. I think we’ve shown that we can improve and I see more improvement even with a flat. I don’t expect us to have our volume be flat though. That’s not the way we’re working at this. Everything that we’ve done is to increase our volume against some pretty big negatives that are structural that we can’t control. So, is it easier when you have increase in volume? Yes, you have another five cars on an intermodal train or a manifest train makes it a lot easier. But, the technology that we’re implementing, the speed that we’re going to be able to change our plan and what we’re doing moving forward will help us to be able to even on a flat volume be able to improve our efficiency. So, I’m very comfortable with, as we move ahead there’ll be more even on a flat."
},
{
"speaker": "Jon Chappell",
"content": "Great. Thanks, Jim."
},
{
"speaker": "Jim Vena",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Stephanie Moore with Jefferies. Please proceed with your question."
},
{
"speaker": "Stephanie Moore",
"content": "Hi, good morning. Thank you."
},
{
"speaker": "Jim Vena",
"content": "Good morning."
},
{
"speaker": "Stephanie Moore",
"content": "I think continuing on the prior question, really nice margin performance for the first half of the year. Can you talk a little bit, just based on maybe some of the mix headwinds and the cost of initiatives and a lot of the kind of puts and takes here, what that should mean in terms of kind of normal seasonality for margins as the OR as the year progresses? Thank you."
},
{
"speaker": "Jim Vena",
"content": "Stephanie, listen, I just sort of answered overall on the high level what I see, but I’m going to pass this off to, Kenny. Kenny, you talked about margin, how we’re looking at pricing, how we move ahead."
},
{
"speaker": "Kenny Rocker",
"content": "Yes, yes. Thanks for that, Jim. So, first of all, you all have heard me say that before, when you look at our approach to revenue growth, it’s volume growth through business development, but it’s also our pricing approach. And, our commercial team has been very clear to articulate some of the inflationary pressures that are out there. But more importantly, the team has taken risks. And so, we are doing as these contracts are coming up everything we can do to maximize price or margin expansion. And so at every turn, at every contract, those are some with our service improving, Eric, those are some really good opportunities for us to maximize our price. So, we’re doing everything we can do there."
},
{
"speaker": "Stephanie Moore",
"content": "So, I guess just a follow-up, really nothing from a seasonality standpoint to really call out as we think about performance as the year progresses?"
},
{
"speaker": "Jennifer Hamann",
"content": "I mean, when you think about seasonality, I’ll jump in here. It really has a lot to do with volumes. And, if you look at our volume performance, generally speaking, the quarters where we have the strongest volume growth, that’s where you tend to get your greatest margin improvement. It goes back to Jim’s comments on productivity and that volume leverage piece. That said, we’ve shown really good sequential improvement in our margins and have kind of broke that trend as we’ve really come in and put a big focus on how we can drive greater productivity across the network over the last three quarters. And quite frankly, I think that’s something that maybe is a little bit underappreciated in terms of how hard it has been for the team to achieve that. Looking forward, it really is going to be about the volumes and the continued emphasis on the productivity and the price. Those are our three levers. And so, as you’re thinking sequentially, I’d be comparing volumes sequentially and see how that progresses. That’s going to really be the determinant."
},
{
"speaker": "Jim Vena",
"content": "Thanks, Stephanie."
},
{
"speaker": "Operator",
"content": "Our next question is from the line of Brian Ossenbeck with J.P. Morgan. Please proceed with your question."
},
{
"speaker": "Jim Vena",
"content": "Good morning, Brian."
},
{
"speaker": "Brian Ossenbeck",
"content": "Hey, good morning, team. Thanks for taking the question. Yes, maybe a couple for, Kenny. Can you just talk about the international intermodal has always been quite strong. There’s been some expectation for that to spill over into domestic. Do you have any thoughts on when that might happen and whether that’s good, bad or indifferent for UP? And then secondly, I don’t know who would want to take this, but just as we get to the Investor Day in a couple of months, you talked about redefining what’s possible. Can you help level set expectations what we’re going to hear from you all and the team? Will we see multi-year growth strategy, again underpinned by some of the end markets, we talk about truckload conversion and quantify that, maybe just help give us some expectations on what to think about in a couple of months when we see you on Dallas?"
},
{
"speaker": "Kenny Rocker",
"content": "Yes, let me take this, the first one on international intermodal. So first of all, yes, we’ve seen some very strong growth on the international intermodal side and yes, we have seen some of that spillover on the domestic intermodal side. And, I want to touch on the fact that our product development, meaning the investment that we’ve made efficient investments in places like Inland Empire helping us to grow. Here recently, even though it’s a short-term phenomenon because of the labor issues up in Canada. We’re not going to just take that volume in the short-term. We’re doing everything we can to get it permanently. We won a piece of business into our Twin Cities Inland Intermodal Terminal and that’s the way we can take advantage again of the product development that’s out there. So, that’s the international intermodal. I talked a little bit about the fact that yes, we are seeing quite a bit that’s being transloaded that’s showing up on the domestic side and our products are helping grow. In fact, when we look at our domestic business, year-over-year in the quarter it was up and we feel pretty good about where it started off here in this quarter. So, that’s some real specific feedback for you."
},
{
"speaker": "Jennifer Hamann",
"content": "Okay. And, then in terms of your question about the Investor Day and what’s possible, that really is going to be how we’re going to frame things and that’s certainly been Jim’s challenge to the team since he came here a little over a year ago, is don’t look back at what you’ve done historically, don’t look back and see what you think has been best ever, look forward and see what you really do think we can achieve together with this great franchise that we have. So, I don’t want to front run things too much with you, Brian. We want to make sure folks tune in September. But, we’re excited about the message and the opportunity to speak to everybody and share some of our plans."
},
{
"speaker": "Brian Ossenbeck",
"content": "Okay, understood. Thank you."
},
{
"speaker": "Jim Vena",
"content": "Thanks, Brian."
},
{
"speaker": "Operator",
"content": "Our next question is from the line of Ken Hoexter with Bank of America. Please proceed with your question."
},
{
"speaker": "Jim Vena",
"content": "Good morning, Ken."
},
{
"speaker": "Ken Hoexter",
"content": "Good morning. So, service was challenged by the weather in the quarter. You’re showing an ability to recover. Jim, you just noted we should continue to see operating ratio improvement going forward. Should we see that improved car velocity going forward now you don’t have storms and being the cost benefit then I guess I’ll ask kind of Stephanie’s question a little differently. Given the hazy economic outlook, can operating ratio improve sequentially?"
},
{
"speaker": "Jim Vena",
"content": "Well, Ken, people always want me to start talking about where we I think the endpoint is on this and I think we continue to improve. We’re going to have quarters that are better than other quarters, but operationally you should always look at, we give a lot of metrics out there and if you take a look at the metrics, car velocity is real important, dwell time is real important and then of course there’s about 100 others that I look at internally that tell me how we’re operating and where we need to focus and how we need to do this. So, that’s one piece and we are aligned. We’ve got a great team. They know what the end goal is. So, I see us optimizing the railroad and continue to get better at how we operate. But, what really helps operating ratio and margins is revenue growth, and we are pushing hard on that piece by both bringing in volume at the right price and also pricing because of inflation and everything we’ve had. So, when you put those two things together, we might have some quarters where sequentially it doesn’t improve as much as people would like because it’s never a straight line. But, I’m very comfortable. I didn’t come back to work. I look at it as I had a sabbatical for a couple of years away from Union Pacific, came on, did what we had to do operationally. I’m back here to drive this place to where is what I see is possible, and I’m very comfortable. And, after the first year, I’m even more comfortable than I was on August 14 when I walked back in the front door. So Ken, it’s take a look at those metrics, but take a look at what’s happening in our volume and translate that on what we did in the second quarter on revenue against where we were with our carload growth. So, hopefully that gives you a better framing of the way I look at it, Ken."
},
{
"speaker": "Ken Hoexter",
"content": "Thanks, Jim."
},
{
"speaker": "Jim Vena",
"content": "You’re welcome."
},
{
"speaker": "Operator",
"content": "Our next question is from the line of Tom Wadewitz with UBS. Please proceed with your question."
},
{
"speaker": "Tom Wadewitz",
"content": "Yes, good morning."
},
{
"speaker": "Jim Vena",
"content": "Good morning."
},
{
"speaker": "Tom Wadewitz",
"content": "So, I wanted to ask just on kind of I think you talked about some weakness in industrial. How do you think about your markets overall if you say industrial and consumer? Are things getting kind of a little bit stronger or a little bit weaker in those two segments? And then, maybe one more for probably for Kenny as well, you mentioned a lot of times business development and new customer wins, which is great. Wondered if you could kind of give us a couple of buckets to think about where the opportunity for new business wins is the most significant, right? Are there some industrial segments or which customer segments give you the most opportunity in the future for those customer wins to matter? Thank you."
},
{
"speaker": "Kenny Rocker",
"content": "Yes. Thank you, Tom. So, you’ve got a few macroeconomic indicators like, industrial production, not strong, housing starts aren’t helping us either and then you know where natural gas prices are. So, we don’t get the rollover and play dead, because coal is not where it needs to be. The commercial team is out there hustling and getting more business. Let me talk about some of the areas that I feel good about from a business development perspective. Renewable diesel, I’ll start with that. That’s an emerging market. I’ve been really excited that the team has been out there growing origin points and destination points. It allows us to pitch and catch. On the petrochemical side in the Gulf, we talked about the investments there and the wins that we’ve been able to get in that petrochemical market. And then, on the Premium side, I’ll talk about it from a couple of angles. One is Mexico will continue to be a market over the near-term and long-term. And, you’ve seen that Eric side has put up some really good products up against it as we talk about that north south quarter getting into the Midwest and products in terms of getting into the Southeast and then bought quite a few new products coming out of Houston, going into Phoenix, setting up our ramp and expanding in different areas. So, in some cases, we have to create our own markets to make the pie larger and that’s exactly what you’re seeing."
},
{
"speaker": "Tom Wadewitz",
"content": "When you say the premium side, you mean premium like domestic and removal products? Or how do you mean that?"
},
{
"speaker": "Kenny Rocker",
"content": "Both domestic and our international intermodal."
},
{
"speaker": "Tom Wadewitz",
"content": "Okay. And just back on the kind of economy question, do you think it’s getting like stronger or weaker or is that hard to say?"
},
{
"speaker": "Kenny Rocker",
"content": "It’s still very unclear for us. I’m not in a position to forecast where it is. All I’m telling you is that we’re going to go out and make our own markets where we can and we’re doing that through the product development that I mentioned and working with customers."
},
{
"speaker": "Tom Wadewitz",
"content": "Okay, great. Thanks for the time."
},
{
"speaker": "Jim Vena",
"content": "Thanks, Tom."
},
{
"speaker": "Operator",
"content": "The next question is from the line of Chris Wetherbee with Wells Fargo. Please proceed with your question."
},
{
"speaker": "Jim Vena",
"content": "Good morning, Chris."
},
{
"speaker": "Chris Wetherbee",
"content": "Hey, morning. Thanks for taking the question. Maybe Kenny coming back on the pricing side, I guess I’m just kind of curious as you’re seeing the market from a volume perspective ex-coal look a little bit more supportive here in ‘24, operationally things are moving well. As you’re having these incremental contract renewals, is it reasonable to say that the rate of increase is beginning to maybe pick up a little bit? I guess I just was curious kind of perspective when you’re thinking in the old days when we used to get sort of same store sales type of numbers, how you think about that? So, I was just kind of curious if we are actually starting to see any uptick there?"
},
{
"speaker": "Kenny Rocker",
"content": "The short answer is yes. The long answer is that every contract is unique, every customer is unique, every discussion is unique. We’re mixing that with what’s happening on the service side. A stronger service product is helping us. We’ve always been very price disciplined as a company. What you’re seeing is that now we’re able to take a little bit more risk as we’re talking to our customers because of the inflationary pressures that are out there."
},
{
"speaker": "Chris Wetherbee",
"content": "Okay, that’s very helpful. Appreciate it. Thank you."
},
{
"speaker": "Jim Vena",
"content": "Thanks, Chris."
},
{
"speaker": "Operator",
"content": "The next question is from the line of Walter Spracklin with RBC. Please proceed with your question."
},
{
"speaker": "Walter Spracklin",
"content": "Thanks very much, operator. So, Jim, you mentioned before your sabbatical there, you were able to achieve an operating ratio as low I think in one quarter it’s 55.1%. And there’s been a lot of talk in about how this time is different and that might not be an achievable number. So, not asking you a target, just rather asking you, are things different -- are there factors that are really limiting you that weren’t there before either cyclical like volume or structural like the work rules? Just trying to get an apples-to-apples compare of what kind of what is the new 55%, not asking you that, but more asking you are there those factors are they meaningful enough to kind of put it in permanent impairment on that on an objective or any comparing it to any prior level of operating ratio achievement?"
},
{
"speaker": "Jim Vena",
"content": "Walter, I like the question because that’s exactly the way we need to look at it is, we know what we’ve done before and I could go back to when I was at Canadian National and numbers that were delivered back in 2013 to 2016. So, I know the game of how and the play and how you have to get there to be able to deliver. Is there some things that are structurally different? Yes, the collective agreements are impact to our cost and will follow for a while with us. Now we’ve done a great job of mitigating some of it, but it’s pretty tough to mitigate it all. So, that’s a negative that’s going to be with us for a while. So, we’ll probably carry a few more people than we normally would have if the railroad had not signed some of the last collective agreements. But I look at it this way, I see a clear picture as we move ahead that we can mitigate a lot of that and have a railroad that’s very efficient. We’re going to use the network we have to optimize our cost structure. We are implementing work patterns and how we operate that will help us. So, I don’t think we’ll be able to mitigate all of that, but you can also mitigate it by bringing more business on and also leveraging our access to Mexico, leveraging our access to customers. Kenny is a little reserved sometimes in Jennifer, but I’ll tell you, we have a railroad that the opportunity is there. And we have discussions, we don’t talk about, oh geez, we have some problems with this. We look at what are we going to do, Phoenix, we opened it up because we think there’s a market there. Minneapolis, we opened it up. Fritz Intermodal Terminal, we expanded. We spent money in the Gulf and working with customers that want to be with us. So, we do both of those. I say, hang on, watch us go. This is not a short-term. I said it the very first time I was on the call, this is not a short-term fix when you have that kind of inflationary pressure. But I’m very happy that this quarter we were able to deliver another 160 basis points of improvement in our OR with everything that we’ve done and we’re going to have some good quarters, some bad quarters, but I’m telling you in the long run stay tuned Walter. And listen Walter, I’ve seen as you’re you’re probably in Canada, I know there’s a lot of people that I know from CN and others impacted with fire in my hometown and I wish everybody the best."
},
{
"speaker": "Walter Spracklin",
"content": "Appreciate it. Okay, thanks for the color, Jim."
},
{
"speaker": "Operator",
"content": "Our next question is from the line of Ben Nolan with Stifel. Please proceed with your question."
},
{
"speaker": "Ben Nolan",
"content": "Yes, thanks. I was interested to see that the average train length, I think you’d said, was the highest that it’s ever been. It was curious if, as you think about that going forward, maybe there were some puts and takes, like more international intermodal, I assume is helpful to that, but maybe coal is detrimental. Do you think there’s more room to go there? Can we continue to see, the train lengths improve? And then, obviously, that is beneficial to everything across the board, but OR in particular."
},
{
"speaker": "Jim Vena",
"content": "Well, let me pass it over to Eric and I can’t give you the answer, because Eric knows it’s a different number than that, but I’ve got a goal out there, but Eric, it’s all yours."
},
{
"speaker": "Eric Gehringer",
"content": "Ben, to be very clear, the answer to your question is yes, we can continue to grow it. Now let’s make sure we’re all on the same page, 2% improvement in the quarter, 3% sequential improvement. To your comment, best quarter we’ve ever had and June was the highest month in the history of Union Pacific at 9,600 feet. And we want to give a lot of credit to our team. That’s hard work to do that. Now when we have conversations about TrainLink, we also got to remind ourselves that since 2019, our mainline derailments are down 42%, while our TrainLink has been up 20%. That’s because we continue to invest in technology and science. And that’s really going to be the continued foundation of how we keep building this out. Yes, to your point, mix makes a difference, but what makes more of a difference is getting more volume on the railroad like we’re seeing with intermodal, that’s been a tailwind for us, but also using our Precision Train Builder software as well as other things that continue to identify opportunities for us to do it. And then on a day to day just fundamentally how we run the railroad and we’ve talked about this before, we still see opportunities to combo trains largely on the bulk side. So yes, there is more opportunity, the team is up against that. I’m looking forward to their continued gains."
},
{
"speaker": "Ben Nolan",
"content": "All right. Appreciate. Thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Jordan Alliger with Goldman Sachs. Please proceed with your question."
},
{
"speaker": "Jordan Alliger",
"content": "Hi. Just a couple of demand related questions, follow ups. I think in the first quarter you had mentioned the commodity outlook was muted. Now it’s uncertain. So, I guess first part of the question is and some commodities moved to the positive bucket like international, intermodal and grains. I’m just sort of wondering, are you feeling better or even though it’s uncertain, are you feeling better than you did a quarter ago? And then specifically on coal, obviously, there’s been a lot of carload pressure, but can you give some sense as to the trajectory as we move through the back half of the year in terms of year-over-year pressures? Thanks."
},
{
"speaker": "Kenny Rocker",
"content": "Yes. I’ll start with coal first and then work my way back. And again, coal is a natural gas prices are all over the place. If you look at April, they were the lowest on record for a few years and as we move throughout the quarter by June they had bounced back up. It’s very difficult to go out and forecast based on that. We talked about preparedness. We’re talking with Eric’s team daily to make sure we can capture the demand that’s out there. I’ve been very encouraged that our commercial team is talking to each coal customer, each coal receiver one by one to see when they can add in set. So, we’re doing everything we can to influence the demand there. So, overall demand, let’s just talk about a few things. One, on the international, intermodal side, that’s been a strength for us. I think that will stay with us at least for the quarter. I can’t see out further than that. I talked about a little bit earlier the positives we’re seeing from that on the domestic side and the products that we have up against it to go out there and grow. Grain, you had a question about grain. Hey, look, the crop looks great right now as it stands today. The demand looks what I call stable. We’ll see what happens on the export market. But while we are waiting for the export market, our commercial team is engaging those domestic receivers. And Mexico is also an area from a business development perspective that we want. So, we can’t just wait around for some of these markets to help us out. We’re doing something about it and making something happen. Automotive, same thing. We talked about the wins. What I hadn’t talked about is that we’ve had some products where Eric has helped us out where we’ve had land bridge opportunities. So, again very specific actions up against the service and the product to really help overcome some of these other macroeconomic challenges on the housing and industrial side."
},
{
"speaker": "Jordan Alliger",
"content": "Okay. Thank you."
},
{
"speaker": "Jim Vena",
"content": "Thank you. Thanks for the question."
},
{
"speaker": "Operator",
"content": "Our next question is from the line of Bascome Majors with Susquehanna. Please proceed with your question."
},
{
"speaker": "A – Jim Vena",
"content": "Good morning, Bascome."
},
{
"speaker": "Bascome Majors",
"content": "Good morning, Jim. Jim and Jennifer, you both talked about having to get past some of the inflationary pressures. And I know you mentioned contracts referring to the labor agreement. I know in the past, this time last year, you were talking about some of the purchased services pressure as well. Can you help us understand kind of where you’re tracking when you blend your sense of inflation and overall labor with both the contractual rates and then some of the work rule adjustments and purchased service. Like where is that today? How does that compare to last year? And what’s the steady state as you look at two, three years to understand what we’re really pricing against the marketplace today? Thank you."
},
{
"speaker": "Jennifer Hamann",
"content": "Yes, thanks for the question, Bascome. So, coming into the year, we said that we thought our full-year inflation would be around 5% or so. I think we’re probably tracking pretty close to that. We’re seeing some wins in some of the purchased service categories, seeing a little bit greater acceptance in the marketplace, few more people coming into bid. So, that’s encouraging and certainly that’s an opportunity for us to get a little bit better pricing on that purchase services side of the world. Same with materials to a certain extent, obviously that plays more into our CapEx spend than it does the OE, but both are very important to us, right. We’re looking to control costs at every turn. Comp and benefits certainly is a big piece of our expenses. That inflation, I would say, is still probably running around that 5% level that we talked to coming into the year. I think as you all know, we’ve got a 4.5% wage increase that became effective. The last one in this round of negotiations became effective July 1 for our craft professionals. So, I don’t see a lot changing there. It’s just some moving pieces and parts and we’re trying to find areas where we can try to mitigate that either through our productivity, through our purchasing and how we’re just running the railroad in general. And obviously, that’s the task that we have up against Kenny and his team is, these are the inflationary pressures that we’re facing, this is what’s going into the cost structure and we need to go out there, have those tough conversations and the team is doing that and I feel very confident about that."
},
{
"speaker": "Bascome Majors",
"content": "To that point, if we get into next year, it sounds like it’s probably a safer expectation to think still closer to that 5% range than maybe the 2.5% to 3% we saw for a long time?"
},
{
"speaker": "Jennifer Hamann",
"content": "Yes. I mean, it’s too soon to say, Bascome, at this point. But boy, my hope is that we’re talking about a number that’s less than 5% next year as we move in. It seems like all of those indicators are moving in the right direction, but we’ll look at that. I think to your point though, when I look back historically, we used to talk about an inflation rate that was around 2%. I don’t think we’re going to get back to those levels, but certainly, we’re going to work to push it down below 5%."
},
{
"speaker": "Jim Vena",
"content": "The only thing I would add Bascome is, there’s a lot of indicators that tell us that there’s a change, what’s happening to inflation, overall inflation, CPI, what’s happening to the job market and what’s happening to the input costs for us. So, those things are trending the right way, but how much of a drop we’re going to see next year, we’ll see, but I’d rather have that view than where we were a year ago."
},
{
"speaker": "Bascome Majors",
"content": "Thank you both."
},
{
"speaker": "Jim Vena",
"content": "Thanks for the question."
},
{
"speaker": "Operator",
"content": "Our next question is from the line of Ravi Shanker with Morgan Stanley. Please proceed with your question."
},
{
"speaker": "Jim Vena",
"content": "Good morning, Ravi."
},
{
"speaker": "Christyne McGarvey",
"content": "Hey, good morning. This is Christyne McGarvey on for Ravi. Thanks for the question. I wanted to circle back to the business development conversation and maybe ask the question in a slightly different way. Just curious if you guys have seen any notable changes in terms of the makeup of the pipeline or maybe even more particularly customer behavior. Just as think about pipeline conversion, is there anything out there with macro or political development that kind of leaving shippers with some decision paralysis that wears off in the coming months and that could start to see conversion accelerate, but just be curious on that angle how you guys are thinking about things?"
},
{
"speaker": "Kenny Rocker",
"content": "Yes. So, the pipeline is strong. It’s a robust pipeline. We feel good about the pipeline both near-term and over the next couple of years. The conversion rates haven’t changed. We keep an eye on that. I know where it is there. What we saw here recently is the realization rates, meaning if a customer said, hey, it’s going to be 100 cars, it wasn’t as high as 100 cars. And, so you would expect as the markets improve that realization rate to also go up. Again, we’re looking at the same macroeconomic indicators. Hey, if housing starts to move, you know what, that moves a lot of things. That’s cement, that’s PVC, that’s roofing, that’s the carpet that goes in there, that’s glass, that’s the soda ash we move. We play a role in all those products. And so, we’ll see where that happens. But, the theme here is that the markets are going to do what the markets are going to do. We are going out and creating our own markets again through product development and business development and doing it as efficiently as possible as we can."
},
{
"speaker": "Jim Vena",
"content": "Thanks for the question."
},
{
"speaker": "Christyne McGarvey",
"content": "Appreciate it."
},
{
"speaker": "Operator",
"content": "Our next question is from the line of Daniel Imbro with Stephens. Please proceed with your question."
},
{
"speaker": "Jim Vena",
"content": "Good morning, Daniel."
},
{
"speaker": "Daniel Imbro",
"content": "Yes. Hey, good morning, everybody. Thanks for taking our questions. Maybe one from a capital efficiency standpoint. So, Jim, how do you feel about the assets you guys have today? I think you all mentioned in the prepared remarks you could flex the fleet up and down. Utilization probably always go up, but obviously there’s longer term savings. So, how do you balance the need to refresh some of the fleet? How do you think about capital spending in this environment just potentially ahead of more volume growth as we look forward from here?"
},
{
"speaker": "Jim Vena",
"content": "Yes, I think we built our capital plan. We always build it from bottom up to see what we need to do and we’re very comfortable with the $3.4 billion that we have this year and we don’t see any substantial difference in our capital plan moving forward. Now, do we do have the capability, you heard us talk about buying back $1.5 billion of shares, you’ve heard us on the cash that we’re producing. So, if we need to, if there’s something out there that really we need to spend money on, we’ll do that. But, as far as the railroad, the assets, the plant that’s fixed, we don’t fool around with that. What we need to spend, we spend and then we have also built into that $3.4 billion was development and what we can do to drive more business to our railroad. So, I’m very comfortable, that’s the way you should think about it. I don’t see a big change as we move ahead. Jennifer, anything else you wanted to add?"
},
{
"speaker": "Jennifer Hamann",
"content": "No, you hit it just right."
},
{
"speaker": "Jim Vena",
"content": "Okay, thank you."
},
{
"speaker": "Daniel Imbro",
"content": "And so, share repurchases would be expected use of excess free cash flow, if cash flow came in stronger, Jim, is that the right way to interpret that comment?"
},
{
"speaker": "Jennifer Hamann",
"content": "Yes, I mean, so I’ll jump in here. I mean, the priorities for our cash spending, we’ve been, I think, very clear on. First dollar goes back into the business, then we prioritize our dividend, which again, just you saw that we gave the 3% increase here last week and then the excess cash is going to share. So yes, if we have, if you look historically at what we’ve put into our share repurchase program, it’s been greater than the $1.5 billion. Some of that’s been using balance sheet capacity. We don’t intend to add any leverage this year. We feel good about our leverage levels, but we’re going to try to drive more cash and if that’s available, we would put it to shares."
},
{
"speaker": "Daniel Imbro",
"content": "Great. Thanks so much. Best of luck."
},
{
"speaker": "Jim Vena",
"content": "Thanks for the question."
},
{
"speaker": "Operator",
"content": "Thank you. Our last question is from the line of David Vernon with Bernstein. Please proceed with you question."
},
{
"speaker": "David Vernon",
"content": "Hey, guys. Thanks for taking the question. So, Kenny, a quick one for you on intermodal pricing for domestic. Obviously, the truck markets remain weak. I’m just wondering if sequentially you’re seeing anything month-to-month of those rates sort of firming or how that direction looks into the back half of the year? And then, bigger picture question for you Jim on the STP wanting to sort of convene a council to discuss railroad growth. I’d love to get your thoughts on kind of why you think the regulators pulling this thing together and maybe some early views of what you guys think you might have to say at that?"
},
{
"speaker": "Kenny Rocker",
"content": "David, Jim, I’ll take the first one. So look, we’ve been 18 months now, a little bit over 18 months where domestic intermodal pricing has either been going down or just staying at the bottom. And, I’m not going to sit here today and try to forecast when it’s going to move up, which I’m highlighting the 18 months because it’s been quite a time here and so we’ll see what happens. Here is the key thing I want you to focus on is that I mentioned here recently we’ve been able to see some year-over-year growth on domestic intermodal. We’ve got a group of private asset providers that give us a lot of add backs, a lot of options and we’ve been really as a company doubling down on our product development. So, that when things change, and they will change, but I’m not going to forecast it, we’ll be prepared."
},
{
"speaker": "Jim Vena",
"content": "Listen, I appreciate the question on the STB. I think we have the exact same goal as the STB on growth. We want to grow our business and I think we’ve done a, if you actually listen carefully to what we said, we’ve been able to grow our business even with some markets that are giving us some huge headwinds and that’s a pretty good quarter. And, if you watch the carloads that we’ve so far this month, I’m pretty happy with where we’re headed. We’re going to have up and down, but we are working hard on that. So, I think it’s a great hearing. I’m looking forward to it. I can’t make it personally, because we are headed to Dallas and I’m looking forward to those couple of days and that sort of is right in between when we need to be in Dallas, just before it. But, guess who is going and Kenny is going there, he is going to represent us well and I’m looking forward to presenting to everybody to see who Union Pacific is, what we’re doing and how we’re going to leverage this great franchise to be able to grow our business even with all the challenges that we have. So, I’m excited to hear what all the other railroads have to say and I’m sure we’re all in the same place. We all want to be price smart and also be able to move the products that are available to us. So, I’m looking forward to the hearing and Kenny, I’m sure you’re going to represent this real well."
},
{
"speaker": "Kenny Rocker",
"content": "I’m ready. You bet you, Jim."
},
{
"speaker": "Jim Vena",
"content": "Thank you very much for the question."
},
{
"speaker": "Operator",
"content": "Thank you. This concludes the question-and-answer session. I’ll now turn the call back over to Jim Vena for closing comments."
},
{
"speaker": "Jim Vena",
"content": "Well, listen, thanks everybody for listening in this morning. We are very excited with what we’ve been able to deliver as a team for our shareholders and what we’ve been able to do safety through the communities that we operate for our employees and we’re very excited that we’ve been able to take the head on challenges that were presented and be able to deliver a quarter that showed improvements both underneath on how we operate and how we operate even safer and the metrics that we’re moving ahead. So, I’m very comfortable where we are. I like our future. I think we got a great railroad and I truly am looking forward to Dallas. I think it’s a great spot to go and have our Investor Day. And, at the Investor Day, we’ll take you through with a little more substance about what we foresee in the future over the next two or three years and what we see in the next year that Union Pacific can deliver. And, I’m looking forward to seeing all of you that can make it in Dallas, wonderful location, great spot for us, an important place for us. So, thank you very much everybody for listening in."
},
{
"speaker": "Operator",
"content": "This will conclude today’s conference. Thanks for your participation. You may now disconnect your lines and have a wonderful day."
}
] |
unp | 2,024 | 1 | [
{
"speaker": "Operator",
"content": "Greetings, and welcome to the Union Pacific First Quarter 2024 Conference Call. [Operator Instructions] A brief question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded, and the slides for today's presentation are available on Union Pacific's website."
},
{
"speaker": "",
"content": "It is now my pleasure to introduce your host, Mr. Jim Vena, Chief Executive Officer for Union Pacific. Thank you, Mr. Vena. You may now begin."
},
{
"speaker": "Vincenzo Vena",
"content": "Thanks, Rob, and good morning to everyone. Beautiful day in Omaha, 60 degrees, a little bit of rain. It is absolutely perfect for railroading. So why don't we get started? And thank you for joining us today to discuss Union Pacific's first quarter results."
},
{
"speaker": "",
"content": "I'm joined in Omaha by our Chief Financial Officer, Jennifer Hamann; our Executive Vice President of Marketing and Sales, Kenny Rocker; and our Executive Vice President of Operations, Eric Gehringer."
},
{
"speaker": "",
"content": "As you'll hear from the team, we continue to execute our multiyear strategy to establish Union Pacific as the industry leader in safety, service and operational excellence. We, again, took positive steps towards that goal in the first quarter. While challenges outside our control persists, we are establishing a foundation for long-term success."
},
{
"speaker": "",
"content": "Now let's discuss first quarter results starting on Slide 3. This morning, Union Pacific reported 2024 1st quarter net income of $1.6 billion or $2.69 per share. This compares to 2023 1st quarter net income of $1.6 billion or $2.67 per share. We're pleased to be able to report earnings growth in a tough environment, especially since last year's results included a $0.14 per share real estate gain."
},
{
"speaker": "",
"content": "First quarter operating revenue was flat as solid core pricing gains and a positive business mix were offset by lower fuel surcharge revenue and reduced volumes. Normalizing for the impact from fuel surcharge, freight revenue was up 4% versus last year. Expenses year-over-year were down 3%, driven by lower fuel prices and productivity gains. This was partially offset by inflation, increased transportation workforce levels to compensate for new labor agreements and higher depreciation."
},
{
"speaker": "",
"content": "Our first quarter operating ratio of 60.7% improved 140 basis points versus last year. This also represents a 20 basis point improvement sequentially from the fourth quarter, which further demonstrates the strong work by the team. Look, it's a great start to the year. I'm pleased with how the Union Pacific team is coming together to unlock what's possible for our company. But there's a lot of work to do. I'll let the team walk you through the quarter in more detail, and I'll come back and wrap it up before we go to question and answer."
},
{
"speaker": "",
"content": "So with that, Jennifer, why don't you go through the first quarter financials?"
},
{
"speaker": "Jennifer Hamann",
"content": "All right. Thanks, Jim, and good morning. I'll begin with a walkdown of our first quarter income statement on Slide 5, where operating revenue of $6 billion was flat versus last year on a 1% volume decline that was significantly driven by a 20% reduction in coal shipments. In fact, excluding coal, volumes would have been up close to 2% year-over-year even in this tough freight environment."
},
{
"speaker": "",
"content": "Looking in at the revenue components further, total freight revenue of $5.6 billion declined 1%. The single largest driver of the year-over-year decrease was a 25% reduction in fuel surcharge revenue to $665 million as lower fuel prices negatively impacted freight revenue 375 basis points. Solid core pricing gains and a favorable business mix combined to add 350 basis points to freight revenue. Reduced coal and rock shipments as well as increased soda ash and petroleum carloads drove the positive mix dynamic. Excluding fuel surcharge, freight revenue grew 4%, a solid start to the year and a demonstration of the great diversity of the UP franchise."
},
{
"speaker": "",
"content": "Wrapping up the top line, other revenue increased 4%, driven by increased accessorial revenue that included a one-time contract settlement of $25 million. Switching to expenses, operating expense of $3.7 billion decreased 3%, as we generated solid productivity against lower demand. Digging deeper into a few of the expense lines, compensation and benefits expense was up 4% versus last year. First quarter workforce levels decreased 2% as reductions in non-transportation employees more than offset a 4% increase in our active TE&Y workforce. Although our training pipeline is significantly reduced, we continue to carry additional train services employees as a buffer for our operations and to offset the impact of newly available sick pay benefits and work rest agreements."
},
{
"speaker": "",
"content": "While talking about workforce levels, I do want to mention one quick housekeeping item. As some of you might be aware, we are in the process of transferring operating responsibility for certain passenger lines in Chicago to Metro. As part of that, in June, we will be transferring around 350 mechanical employees to Metro. On a quarterly basis, this will lower both revenue and expense by roughly $15 million. Cost per employee in the first quarter increased 5%, reflecting wage inflation and additional costs associated with new labor agreements. Fuel expense in the quarter declined 14% on a 13% decrease in fuel prices from $3.22 per gallon to $2.81 per gallon."
},
{
"speaker": "",
"content": "We also improved our fuel consumption rate by 1% as locomotive productivity more than offset a less fuel-efficient business mix given the decline in coal shipments. Purchased Services & Materials expense decreased 6% versus last year, as we maintained a smaller active locomotive fleet, and our logistics subsidiary incurred less drayage expense. In addition, a little less than half of the year-over-year variance related to resolution of a contract dispute."
},
{
"speaker": "",
"content": "Finally, Equipment & Other Rents declined 8%, reflecting a more fluid network seen through improved cycle times and lower lease expenses. By controlling the controllables in our cost structure, first quarter operating income of $2.4 billion increased 3% versus last year. Below the line, Jim noted last year's real estate transaction and other income, and our interest expense declined 4% on lower average debt levels. First quarter net income of $1.6 billion and earnings per share of $2.69 both improved 1% versus 2023. And our quarterly operating ratio of 60.7% improved 140 basis points year-over-year, which includes a 60 basis point headwind from lower fuel prices."
},
{
"speaker": "",
"content": "Turning to shareholder returns and the balance sheet on Slide 6. First quarter cash from operations totaled $2.1 billion, up roughly $280 million versus last year. Growth in operating income as well as the impact from 2023 labor agreement payments are reflected in that increase. In addition, free cash flow and our cash flow conversion rate both showed nice improvements. As planned, we paid down $1.3 billion of debt maturities in March. That resulted in our adjusted debt-to-EBITDA ratio declining to 2.9x at the end of the quarter, and we continue to be A-rated by our 3 credit rating agencies. Also during the quarter, we paid dividends totaling $795 million."
},
{
"speaker": "",
"content": "Wrapping things up on Slide 7. As you'll hear from Kenny, our overall outlook on the freight environment hasn't changed a lot since January. Yes, there have been some pluses and minuses from our original outlook, but in totality, we still see the same economic uncertainty. What I am certain of, however, is that our service product is meeting and will continue to meet the demand in the marketplace. And when volumes strengthen, we will be ready to provide our customers with the service they need to grow with us. In addition, as evidenced by our first quarter results, we will continue to generate productivity that improves our network efficiency."
},
{
"speaker": "",
"content": "Also demonstrated by those first quarter results is our commitment to generating pricing dollars in excess of inflation dollars. If you set fuel aside, our price commitment as well as expectations for positive mix in 2024 should allow us to pace freight revenue ahead of volume."
},
{
"speaker": "",
"content": "And finally, with capital allocation, we plan to start -- restart share repurchases in the second quarter, a further demonstration of the confidence we have in our strategy and the momentum that is building. The actions we're taking to improve safety, service and operational excellence are reflected in our financials, and continuing on with this strategy will drive shareholder value in 2024 and well into the future."
},
{
"speaker": "",
"content": "Let me turn it over to Kenny now to provide an update on the business environment."
},
{
"speaker": "Kenny Rocker",
"content": "Thank you, Jennifer, and good morning. As Jennifer mentioned, freight revenues totaled $5.6 billion for the quarter, which was down 1% as core pricing was offset by lower fuel surcharges and a 1% drop in volume."
},
{
"speaker": "",
"content": "Let's jump right in and talk about the key drivers in each of our business groups. Starting with Bulk, revenue for the quarter was down 4% compared to last year on a 5% decrease in volume and a 1% increase in average revenue per car. Solid core pricing gains across most Bulk segments were largely offset by low natural gas prices that unfavorably impacted our coal index contracts and lower on fuel surcharges."
},
{
"speaker": "",
"content": "As stated, coal continued to face difficult market conditions in the first quarter as warmer temperatures overall led to record low natural gas prices and caused significant declines in demand. Grain and grain products volume was up for the quarter with increased shipments of corn to Mexico as well as more shipments from Canadian origins. Lastly, despite strong truck competition, food and refrigerated shipments increased as a result of new business for dry goods solid demand and network service improvement."
},
{
"speaker": "",
"content": "Moving to Industrial. Revenue was up 4% for the quarter, driven by a 1% increase in volume. Strong core pricing gains and a positive mix in traffic were partially offset by lower fuel surcharges. Our strong business development efforts in petroleum allowed us to capitalize on windows of opportunity along with new domestic contract wins. Demand improved for our Petrochemicals business in both export and domestic markets. However, challenges with high inventories and weather negatively impacted our rock volumes."
},
{
"speaker": "",
"content": "Premium revenue for the quarter was down 3% on a 1% increase in volume and a 4% decrease in average revenue per car, reflecting lower fuel surcharges and truck market pressures. Automotive volumes were positive due to business development wins with Volkswagen and General Motors, along with continued strength from dealer inventory replenishment. Intermodal volumes were positive in the quarter, driven by strong international West Coast demand, which was partially offset by the international contract loss I mentioned in January and soft market conditions in domestic intermodal."
},
{
"speaker": "",
"content": "Turning to Slide 10. Here is our 2024 outlook as we see it today for the key markets we serve. Starting with Bulk, we anticipate continued challenges in coal as inventories are projected to be at record levels and natural gas futures remain depressed. We are hopefully watching grain, particularly as it relates to new crop conditions and fourth quarter export demand. We expect domestic grain demand to be stable."
},
{
"speaker": "",
"content": "Lastly, we are optimistic about grain products, as we continue to see growth in biofuel feedstocks. Additionally, we recently won incremental grain products business out of Iowa that started moving earlier this year by demonstrating our consistent service products and developing competitive solutions to support our customer's business."
},
{
"speaker": "",
"content": "Turning to Industrial. The rock market will be challenged to exceed last year's record volume. However, we expect petroleum and petrochem markets to remain favorable due to our focus on business development, supported by our investments in the Gulf Coast and operational excellence."
},
{
"speaker": "",
"content": "And finally, for Premium, on the intermodal side, we expect to see consistent, strong West Coast imports in the near term, but it's still too early to predict what will happen in the back half of the year. On the domestic intermodal side, we continue to see market softness, but expect our strong service products and diversified set of IMC and private asset partners will set us up well when demand returns. For Automotive, we will see continued strength due to our business development wins and improved OEM production."
},
{
"speaker": "",
"content": "In summary, coal and domestic intermodal will put pressure on our volumes this year, but the team has taken action. As you saw in the first quarter, excluding fuel, we were able to grow revenue even as we face lower volumes overall. I am confident that with our improved service products, we will continue to win new business and take trucks off the road. On the price side, we are having deliberate conversations with customers on price increases to overcome inflationary pressures. And those conversations are backed up by an efficient service product that Eric's team has given to our customers so that they can compete and win."
},
{
"speaker": "",
"content": "We have a great franchise, along with being the premier cross-border rail provider to and from Mexico that positions us well to serve markets in both the U.S. and Mexico. Our legacy service and the new service offerings we've added allows us to win in the marketplace, and we see strong opportunities in front of us to grow with our customers."
},
{
"speaker": "",
"content": "And with that, I'll turn it over to Eric to review our operational performance."
},
{
"speaker": "Eric Gehringer",
"content": "Thank you, Kenny, and good morning. Moving to Slide 12. We exited 2023 with strong operational momentum across the board. And while weather quickly presented its challenges, the team rose to the task. The speed with which our service product recovered is a testament to our strategy and the resiliency of our network. We continue to see meaningful year-over-year improvements in our metrics. This is a direct result of our steadfast focus on providing industry-leading safety, service and operational excellence."
},
{
"speaker": "",
"content": "Starting with Freight Car Velocity. Improvements in terminal dwell and overall network fluidity led to a 4% improvement compared to first quarter 2023. Sequentially, Freight Car Velocity declined 6%, primarily due to shifts in product mix between our Bulk, Manifest and Intermodal services. Particularly, we are seeing an impact from declines in Intermodal and Bulk shipments, which generally contribute higher average daily car miles. Key is that our service product remains consistent, and we are delivering what we sold to our customers. We want our customers to win. And if they win, we win."
},
{
"speaker": "",
"content": "To further deliver on the service we sold to our customers, we recently introduced a new measure Service Performance Index, or SPI. As the name implies, it's a combined metric that reflects the actual service provided, and we believe it's a better measure than trip plan compliance alone. For those customers with specific transit commitments, we measure against that. And for the many customers who rely on our historical performance to inform their rail transportation planning decision, SPI provides a measure that aligns with this practice."
},
{
"speaker": "",
"content": "For the first quarter, both Intermodal and Manifest and Auto SPI saw a sizable 14 and 7-point year-over-year improvement, respectively. The team also delivered safety performance in the quarter, both on derailment and personal injury fronts. As we continue to emphasize the culture of safety, we're also investing in technology and process, ensuring our employees have the tools they need to operate safely and efficiently. Our goal is clear, we want to lead the industry and drive tangible change so everyone goes home safely each day."
},
{
"speaker": "",
"content": "Now let's review our key efficiency metrics on Slide 13. While maintaining focus on enhancing safety and service, it is equally crucial that we do so in a cost-effective manner, enabling Kenny and the team to compete in a broader range of markets. In alignment with this objective, we saw year-over-year improvement across all of our first quarter metrics, indicating that the efficiency of our railroad is on the right track."
},
{
"speaker": "",
"content": "Locomotive productivity improved 10% compared to first quarter 2023, as the team continues to run an efficient operation and a transportation plan that requires fewer locomotives to satisfy the demands of the business. In fact, we have reduced our active fleet by about 500 locomotives compared to last year."
},
{
"speaker": "",
"content": "Workforce productivity, which includes all employees, improved 1% as average daily car miles declined slightly and employees decreased 2% compared to 2023. While overall workforce counts declined, our train, engine and yard employees increased 4%, as we continue to support our training pipeline, scheduled work agreements and provide the capacity buffer necessary to navigate an ever-changing environment."
},
{
"speaker": "",
"content": "Train length improved 1% compared to first quarter 2023. After a particularly challenging January due to winter weather, we quickly adjusted to set train length records in both February and March. Notably, manifest train length increased by around 300 feet. While train length increased for nearly all train categories year-over-year, declines in intermodal shipments, which generally move on longer trains, moderated sequential performance."
},
{
"speaker": "",
"content": "Although we are encouraged by these results, there are ample opportunities ahead for us to further improve asset utilization and the efficiency of our network. For instance, we are leveraging technology to automate terminal functions and engineering renewal activities, increasing energy management utilization to improve fuel consumption and developing car plan optimizers to reduce car touches. While these are just a few of key initiatives, running a safe, reliable and efficient railroad for all our stakeholders is vital. And as we move forward, we will continue pushing the envelope in our pursuit of industry-leading safety, service and operational excellence."
},
{
"speaker": "",
"content": "So with that, I'll turn it back to Jim."
},
{
"speaker": "Vincenzo Vena",
"content": "Thank you, Eric. Turning now to Slide 15. Before we get to your questions, I'd like to quickly summarize what you've heard from our team. First, as you heard from Jennifer and Kenny, our volume outlook in some markets continues to be challenged. We are mitigating those challenges by driving efficiency in the network, which is driving stronger financial returns, and this provides confidence to start repurchasing shares in the second quarter."
},
{
"speaker": "",
"content": "Kenny provided you with an overview of the first quarter volumes and laid out some updated thoughts for the year. Coal is going to be a headwind. It is what it is. We need to outperform what our markets give us naturally to offset that impact. And if we provide the service we sold to our customers, I'm confident they'll grow with us. It's also imperative that we generate pricing for the value we're providing our customers."
},
{
"speaker": "",
"content": "Lastly, Eric walked you through the progress we're making across safety, service and operational excellence. When I look at how we're performing, I see improvement across the board. The network is operating fluidly and efficiently, allowing us to meet the demand in the market. And that drove the financial success, as you saw here in the first quarter. There's certainly more to do, but we're on the right path."
},
{
"speaker": "",
"content": "At the end of the day, we're demonstrating continuous improvement, getting a little better each day. In the long run, our focus on being the best across the spectrum will generate sustainable long-term value for the years ahead."
},
{
"speaker": "",
"content": "One final item for you all, a Save the Date. We are planning an Investor Day on September 18 and 19 in Dallas, Texas. More details to follow, but we're excited to lay out more of our vision to demonstrate what's possible for this great company of ours."
},
{
"speaker": "",
"content": "And with that, Rob, we're ready to take on some of the questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] And our first question comes from the line of David Vernon with Bernstein."
},
{
"speaker": "David Vernon",
"content": "So it seems like the operations are working pretty well, Jim. I'd like you to maybe talk about kind of what you're doing with Kenny and his team to start focusing on growth that's maybe different or hasn't been done at UNP in the past. We know there's been a couple of the joint services with the CN and the Falcon and stuff like that. But internally in terms of focusing the team on more business development efforts, can you just kind of talk to us a little bit about what kind of changes you're making or what kind of initiatives you're emphasizing to start driving a little bit more growth on the networks?"
},
{
"speaker": "Vincenzo Vena",
"content": "You bet. David, thanks for the question. And I'll just summarize real quick what we're doing. And then, Kenny, maybe you want to get into a little bit more of the specifics, okay? So if we look at what we're doing on the railroad side, and that's very important in how we're going to be able to grow and grow with our customers is our customers -- some customers we have expect speed and resiliency in the model. And others, it is -- speed is less of a concern. It is consistency in the model. So if you take a look at what we're doing, we are building the fundamental blocks that we are able to provide a service like no one else. We can go from and we're out there selling it. So in the high-speed market to market, we have a service that operates very high speed, 2,000 miles in less than 2 days, that makes us competitive against other modes of transportation."
},
{
"speaker": "",
"content": "If we look at the consistency, we want our customers to win. And the best way for us to grow is with the customers that we have, whether it's the automobile business that we handle, whether it's the export business that we handle, whether it's in the Gulf, whether it's our access into Mexico and our interchanges with the other railroads and how we can originate, and we all win together. So we're doing all of that. I'm spending -- Eric might say, I'm not -- he wishes I would spend more time on some other things, so I still look at the operation. It's still there. I think there's a lot more that needs to be delivered."
},
{
"speaker": "",
"content": "And when you do an analysis, and the way I like to do a regression analysis on what the operation is like, I'm comfortable, but there's more to do. And the pressure is on to be more consistent and faster and be able to deliver a better service product. We do that, we win. But I've also spent a lot of time with Kenny and his team and myself personally, meeting with customers, understanding what they need to win, our present customers and future customers. And I think we continue down this path with consistent service. And the value that we can provide to customers for them to grow is such that they want to partner with UP, and we want to partner with them because we want our customers to win, and I really like where we are. And if we can keep this consistency, David, going, which I'm very confident we can, then I think, Kenny, I hate to tell you, it should be pretty easy for you to grow the business in a way you go."
},
{
"speaker": "Kenny Rocker",
"content": "All right. So look, David, you hit it on the head. What are we doing differently? And I just want to talk to you about some of the product development that Eric and I and our teams are doing together. You look at the Phoenix ramp. We're excited about it. We're seeing that volume come in there and grow sequentially. It just gives our customers and BCOs more optionality."
},
{
"speaker": "",
"content": "Port of Houston is one. We put that service back on. We've been excited about the growth that we've seen come out of there, and we'll continue to add on to the destinations that are there. We started off with 5, now we're at 11. You look at Inland Empire, we just added on a new product there. Now we're going to 20 cities, east of Chicago with the CSX and the NS on the unit train side. Because we are seeing the cycle times improve, we're naturally getting more volume, so we like that piece."
},
{
"speaker": "",
"content": "On the finished vehicle side, you talk about product development. business that's coming off of the water that's getting land bridge that we're moving back east. Look, this lower cost that we have really opens up new markets for us at great margins. So we're on offense. I mean we're pushing every lever we can to get business onto our network. We got a beautiful franchise, as Jim mentioned, and we're taking advantage of it."
},
{
"speaker": "David Vernon",
"content": "All right. If I could maybe squeak one quick follow-up. How is the FXE performing with the extra volume? I know south of the border, there's been a lot that shipped over onto that. And then, are you thinking about sort of expanding capacity over the Eagle Pass Gateway to maybe accommodate future growth out of Mexico?"
},
{
"speaker": "Vincenzo Vena",
"content": "David, real quick, I've spent a lot of time, I think I've made like 8 or 9 trips down to Mexico already in the 8 months I've been here, working very closely with FXE with our ownership position in them. We know where the points of concern are. FXE has done a good job of identifying what they have to do, and I think they run a good service product. They're going to continue with the same goal as we have to strive, and we're working together on it. In fact, in a couple of weeks, I'm going to ride a train, head end of a freight train, down on the FXE to take a look at their railroad even more."
},
{
"speaker": "",
"content": "The border, we have processes in place to make it easier for our crews to not stop right at the border and get trains across, which just makes sense, just like between Canada and the U.S. at International Falls. So we are in the process of cleaning up those items that limit the speed and the efficiency for our customers to get across the border. So I'm very happy to see where we are. And we're trying to work as one railroad. I don't like to give other railroads my excess locomotives, and you can understand why, I don't have to explain it. But we have provided FXE some locomotives to make sure that they can move the traffic that's out there. And they've seen a large growth. Their number is -- I'll let them give you the exact number, but the -- we see growth in Mexico, both northbound and southbound, and that's a market we want to use those 6 touchpoints we have to get into Mexico and optimize it for Union Pacific."
},
{
"speaker": "Operator",
"content": "Our next question is from the line of Justin Long from Stephens."
},
{
"speaker": "Justin Long",
"content": "So it was good to see the OR improve a little bit sequentially despite the typical seasonality that you see. And in the outlook, you talked about profitability gaining momentum. But can you help us translate that into how you're expecting the OR to trend over the balance of the year? It seems like we're tracking towards the sub-60 the rest of 2024, but is there anything on the horizon that could prevent that from happening?"
},
{
"speaker": "Jennifer Hamann",
"content": "Thanks, Justin. We are not providing OR guidance, but -- so I'm not going to comment on your number. But I think the way that you're describing it in terms of what we expect from ourselves is to continue to make improvement. You heard Jim talk about the fact that we made good gains, but there's more to do. And that's really our focus, is to continue to do that quarter-over-quarter to make gains. Obviously, we're doing that in an environment that we can't totally control."
},
{
"speaker": "",
"content": "We control a lot of things, especially about our service product and our cost structure and how we go into the market and how Kenny and his team are pricing, but we are doing that against an economic backdrop that's a little uncertain. We don't know what's going to happen with interest rates yet. So those are the things that do have an impact on us, including fuel prices. So just stay tuned. We feel really good about the setup and are very confident about our ability to perform."
},
{
"speaker": "Operator",
"content": "Our next question is from the line of Amit Mehrotra with Deutsche Bank."
},
{
"speaker": "Amit Mehrotra",
"content": "Congrats on the strong results. Eric, obviously, you and the team have done a phenomenal job with the operations and the metrics. We've kind of been stuck in this 155,000-ish 7-day carload number. I will be curious to get your confidence and perspective on how much more you can handle when Kenny gives you that to handle. How you feel comfortable about moving 5,000, 10,000 more carloads per week, if you can talk about that?"
},
{
"speaker": "",
"content": "And then just, Jennifer, related to that this question that was just asked, the weather gets better from 1Q to 2Q, you move more industrial carloads. It's a pretty meaningful advantage as you move from 1Q to 2Q, if you can just talk about any. And fuel, I think fuel noise moderates a little bit. If you can just talk about anything that I'm missing there as we think about from 1Q to 2Q that might be on the negative side of the ledger."
},
{
"speaker": "Eric Gehringer",
"content": "Good. I'll start with it, Amit. Thank you very much for that question. Now I want to be really clear right off the bat. We have the capacity to be able to handle more than 155,000 carloads. What brings us tremendous confidence is when you think about the 5 critical resources that we have. We clearly have enough terminal capacity. We clearly have enough mainline capacity. More specifically, we've talked about in the past and continue to maintain a buffer in our crew base. We have a couple of hundred extra crews based across the system that are available. As to your point, when that volume comes on, we have the crews."
},
{
"speaker": "",
"content": "Locomotives, in my prepared comments, I said that over the last 12 months, we've been able to store 500 locomotives due largely because of the increased fluidity in the system. Those are available to us. As Kenny brings more volume to the railroad, we don't have to wait a week, we don't have to wait 30 days, they're parked across the system available to us."
},
{
"speaker": "",
"content": "And then, of course, on the car side, we have cars not only spaced across the system that we call out the ready cars, but we actually have been working with customers in which we're storing cars right at their facility, so the moment they're ready to give us that load, we're ready to pick it up."
},
{
"speaker": "",
"content": "Now when you think about capacity, the final thing you have to think about is the work that we do on train lengths. We talk often about driving volume variable approach to how we operate the railroad. Train length is one of the ways we do it. At a 300-foot improvement in our manifest quarter versus same quarter last year, that's a huge lift. That's a massive accomplishment by the team. Building train length in the manifest network is one of the hardest things we do. What that tells you is if we're really good at the hardest things we do, as the intermodal volume starts to come back, we don't have to add train pairs on. We can take some of the latent capacity we have in our existing train peers and utilize it. So we're ready."
},
{
"speaker": "Vincenzo Vena",
"content": "So, Amit, the only thing I would add is, and you know, I've never given guidance on operating ratio because it's a result of how you operate the railroad, and that's really important. But ex-fuel, a 60.1% last quarter with where the volumes were, what we did with price and what we did with efficiency on the railroad, that's a pretty good number. It's okay in the way I look at the world. Some people would say it's excellent. I go, it's pretty good."
},
{
"speaker": "",
"content": "So I see moving us forward, and unless we get surprised, Kenny does his job properly, and we are able to return the proper price because of the great service and the product that we're delivering, and we continue to operate the railroad efficiently, and numbers underneath and the numbers that people don't see every day that I look at, make me very comfortable that we have a clear view of how we become more productive down at the ground level in this railroad driving decision-making closer to the people that need to make the decision and not trying to do it here in Omaha in like the headquarters."
},
{
"speaker": "",
"content": "So, Amit, I'm not going to give a number, but I'm comfortable with where we're headed in the long term for Union Pacific."
},
{
"speaker": "Operator",
"content": "Our next question is from the line of Jon Chappell with Evercore ISI."
},
{
"speaker": "Jonathan Chappell",
"content": "Jim, I was going to ask just kind of where you left off. In January, you kind of admitted somewhat modestly that it would be difficult to improve the margin without a volume tailwind. And here you are with 200 basis points of core improvement with volumes down year-over-year. So what was the, I guess, change in the last couple of months? Eric touched on a lot of things, but how are you able to make such a huge improvement in such a short period of time? And what's your comfort in the sustainability of that when you actually do get a volume tailwind in the network?"
},
{
"speaker": "Vincenzo Vena",
"content": "Well, let's start with the end of the question. I love volume, and I love revenue. So at the end of the day, that's really important to us to be able to drive it forward. And what we've done is we worked hard. It looks easy sometimes to operate a railroad and especially as complicated as the Union Pacific network is because it is complicated. It's not a linear railroad. It's very, very spread out in the way it operates. But I think we're focusing the people at the right level. We're doing the right things when it comes on the expense side and headcount and everything that's involved in it, making sure that we don't impact service. And I think we did a great job of it, and I can see us improve in every one of those."
},
{
"speaker": "",
"content": "So Kenny is going to deliver, Eric is going to deliver and the rest of us are going to make sure that we do everything we can possible to make sure that this company moves ahead because if we can have better margins, it opens up markets to us, even more markets than what we have today. So that is the end game, and you basically have asked me what our strategy is, and I'm looking forward to delivering it in the next couple of years."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Ken Hoexter with Bank of America."
},
{
"speaker": "Ken Hoexter",
"content": "Congrats for the team on some great results in a tough volume environment. But I wanted to dig into, maybe flipping Amit's question a little bit on the other side. You've been focused on these operations for 8 months now. I want to understand the more room to run, right? So you're getting service to where you want, but -- maybe is there a continued ability to pull out locomotives and cars as you continue to get more efficient? Maybe just give kind of some examples of -- Eric talked about increasing train life. Isn't there ability to go further before the volumes come online? But just -- PSR typically is, you focus on improving the service and then you get the ability to pull out the equipment and employees as you move forward, so maybe just talk about the opportunity to keep doing that."
},
{
"speaker": "Vincenzo Vena",
"content": "Yes. Listen, great question. And I'm going to give Eric to talk about how he sees and what's moving forward and Kenny, but let me just summarize the way I like to look at things is you always try to optimize the network operationally and look for ways to be able to drive efficiencies in the network. But the base plan always is what did we sell to customers, what did we tell the customers we're going to deliver and make sure that that's the base plan. And from that, you build it up."
},
{
"speaker": "",
"content": "So we see improvements not only in train length -- we had a few more cars on every train, that's very efficient in the network. It allows us to have better capacity. But we also look at how we handle the terminals, touch points in the cars, how can we forward the cars without touching them for a longer distance."
},
{
"speaker": "",
"content": "And the next piece for us is how fast we can react to our train plan so that it takes us way too long right now and to be able to adjust our train plan so that we still provide the service that we sold. So we have tools in place, and we're developing them even further that allow us to change our plan in a much shorter period of time, in a few days or a week versus weeks so that we can optimize the railroad even more. So very excited about that, and I see that as being a positive step."
},
{
"speaker": "",
"content": "Eric, Kenny, anything to add?"
},
{
"speaker": "Eric Gehringer",
"content": "I'll start building up with that. So, Ken, to Jim's point, when you look at our quarterly performance from a dwell perspective, and we had a 5% improvement in our car dwell during the quarter, that's a full half of 1 hour off of every car on the Union Pacific. That's how we are able to move the cars faster. Now when you think about that going beyond that, to Jim's point about being agile, we took out 4,000 touchpoints just in the first quarter as we looked for more and more ways to be able to modify the transportation plan to move the cars faster."
},
{
"speaker": "",
"content": "Now you build off of that and you start to get to the fundamentals of the railroad, the improvements we've made in recrew rate. There's still opportunity there. Certainly, our investments in technology, both with [ RCO ] as well as [ Mobilinx ], that's about getting more productive in the yards. Even when we think about the brake-person deal that we signed last year that we spoke about working to ensure that we have capitalized on all those opportunities."
},
{
"speaker": "",
"content": "We've talked about locomotives, 500 already out. We see more opportunities. You hit on train length to start your question, but also sometimes things we don't talk about, our purchase services, we made great progress, as Jennifer reported in the quarter on purchased services. We did that from everything from maximizing the material movement using trains instead of trucks to how many vehicles we have on the railroad."
},
{
"speaker": "",
"content": "You've seen what our headcount has done over the last year. We've aligned our fleet from a vehicle perspective to that, to about 600 vehicles coming out. So everything is in play right now, Ken. We look at it every single day. We work through it every single day. And the biggest thing that we're looking for is how do we ensure that we make meaningful changes to not only improve our service product, but also make us safe while we drive financial success."
},
{
"speaker": "Vincenzo Vena",
"content": "Ken, anything to add?"
},
{
"speaker": "Kenny Rocker",
"content": "I mean we talked about the efficiency. It shows up in the product development that we talked about. It shows up in all these small discrete things like adding more cars right at the customer's plant and asking for more business by customer, by plant."
},
{
"speaker": "Operator",
"content": "Our next question is from the line of Ravi Shanker with Morgan Stanley."
},
{
"speaker": "Ravi Shanker",
"content": "So the 3.5% price/mix number in 1Q, kind of how do you think about that over the course of the year? And obviously, puts and takes on the macro, truck pricing, et cetera, and some movements in the mix side as well. So how do we think the number evolves?"
},
{
"speaker": "Jennifer Hamann",
"content": "So -- we're probably not going to give you a number, Ravi, which isn't going to surprise you, but I'll let Kenny talk to the markets. But just from a mix perspective, with intermodal probably staying weak through most of the year, that probably is going to give us the ability to have some positive mix within our business as we think about that for the rest of the year. Kenny?"
},
{
"speaker": "Kenny Rocker",
"content": "Yes. I've been very encouraged and proud of the commercial team and the conversations that they're having with customers on price, articulating the inflationary pressures that are there and working with those customers to price to the market, taking a little bit more risk to price that business. And at the end of the day, our service product has improved, as you can see in the results, and we're talking to our customers about that and aligning that with the capital investments we're making. So it is not a coincidence or by luck, we are having very deliberate conversations with our customers."
},
{
"speaker": "Ravi Shanker",
"content": "Understood. And if I can squeeze a super quick follow-up kind of, I think you had said in other revenue, there was a contract settlement and there's a claim settlement and other expenses as well. Is that the same one? Or Are they 2 different ones?"
},
{
"speaker": "Jennifer Hamann",
"content": "Those are 2 different ones, Ravi."
},
{
"speaker": "Operator",
"content": "Our next question is from the line of Brian Ossenbeck with JPMorgan."
},
{
"speaker": "Brian Ossenbeck",
"content": "Just wanted to kind of follow up on that last question from Ravi. In terms of just the mix, it sounds like it's getting better from here. Maybe, Kenny, you can give us some color in terms of the pace of renewals as it was always going to take a bit of time to touch through the rest of the business and services helping with that momentum. So it would be helpful to hear that."
},
{
"speaker": "",
"content": "And then just secondarily, similarly on the labor agreements in coal, like are both of those with coal network rightsized to the big drop you've seen right now? Or is there a little bit more to do? And on the labor side, you obviously had some new agreements to adjust for as well. So just trying to figure out where those 3 things stand in terms of where they are now and sort of looking at the rest of the year."
},
{
"speaker": "Kenny Rocker",
"content": "Yes, I'll start off. Thanks for the question. I said that back in January, it's not like we woke up January 1 and started deciding that we needed to have these deliberate conversations with customers. These started well early last year. And we've shared this. We can touch close to half of our price annually. The other half is in multiyear deals. I touched on it a little bit, about the deliberate conversations that we're having, the risk that's out there. And then I'll talk about a couple of markets."
},
{
"speaker": "",
"content": "You look at domestic intermodal, those spot markets, if you look at it, here where we stand today, they are the same that they were from a spot market perspective last year, so this has been a long time, same thing on the contracted rates. Those contract rates have been where they are for a long time, over 8 months. And so the good thing, if you're an optimist like I am, there -- you know you're at the trough, but the thing you don't know is when things will improve or get better. And we're not in a position where we're going to forecast that they -- when that will happen."
},
{
"speaker": "",
"content": "What I will tell you, and I talked about the product development already, we're prepared. We're ready. We're working with Eric's team, and we're bringing on more volume that comes on. And so we'll see what happens there, but I can tell you that we're prepared and excited."
},
{
"speaker": "Eric Gehringer",
"content": "And Brian, to your question about crews and the coal lines, so every single week, we review every board across the system. And we're looking, just as you pointed out, for changes in the market that shows up an increased or reduced demand. We've made adjustments. We'll continue to make adjustments."
},
{
"speaker": "",
"content": "And it reminds me to make sure that we remind ourselves a year ago, we were talking to all of you about 200, 250 borrow-outs across the system. For the third month in a row, we have 0 borrow-outs across the entire system. Now that doesn't mean that with some seasonal adjustments to some business like grain harvest, we might put some out there, but it's a massive accomplishment, and I give the team credit for it because they've been able to manage the crews in a way that we don't have any borrow-out. So agility, all day long."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Jordan Alliger with Goldman Sachs."
},
{
"speaker": "Jordan Alliger",
"content": "You've alluded to this a few times this morning, but productive and cost takeout, certainly seem better than we would have had in our model, particularly in areas such as PT, which you have alluded to as well as the rents. Can you maybe talk to some of the sustainability of the current trend line? Because it was quite a bit of a delta versus what we've seen lately as we move forward from here."
},
{
"speaker": "Jennifer Hamann",
"content": "Yes. Jordan, thanks for that question. So I think you're right. You're hearing a lot of positivity by the team because we know that there are more opportunities. And first, it's building the momentum, it's sustaining the momentum and then keeping the cost out. And so if you think about equipment rents, that really is all about continuing to drive the car velocity, continue to drive the cycle time and the dwell that Eric referenced. So those are directly impacting that line."
},
{
"speaker": "",
"content": "And then purchased services, certainly, the locomotive fleet is a big part of that, as we continue to use our locomotive fleet more protectively and reduce those numbers, that's an opportunity to sustain and potentially improve there as well as across the rest of the contract services that we use, is we're being smarter and looking deeper at every dollar that we're spending. And that's been one of Jim's messages to the team is, when you're looking at the resources, spend the dollars like your own and make sure that it's a wise dollar that's being spent and that you're getting the appropriate return for it. So feel good about continuing to make progress."
},
{
"speaker": "Operator",
"content": "Our next question is from the line of Brandon Oglenski with Barclays."
},
{
"speaker": "Eric Morgan",
"content": "This is actually Eric Morgan on for Brandon. I just wanted to ask another one about mix. I appreciate the detail on the impact to yields, but I was just curious if you could speak to any effects on margins just because with coal being down, big drag on volumes right now in international intermodal as well. Should we be thinking these sort of mix swings helped to drive the strong OR in the quarter? Or is it really just an RPU impact?"
},
{
"speaker": "Jennifer Hamann",
"content": "Yes. Thanks for that question. So mix does help on the RPU. And when we think about mix, there is some different mix in terms of the cost profile that's behind that. Our opportunity and our job is to improve the profitability of every line of business that we have. And so we are very proud of our manifest franchise. That's really our sweet spot for sure. But as Eric talked, intermodal, grain, coal, those are very profitable businesses for us as well to the extent that we can drive greater train length, So -- I'm not going to say we're totally agnostic, but we want to grow, and we want to grow across all lines of business. And so I think if you see us do that, you're going to like the margins that come from them."
},
{
"speaker": "Vincenzo Vena",
"content": "You bet. And just to sort of -- why don't I summarize the way I look at the quarter and what we see moving forward? First of all, if you look -- if you take a look at our results, our industrial, and that's what I love about Union Pacific is our industrial originations, the Mexico product that is non-intermodal, which gives us a different level of return and price capability, is strong. And that's what we want to see. And that was -- that's what helped us in the first quarter, and I can't see that changing, except I just don't know where the macro items are going to be in the short term in the U.S."
},
{
"speaker": "",
"content": "I was hoping with all the products that we ship and handle for people and consumers that I would have seen an interest rate cut in the next few months and maybe it will happen later on this year. So an interest rate cut would help us in what people are spending on their homes from lumber and number of products. But if you take a look at where we are, and that's what I like, we leverage that franchise we have in the Gulf in originations in the middle of the heartland of the United States."
},
{
"speaker": "",
"content": "And we always look for ways to improve our efficiency. We drive better return with whatever price we get out of the international and domestic business. And every time I see a train full of box cars and tank cars, it's music to my ears when those wheels roll by. So thank you very much."
},
{
"speaker": "Operator",
"content": "Next question comes from the line of Jeff Kauffman with Vertical Research Partners."
},
{
"speaker": "Jeffrey Kauffman",
"content": "Congratulations, this quarter, a tremendous result. I wanted to take a step back, a question for Kenny. What are you seeing in terms of customer commitments to near-shoring or rebasing manufacturing? And then in terms of coming back to the rail, your service metrics are up. And clearly, there's a flywheel effect there, but what are your customers telling you they need to see, those that maybe took business away before they would bring that business back?"
},
{
"speaker": "Kenny Rocker",
"content": "Yes. Thanks for the question. On the near-shoring piece, it's real. You've seen the amount of investments that's there. We've got a strong commercial presence that's there, and you look at the overall rail, I'm talking the rail industry market share into and out of Mexico, is still relatively low if you put it in the mid-teens or so."
},
{
"speaker": "",
"content": "Our new service product that we have in place at this time has been picking up steam and we've seen it grow. We've seen it grow in that North-South corridor. We've seen it grow in the traffic that we put on, the new product that we put on going in the Southeast, so tremendous growth there."
},
{
"speaker": "",
"content": "There is also a more carload business that will come online and more plants that will come online, some of them for some of the autos that are going to come on and some just other what I'll call just industrial pieces. We're set up for that. We're engaging those customers. Our network strength and franchise gives us an opportunity to move a lot of that, both the feedstocks in Mexico and the finished product out of Mexico, so a very strong place for us, the 6 gateways. We had a great quarter coming into and out of Mexico, and we want to build on that."
},
{
"speaker": "",
"content": "As far as those customers coming back to us, with every month that we are able to sustain and ensure reliable product, we're able to capture a little bit more business, but we're also able to sit down with them and talk to them about adding the 1 or 2 carloads or talk to them about a truck lane piece or talk to them about their rail versus truck by lane percentage. So the stronger service product is certainly a positive for us, and our commercial team has been very aggressive out there hustling to get every carload."
},
{
"speaker": "Operator",
"content": "Our next question is from the line of Tom Wadewitz with UBS."
},
{
"speaker": "Thomas Wadewitz",
"content": "Nice performance on the OR and the network and everything, so congratulations on that. I wanted to just get a little more color, I think, Jennifer or whoever else wants to jump in on the expense side, I know you've got a couple of questions, but comp and benefits, how do we think about that going forward? Is headcount stable? Did that go down a little bit?"
},
{
"speaker": "",
"content": "And then on the purchase services line, I know, kind of storing locomotives, cars, that's helpful, but is that -- should we model that kind of flat looking forward? Or I guess you said there's a onetime where you didn't identify whether that's kind of small or meaningful, so I think just from a modeling perspective. And -- is there kind of further improvement? Or how do we think about it sequentially on comp and benefits and purchase services?"
},
{
"speaker": "Jennifer Hamann",
"content": "You bet, Tom. So let me start with the purchased services. So I think I did say that the one-time item there accounted for about half of the year-over-year decrease. So you should set that aside when you're thinking about rolling that forward. But again, as you heard me talk on another question, we still obviously think we have opportunities there."
},
{
"speaker": "",
"content": "If you switch to comp and benefits then, back in January, we said we thought that we would probably see about a 5% increase in that line for the year. We were at 4% here in the first quarter, so really kind of right online there. And I think you know the drivers, they're wage inflation, they're the sick pay benefits, some higher guarantee pay, offset by what we're doing to improve our overall productivity and how we're managing the headcount."
},
{
"speaker": "",
"content": "When you think about those new contract benefits in terms of the sick pay, it's also -- when we're rolling out the work rest agreements, that is resulting in a little bit of an elevation in terms of our TE&Y headcounts in anticipation of those benefits. And so really, the way to think about that is that we're paying a little bit more due to those agreements for the same unit of work. But I think what's encouraging there is we're offsetting that with some of our productivity, and that's our plan going forward."
},
{
"speaker": "Thomas Wadewitz",
"content": "Okay. So that kind of comp and benefit plan probably is stable is the right way to look at it?"
},
{
"speaker": "Jennifer Hamann",
"content": "Yes. I mean, obviously, if there's a significant change up or down from a volume perspective, that can have an impact, but I think we feel like we're in a pretty good place right now."
},
{
"speaker": "Vincenzo Vena",
"content": "It's a great way to look at it, Tom, in the short term, you'll see in the next few quarters. But the challenge, and one that we know that we have to tackle, is we have wage inflation. You deal with that absolutely, and you have a great service product and you price properly. I think we're doing the right things there so that we don't impact our customers to the point where they can't win in the marketplace."
},
{
"speaker": "",
"content": "But efficiency-wise, if you look at how the number of cars we're switching for employee and everything that we're doing with technology, I'm very comfortable that we'll figure out a way to change that slope on that line on what it costs us and the number of people per car to be able to hand the business level that we're at. So a little bit -- it's a lot of hard work, but I see over the next couple of years for us to get back in line to where we were."
},
{
"speaker": "Operator",
"content": "Our next question is coming from the line of Bascome Majors with Susquehanna."
},
{
"speaker": "Bascome Majors",
"content": "The owners of your Western competitor made some very public comments about really wanting more margin and profitability out of that business just a few months ago. Can you speak to if you've seen anything different in either how they approach the market or operate their business? And is or can that create opportunities for you to grow in the midterm?"
},
{
"speaker": "Vincenzo Vena",
"content": "Bascome, it's a great question. And did I like to hear that? Absolutely. But because I think we're in an industry where we provide for the price that we charge very competitive and we beat most modes of transportation. So I think you need to be smart on how you price, and I think you need to make sure that we provide the service for that price that we sold."
},
{
"speaker": "",
"content": "So we compete every day against our competitor, and we're here to win. And hopefully, they're prudent in the way they look at their markets, and I don't tell them what to do. They need to do theirs. And we're very comfortable that we're doing the right things. And I think head-to-head, we'll put our complex of what we have, including the Mexico piece, and I think it gives us a great opportunity to compete. And you have to love it, great competition against the great. The railroad is a wonderful thing. I love it. It makes us better. It makes the whole industry better. So I love the comments, but we'll see what their actions are as we see them go down the road."
},
{
"speaker": "Operator",
"content": "Our next question is from the line of Scott Group with Wolfe Research."
},
{
"speaker": "Scott Group",
"content": "So Jennifer, Kenny sounded a bit better on price. I know last quarter, you talked about price/cost is a margin headwind for the year. I'm just wondering, are we getting any closer to that becoming a tailwind, right, if we can combine some of the productivity stuff with price/cost that the margins could get pretty good. I just don't know if we're getting closer to that inflection yet. And then can you just clarify that if we've seen the full impact of the coal RPU headwind from lower nat gas, or if there's another step-down coming there?"
},
{
"speaker": "Jennifer Hamann",
"content": "Yes. I'll let Kenny talk -- take that coal question. But you're hearing it right. We're putting a lot of pressure on Kenny and the team to go out there and deliver the price, and they're very much stepping up to that and are taking on that challenge and being aggressive in the marketplace. Obviously, we improved our margins in the quarter. So the combination of our volume, which was down a little bit, but price and productivity is what's driving the margin improvement. I can't say that we're accretive yet from just a pure price inflation standpoint, but that absolutely is the goal. We are though exceeding, just the dollars are exceeding the inflation dollars. We're still very confident of that. Kenny?"
},
{
"speaker": "Kenny Rocker",
"content": "Yes. I just want to reiterate what Jennifer said, we'll exceed our inflationary dollars. On this coal question that you have, we're looking at the same things. You're looking at in terms of the natural gas futures, and we're talking to our customers, similar to my comments around domestic intermodal. Yes, I think we're at the trough levels, when they will come up is yet to be seen. They're still depressed. We'll see if we get some seasonal lift here going into the spring and the summer. I want a hot, muggy summer so we can move more business. But if that doesn't happen, we'll see what Eric and the team to do for us to efficiently move the coal business. Thank you for the question."
},
{
"speaker": "Vincenzo Vena",
"content": "I'm telling you, and I have to jump in on this one here, Kenny and team and everybody, coal is what it is, and I said it in my prepared comments on purpose. We have other markets that are going to take care of that coal business. It's tough to replace the number of the trains that we originate, but we used to originate a heck of a lot more than we do today, and we need to be able to grow it. So we can hope, and I'm not into hope. I'm into, let's go out there, deliver, have the right processes, have the right things possible, and we go deliver and we win."
},
{
"speaker": "",
"content": "And I've spoken about our franchise a few times on this call. That's what allows us to win. We provide good service and will more than offset anything that happens over the long term with coal. It is what it is, okay? I don't see it coming back to a large level that it will change us. It might do it for a short term, but that's the way I look at it, and that's the way the team here at Union Pacific is. We're going to win regardless of what happens to one commodity that we ship."
},
{
"speaker": "Operator",
"content": "Our next question is from the line of Stephanie Moore with Jefferies."
},
{
"speaker": "Stephanie Benjamin Moore",
"content": "So, Jim, really nice progress here across safety and service. So in terms of customer engagement post these improvements, what are you hearing from customers? Are you seeing engagement accelerate at all? Kind of what's the opportunity from here? And then maybe on the flip side, I'd love to hear, have you noticed any challenges to the network, maybe revenue holds looking to fill that, that were maybe less apparent? I'd love to get your thoughts."
},
{
"speaker": "Vincenzo Vena",
"content": "It's a great question. I think it's -- when I came back to work, a lot of people thought that the only thing I'd concentrate is on operations, and I have been spending some time there. But I have spent a lot of time speaking to customers. I did it the first week I was on the job. I've followed up with them. I've gone to meetings when we bring them in, our Industrial, our Bulk, our Premium business."
},
{
"speaker": "",
"content": "So the feedback is they want us to win, and they see themselves winning in the marketplace if Union Pacific can be successful in what our strategy is. So the feedback has been positive. There's always some markets and some customers that we have to truly understand what their impacts are and where they are because we want them to survive and win. So we're doing everything we can. And maybe, Kenny, you can speak a little bit more about our engagement and what we're doing with customers."
},
{
"speaker": "Kenny Rocker",
"content": "Yes. If you look at it, so far this year, our face-to-face meetings, the strong customer engagement strategies. We have a lot more, significantly more contacts with customers, and we're touching them in different ways. One of the unique strategies that we have as I'm looking at Eric, 1/3 of our meetings have an operating leader or a local operating person is there. And we're doing that to see how we can grow more business specifically. So strong customer engagement strategy at all levels, and we're going to keep at it. Thanks for the question."
},
{
"speaker": "Operator",
"content": "Our next question is from the line of Elliot Alper with TD Cowen."
},
{
"speaker": "Elliot Alper",
"content": "This is Elliot on for Jason Seidl. My question is on international intermodal. So the outlook calls for pretty muted international intermodal for the year, I guess. We would appreciate some more context around that. I mean, I understand there was a customer loss that you called out last quarter. We've seen some strong volumes coming out of the West Coast ports, I guess. Should we continue to think about that continued acceleration on the West Coast mostly offset? Or could there be some upside if the strength on the West Coast continues?"
},
{
"speaker": "Kenny Rocker",
"content": "Elliot, thanks for the question. So a few things here. Let's set aside the contract loss you referenced. It's been strong. International intermodal has been strong for us, a little bit of a pleasant surprise for us that we've been able to capitalize on it. We're seeing more IPI business or business that's going into our network increase by a few points. We are aware that there has been a small impact on the positive side because of some of the challenges with the Panama Canal. We'll see what happens if some of the BCOs are a little bit more concerned with any labor issues on the East Coast."
},
{
"speaker": "",
"content": "But as we go through the second quarter, I feel pretty good about those volumes staying where they are, as we talk to our customers in their pipeline. I'd like to see as we move a few weeks out what happens in the second half of the year. So I'm not ready today here in April to bet on what's going to happen in the second half of the year."
},
{
"speaker": "",
"content": "The last thing I'll end with, and I've said this quite a bit, I do like the fact that regardless of what happens at the West Coast, we're preparing for if it does get transloaded, more products were to get to the East Coast that I talked about, those 20 cities that will move with the NS and the CSX, our Phoenix product and us being holistically and leveraging the entire franchise to go after more business out of the Port of Houston. Thanks for your question."
},
{
"speaker": "Operator",
"content": "The next question is from the line of Walter Spracklin with RBC Capital Markets."
},
{
"speaker": "Walter Spracklin",
"content": "So I want to take a little bit of a bigger picture on the competitive environment and how you interact with your competitors, both East and West. When we were at -- we were attending a recent session with the -- with Southern campaign, they called out the CP, KCS, CSX as a natural alliance. Just curious whether you see yourself as naturally being able to cooperate, coordinate operations to bring a more effective, higher service product to your customers."
},
{
"speaker": "",
"content": "Is there one company in particular or -- that you could align a little bit closer with given the network interplay between the companies? Just curious what you're thinking about longer term in the absence of acquisitions or mergers. Could there be increased cooperation that allows you to bring a higher service to the customer?"
},
{
"speaker": "Vincenzo Vena",
"content": "Walter, I appreciate the question. You have to think about it that 40% of the traffic that we either originate or receive starts somewhere else. So when you put that number in perspective, we can't be choosy and say that we'd rather partner with one Eastern railroad or one Canadian. I guess, I can't call CP or CN Canadian railroads anymore. I apologize to both of them, but international railroads. And what we need to do -- and all the short lines that we touch. The way I look at it is what is the best and the fastest and the quickest. So if we're all efficient, we all have good service, we all are smart in running a very fluid railroad that has buffer to be able to handle the ups and downs that naturally occur, Walter, we all win. So I don't have a preference."
},
{
"speaker": "",
"content": "Now I love it that we get to compete with some of them, and we say, we originate lots of many cars, and we say to them, which one wants the business, is it CSX or NS or is it CN or CP. And I think we compete on some. But when we work together, which we are, we have very detailed meetings with CPKC, with CN, with NS and with CSX to talk about on that interline business, how do we make those interchanges fluid, so we don't spend 24 hours to interchange cars at some interchange when we go one way or the other. So we can win and beat trucks, especially in that speed network that requires that kind of work."
},
{
"speaker": "",
"content": "So, Walter, no preference, best one wins, and we want to be able to tell people, you want to interchange with us because -- versus the other carrier in the West, the BNSF because we have the best model, we are the fastest, we can get the markets and we move quick. And once we get there, because the customer looks at it end-to-end, how good are you at origination, are you on time, how fast you get it over the road. And that's why I look at the -- I don't look at train speed, it's an illogical measure on productivity on the railroad. I look at car velocity, and that's what's important. So hopefully, I answered your question, Walter."
},
{
"speaker": "Walter Spracklin",
"content": "It does. Congrats on a great quarter."
},
{
"speaker": "Operator",
"content": "Our final question is from the line of Ben Nolan from Stifel."
},
{
"speaker": "Benjamin Nolan",
"content": "And as much as we, you guys don't want to talk about specific markets. One of the things that I've been hearing about lately a lot is more crude by rail. Kenny, I was wondering if you could elaborate a little bit on that. Is that something that you guys are seeing? And as you think about sort of the outlook going forward, how needle moving is that to the business?"
},
{
"speaker": "Kenny Rocker",
"content": "Yes. Thanks for the question. You heard my comments around our petroleum markets and business development wins there. And it's a type of oil that we're moving that we're excited about, and it's moving right now domestically. We've seen some strength. Eric's team has been able to help us grow a little bit of that business and get as much of it as we can. So we don't see that kind of traditional crude by rail that we saw 10 years ago, but we're seeing another emerging commodity in the market that we're excited to be moving, and it's going great for us."
},
{
"speaker": "Vincenzo Vena",
"content": "Rob, just let me -- if that was the last question, let me just summarize real quick because I think there's a few key points that I want to make sure that we highlight. One is, I think, the last 2 quarters have shown what's possible for this railroad. And that's really important to us is what's possible. We will have headwinds. We have a wage increase coming July 1. That's a headwind."
},
{
"speaker": "",
"content": "We have certain segments of our business that are down and can be up and others that are up that are going to impact us. But the way we look at it, and I'm so proud of this entire team and the entire railroad, if you look at what we're doing is we're making ourselves more efficient, we're driving decision-making to the right level, we're providing service that we sold our customers at a high level. And the franchise that we have and the network that we have gives us every possibility to win in the long term. That's the goal."
},
{
"speaker": "",
"content": "I'm looking forward to in September deep diving what we look like in the next 2 or 3 years, have a longer-term plan for everybody. And I'm sure I'm going to run into some of you before. But, otherwise, looking forward to the next quarter that closes. April is a great start with where our carloads are, and this is a great railroad, great franchise, and I'm looking forward to moving it forward."
},
{
"speaker": "",
"content": "Thank you very much for joining us today."
},
{
"speaker": "Operator",
"content": "This concludes today's teleconference. You may disconnect your lines at this time. Thank you for your participation."
}
] |
ups | 2,024 | 4 | [
{
"speaker": "Operator",
"content": "Good morning, my name is Greg Alexander, and I will be your facilitator today. I would like to welcome everyone to the UPS Fourth Quarter 2024 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. And after the speakers remarks there will be a question-and-answer period. [Operator Instructions]. It is now my pleasure to turn the floor over to your host, Mr. PJ Guido, Investor Relations Officer. Sir, the floor is yours."
},
{
"speaker": "PJ Guido",
"content": "Good morning, and welcome to the UPS fourth quarter 2024 earnings call. Joining me today are Carol Tomé, our CEO; Brian Dykes, our CFO and a few additional members of our executive leadership team. Before we begin, I want to remind you that some of the comments we'll make today are forward-looking statements within the Federal Securities Laws and address our expectations for the future performance or operating results of our company. These statements are subject to risks and uncertainties, which are described in our 2023 Form 10-K and other reports we file with or furnish to the Securities and Exchange Commission. These reports, when filed, are available on the UPS Investor Relations website and from the SEC. Now let me share a reporting change we have made between business segments. Effective with the fourth quarter of 2024 USPS Air Cargo results have been moved from supply chain solutions to the U.S. domestic segment. We made this change to align with our management structure and to simplify intercompany allocations and reporting. This change is visible in the web schedules that have been posted on the UPS Investor Relations website. Not that U.S. domestic revenue per piece and cost per piece metrics are not impacted by this change as USPS transacts with us on a weight basis not on a per piece basis. Unless stated otherwise, our discussion today refers to non-GAAP adjusted results. For the fourth quarter of 2024, GAAP results include a non-cash after-tax mark-to-market pension charge of $506 million. Total after-tax transformation strategy costs of $73 million, after-tax asset impairment charges of $46 million, and an after-tax cost related to the withdrawal from a multi-employer pension plan of $14 million. The after-tax total for these items is $639 million or $0.74 per diluted share. Additional details regarding year-end pension charges are included in the appendix of our fourth quarter 2024 earnings presentation that is posted to the UPS Investor Relations website. A reconciliation of non-GAAP adjusted amounts to GAAP financial results is available in today's webcast materials. These materials are also available on the UPS Investor Relations website. Following our prepared remarks, we will take questions from those joining us via the teleconference. [Operator Instructions]. Please ask only one question so that we may allow as many as possible to participate. You may rejoin the queue for the opportunity to ask an additional question. And now I'll turn the call over to Carol."
},
{
"speaker": "Carol B. Tomé",
"content": "Thank you, PJ and good morning. We have a lot to cover today. I'll begin with a review of our fourth quarter and full year results. Then I'll provide an overview of the moves we are taking in 2025 to drive our performance. Brian will wrap up our prepared remarks with more detail about our financial performance and our 2025 outlook. And we'll leave plenty of time for questions. But first, let me start by thanking UPSers for their hard work and efforts as we executed another outstanding peak. For the seventh year in a row, we were the industry leader in on-time service during peak season, the most important time of the year for our customers. In the face of a compressed holiday period, our people, enabled by the agility of our integrated network, did what they do best and that's deliver for our customers. Moving to our results, the positive momentum we saw in the third quarter continued into the fourth quarter. Compared to last year, consolidated fourth quarter revenue increased 1.5% to $25.3 billion. Operating profit was $3.1 billion, an increase of 11.2% from last year, better than we expected, and consolidated operating margin was 12.3%. Importantly, our U.S. domestic operating margin was over 10% for the quarter, reflecting improved revenue quality and strong expense control. Looking at the full year, our consolidated revenue was $91.1 billion, slightly above last year. Consolidated operating profit totaled $8.9 billion, and consolidated operating margin was 9.8%. We generated $10.1 billion in cash from operations in 2024, and we returned $5.9 billion to share owners in the form of dividends and share repurchases. Before I discuss our plans for 2025, let me share a few operational and financial highlights. In 2024, we continue to grow our U.S. SMB penetration, and finish the year with SMBs making up 28.9% of our total U.S. volume, an increase of 30 basis points from last year. DAP, our digital access program, was a big driver of the increase and in 2024, we generated $3.3 billion in global DAP revenue, a 17% increase year-over-year. As we discussed, we are moving from a scanning network to a sensing network through our smart package, smart facility, RFID initiative. In 2024, we equipped nearly 60,000 U.S. package cars with sensors, which represents 66% of our fleet, eliminating 12 million manual scans per day, and enhancing package visibility for our customers. Within network of the future, in 2024, we accelerated operational closures and completed nine more than planned, resulting in 49 operational closures which included permanently closing 11 buildings. And we did this while continuing to deliver outstanding customer service. Today, about 63% of our U.S. volume flows through our automated facilities, compared to 60% in 2023. Finally, we took actions in our healthcare logistics business to further support our growth plans. Earlier this month, we completed the acquisition of Frigo-Trans, a European healthcare logistics company specializing in cold chain and in December we opened two state-of-the-art healthcare cross-dock facilities in Italy and Germany. These moves further expand our cold chain capabilities to serve a growing European market. Before I talk about 2025 I'd like to take a short look back at the last five years. In June of 2020 in the face of the COVID-19 pandemic we launched our better-not-bigger strategy hinged on three elements. Customer first, people led, innovation driven. For the first few years we focused on growing select markets and optimizing financially attractive volume including volume from SMBs and healthcare customers. Further we focused on making productivity a virtuous cycle by launching transformation 2.0 and we began a portfolio optimization program including selling our LTL freight business and making a few strategically important acquisitions. From 2020 through 2022 we delivered solid financial results in line with our strategy at a time when much of the world was struggling due to the challenges presented by the pandemic. In 2023 our financial results faced unexpected challenges due to an unfavorable economic environment and a prolonged payment [ph] negotiation with the teamsters. While the labor negotiation caused volume and earnings disruption we gained certainty regarding our labor cost for the next several years. After wrapping the first year of our new labor contract in the third quarter of 2024, positive momentum began to build and we returned to volume, revenue, and operating profit growth. We continued to drive productivity through several programs and focused on revenue quality and we took further actions to optimize our portfolio by selling our truckload brokerage business known as Coyote and we entered into agreements to acquire Estafeta, a leading Mexican logistics integrator and Frigo-Trans. We closed out 2024 with an outstanding peak delivery investing class service and financial results ahead of our target. But as we wrapped up 2024 it became clear to us that if we didn't address three specific challenges facing us in the U.S. we could lose momentum. The first challenge relates to the dynamics of the U.S. small package market. Today it's a slow growth market with changing package characteristics. The second challenge comes from the concentration of volume and revenue we have with our largest customer. Looking ahead we project this business if we take no action we'll drive diminishing returns. The third challenge is the reliance we have had with the USPS for our SurePost product. In this case the USPS is changing its operating model which we believe puts service at risk. So we've taken actions to address all three of these challenges head on including doubling down on revenue quality and serving the customer segments we want to serve best. First, we've reached an agreement in principle with our largest customer for a significant reduction in volume, lowering their volume with us by more than 50% by the second half of 2026. With this we will right size our network and retain the volume that is nutritive for us and for our customer. Second, effective this year on January 1st we no longer use the USPS for our SurePost product. Service is a fundamental part of our value proposition and by insourcing this product we can be certain we deliver great service with no material impact to our financial performance. In connection with these changes while I'm incredibly proud of the productivity actions taken by our leaders, we've realized we're not done. We are reconfiguring our U.S. network and have launched multi-year initiatives we're calling Efficiency Reimagined which tackle our processes from end to end, from peak hiring practices to processing payments and more. Efficiency Reimagined should drive approximately $1 billion in savings. These significant business and operational changes coupled with the foundational changes that we've already made will put us further down the path to becoming a more profitable, agile and differentiated UPS that is growing in the best parts of the market namely healthcare, B2B, SNB, and international. We've got some work to do to make this all happen, but there's no better team than the UPS team. We will deliver. As Brian will detail, in 2025 these actions are expected to result in expanded operating margins and an improvement in return on invested capital. And by taking these actions, we expect by the fourth quarter of 2026 to have a U.S. domestic operating margin of at least 12%. With that, thank you for listening, and I'll now turn the call over to Brian."
},
{
"speaker": "Brian Dykes",
"content": "Thank you, Carol and good morning, everyone. Our financial performance in the fourth quarter was better than we expected due to our focus on revenue quality and excellent cost management. The positive momentum that we began in the third quarter continued throughout our busiest time of the year. This morning, I'll cover four areas, starting with our fourth quarter results, followed by a review of our full year 2024 results, including cash and shareowner returns, then I'll provide more detail on the business and operational changes we are making. And I'll close with our expectations for the market and our financial outlook for 2025. Starting with our consolidated performance. In the fourth quarter, we delivered revenue and operating profit growth and margin expansion. This is a continuation of the momentum that we showed in the third quarter and the first time in three years that we've shown growth in the fourth quarter on all three of these financial metrics. In the fourth quarter, we generated $25.3 billion in consolidated revenue, an increase of 1.5% compared to the fourth quarter of last year. Consolidated operating profit was $3.1 billion, an increase of 11.2% versus the fourth quarter of 2023, and consolidated operating margin was 12.3%, an increase of 110 basis points compared to the fourth quarter of last year. Diluted earnings per year was $2.75, up 11.3% from the fourth quarter of 2023. Now moving to our segment performance. U.S. domestic delivered strong fourth quarter results driven by gains in revenue quality and outstanding cost management. And during the compressed 2024 peak season, our average on-time service led the industry by 470 basis points over our closest competitor, which drove high demand for our services, allowing us to continue winning new customers throughout peak. For the quarter, U.S. average daily volume or ADV was flat to last year, ground average daily volume increased 2.1% year-over-year, while total air average daily volume was down 12.9%. Excluding the volume decline from our largest customer, total air ADV grew driven by demand from healthcare and high-tech customers. Within ground, SurePost ADV as a percentage of total ADV, increased slightly compared to the third quarter of 2024. Through the power of our matching algorithm, we increased SurePost redirects by 660 basis points sequentially from the third quarter, which resulted in half of the SurePost volume being delivered by UPS drivers. For the quarter, total B2B average daily volume was down 1% year-over-year. However, we saw B2B growth from healthcare customers, including healthcare SMBs. On the B2C side, average daily volume was up slightly year-over-year and made up 64.7% of our volume. In terms of customer mix, we saw strong ADV growth from SMB customers, which grew 4.5% in the fourth quarter, driven by double-digit growth in December. In the fourth quarter, SMBs made up 27.8% of total U.S. volume. This was the highest fourth quarter concentration we've seen in 10 years. For the quarter, U.S. domestic generated revenue of $17.3 billion, up 2.2% compared to last year due to the strength of small package in December and increases in air cargo. In the fourth quarter, the revenue per piece growth rate flipped positive for the first time this year, and was up 2.4% year-over-year, which was a sequential improvement of 460 basis points from the third quarter of this year. Breaking down the components of the 2.4% revenue per piece improvement, base rates increased the revenue per piece growth rate around 250 basis points. Strong keep-rates on our holiday demand surcharge increased the revenue per piece growth rate by 110 basis points. The net impact of customer mix, combined with product mix and lighter weights decreased the revenue per piece growth rate by 80 basis points. Lastly, fuel drove a 40 basis point decline in the revenue per piece growth rate. Turning to cost, total expense increased 1.3%. Since we -- the first year of our labor contract at the end of July, this was the first full quarter at a lower contractual union wage growth rate. In fact, the average increase over the prior four quarters was 10.5%, and the fourth quarter this year union wage rates increased by only 3%. Through our network of the future initiative, we exceeded our initial target by completing 49 operational closures this year, including 11 buildings. By leveraging our technology and increasing automation, we've processed and delivered the same amount of volume in the fourth quarter as last year, but we did it with 3 million fewer hours while delivering excellent service. We lowered small package block hours within our air network in response to changing volume levels, purchase transportation and other expenses declined as we insourced 50% of SurePost volume during the fourth quarter, and we tightly managed rental equipment through peak. Lastly, our safety performance was better than we expected and drove a benefit in casual peak spend. Looking at cost per piece, throughout the fourth quarter in the peak period, we leveraged technology and our proven practices to hold the increase to just 0.9%. The U.S. domestic segment delivered $1.8 billion in operating profit at 11% increase compared to the fourth quarter of 2023, and the operating margin was 10.1%, a year-over-year increase of 80 basis points. Moving to our international segment, for the second quarter in a row, our international business grew revenue and operating profit and expanded operating margins. Total international average daily volume growth were positive for the first time in three years and was up 8.8% year-over-year. International domestic average daily volume increased 5.8% compared to last year, driven by strong performance in Canada. And on the export side, average daily volume increased 11.7% year-over-year, with all regions delivering ADV growth. Asia export average daily volume was up 15.4%, delivering growth for the third consecutive quarter. And at the country level, 17 of our top 20 export countries grew export ADV led by Mexico and Germany. And in Germany, which is our largest export market, export average daily volume increased 8.6% compared to last year. In the fourth quarter, international revenue was $4.9 billion up 6.9% from last year, with all regions growing revenue year-over-year. International generated positive operating leverage, driven by our ongoing network optimization and cost management efforts. Operating profit in the international segment was $1.1 billion, an increase of 18.1% year-over-year. Operating margin in the fourth quarter was 21.6%, an increase of 210 basis points from a year ago. Moving to supply chain solutions, in the fourth quarter, revenue was $3.1 billion. Revenue decreased $306 million, with the reduction impacted by $588 million in revenue from Coyote in the 2023 period. Revenue within our forwarding and logistics businesses increased $282 million. Looking at the key drivers, air and ocean forwarding revenue was up 10.3%, led by continued strong market demand out of Asia. And logistics revenue grew by 16.2%. In the fourth quarter, Supply Chain Solutions generated operating profit of $284 million down $24 million year-over-year, which included an impact of $13.5 million of operating profit from Coyote in the same period in 2023. Operating margin in the fourth quarter was 9.3%, an increase of 20 basis points compared to last year. Walking through the rest of the income statement, we had $229 million of interest expense, our other pension income was $67 million, and our effective tax rate for the fourth quarter was approximately 20.5%, lower than our expectations due to discrete items. Now let me comment on our full-year 2024 results. For the full-year 2024 revenue was $91.1 billion, a slight increase over 2023. We delivered operating profit of $8.9 billion and a consolidated operating margin of 9.8%. We generated $10.1 billion in cash from operations and continued to follow our capital allocation priorities. We invested $3.9 billion in CAPEX, we distributed $5.4 billion in dividends, we repaid $3.8 billion in debt that matured during the year, and at the end of the year, our debt to EBITDA ratio was 2.25 turns. Lastly, we completed $500 million in share buybacks in 2024. And in the segments for the full year, U.S. domestic operating profit was $4.5 billion and operating margin was 7.5%. The international segment generated $3.4 billion in operating profit, and operating margin was 18.7%. And Supply Chain Solutions delivered operating profit of $1 billion and operating margin was 8%. Which brings us to 2025. As Carol described, we are taking a set of strategic actions to address the challenges facing our U.S. business head-on. Execution is already well underway and these actions together will create a more agile and profitable UPS. Let me provide more detail on what we're doing. I'll start with the agreement in principle we've reached with our largest customers significantly reduced the volume we deliver for them. The accelerated decline has already begun and will step up meaningfully so that by the second half of 2026, their volume will be down by more than 50% of what it was at the beginning of the year. The speed of the glide down is five times faster than our initial glide down efforts between 2021 and 2024. The results of this change will be lower overall volume levels but an improved customer mix at a significantly higher revenue per piece. We are deliberately shifting our business and increasing our focus on growing higher yielding volume and value share. Lower overall volume levels from this customer will lead to lower revenue dollars in the near term. However, we expect to grow revenue per piece through shifting our customer mix and by leveraging our architecture of tomorrow pricing technology. This will enable us to continue the strong base rate improvements in 2025 that we delivered from our enterprise and SMB customers in the second half of 2024. Additionally, we will double down on growing volume and revenue in the best parts of the market for us, including SMB, healthcare, and B2B. And in terms of SMBs, this year we expect to take the SMB percent of our U.S. volume to 32%, and the momentum will continue for the longer term. Now looking at cost, as we bring volume down, we will not only reduce the hours and miles associated with this volume, we will be able to take out fixed costs to match our capacity to our new expected volume levels. All facts to the network are included in the reconfiguration. And we expect to close up to 10% of our building, cut back our vehicle and aircraft leads, and reduce labor. The right sizing of our U.S. capacity allows us to accelerate our network of the future initiative. We will be able to more quickly bring down less efficient capacity while further investing in automation across the network, getting us to a more efficient U.S. network faster. The capital requirements to run our reconfigured network will also decrease. We will share more details on our execution plan on our first quarter earnings call in April. Now turning to the changes we made with SurePost. As of January 1st we began delivering 100% of our SurePost volume, and in mid-January we implemented a 9.9% average rate increase on SurePost. Offering a reliable economy service is an important part of our product portfolio and overall value proposition. The changes we made give us greater point-to-point operational control and the ability to provide better service to our customers, which brings me to our Efficiency Reimagined initiatives. Lower overall volume and a reconfigured U.S. network created an opportunity for us to increase efficiency by redesigning processes from end to end. Through our Efficiency Reimagined we expect to deliver approximately $1 billion in savings. Pulling it all together, even while we're undergoing the largest network reconfiguration in our history, we expect to expand U.S. domestic operating margin in every quarter of 2025, with a full year operating margin approaching 9%. As the impact of our cost-out efforts increased over the next 18 months, we expect to pace operating margin improvement to accelerate into 2026, where we expect by the fourth quarter to generate a 12% U.S. operating margin. And we see even more upside potential in the longer term. Turning to guidance for 2025, starting with the macro, S&P Global Forecast Global GDP growth of 2.5% compared to 2024. Real exports and global industrial production are both expected to increase around 2% year-over-year. In the U.S., manufacturing is expected to turn positive for the first quarter of 2025 after seven quarters of negative year-over-year growth, and the consumer is expected to remain resilient. Moving to our 2025 financial outlook, for the full year 2025 on a consolidated basis, revenue is expected to be approximately $89 billion, and operating margin is expected to be approximately 10.8%. Our guidance for 2025 does not reflect any significant potential global trade implications due to changes in tariffs. Now let me give you a little color on the segment. Looking at U.S. domestic, as a result of the actions we're taking, full year 2025 revenue is expected to decline 2.3% year-over-year driven by an ADV reduction of about 8.5%, partially offset by strong expected revenue per piece growth of approximately 6%, and we will wrap the newly on-boarded USPS air cargo business. We expect the intended volume and revenue declines to accelerate as we progress throughout the year. Full year operating margin is expected to be approximately 8.8%, an increase of 130 basis points compared to 2024. And to provide a little shape for the first quarter, which has one fewer operating day compared to the first quarter of 2024 we expect revenue to increase nearly 1% year-over-year, despite ADV being down approximately 4% and we expect to expand operating margin by approximately 140 basis points year-over-year. Moving to the international segment, we expect mid-single digit ADV growth throughout the year, but with lower demand related surcharges than we've seen in prior years. For the year, we expect 2025 revenues to increase approximately 2.5% year-over-year, with an operating margin of around 18.6% and looking at the first quarter, we expect revenue to be flattish compared to the same period last year, and operating margin to be moderately down year-over-year due to lower demand related surcharges. And in Supply Chain Solutions for the full year 2025, we expect revenue to be approximately $11 billion and operating margin to be approximately 8.5%. In SCS in the first quarter, revenue is expected to decline about $500 million due to the reduction in revenue associated with Coyote in the same period last year. Operating margin in SCS in the first quarter is anticipated to be low to mid-single digits due to pressure from purchase transportation costs related to our mail innovations business. We expect the first quarter to be the lowest SCS operating margin in 2025. For modeling purposes, in total below the line, we expect approximately $780 million in expense, with a little more than half in the back half of the year. We expect pension expense to be approximately $37 million for the full year 2025 which is $306 million higher than in 2024 primarily due to the impact of market shifts and interest rates on our pension assets last year. We included a slide in the appendix of today's webcast deck to provide you more detail on pension. The webcast deck is available on the UPS Investor Relations website. Now let's turn to our expectations for cash and the balance sheet. We expect free cash flow to be approximately $5.7 billion including our annual pension contribution of $1.4 billion. Capital expenditures are expected to be about $3.5 billion. While we are accelerating our network of the future initiative, our reconfigured U.S. network should require less investment in vehicles and aircraft as we right size the capital base. We are planning to pay out around $5.5 billion in dividends in 2025 subject to Board approval. We expect to buyback around $1 billion of our shares. And lastly, we expect the tax rate for the full year to be approximately 23.5% as we expect the current U.S. corporate tax regime to remain. We've covered a lot today. We're moving quickly to continue our momentum. The results of our actions will be an even stronger, more agile, and more profitable UPS that's growing in the best parts of the market that value our end to end integrated network. With that Operator, please open the lines for questions."
},
{
"speaker": "Operator",
"content": "Thank you. Your first question today comes from the line of Tom Wadewitz from UBS. Please go ahead."
},
{
"speaker": "Tom Wadewitz",
"content": "Yeah, good morning. You got a lot of big things going on. One, wanted to see if you could talk a little bit more about how can we build confidence that, against a pretty meaningful drop in revenue from the Amazon change that you're able to, I guess, quickly enough get out the fixed costs, so that as opposed to seeing deleveraging and margin pressure that you're seeing the margin improvement that you're talking about, so yeah, I think just a bit more of kind of how that equation can play out, recognizing that we think of the network as having a fair bit of fixed cost to start with? Thank you."
},
{
"speaker": "Carol B. Tomé",
"content": "Tom happy to do that, but maybe I'll just start by talking about the Amazon announcement. We've been a partner to Amazon for nearly 30 years, and we hold that company in high regard. Amazon is our largest customer, but it's not our most profitable customer. Its margin is very dilutive to the U.S. domestic business. Our contract with Amazon came up this year, and so we said it's time to step back for a moment and reassess our relationship, because if we take no action, it will likely result in diminishing returns. So we considered a number of different options and landed on what we think is the best option for our company, and that is to accelerate the glide down of their volume with us, as we commented in our prepared remarks, by more than 50% by June of 2026. As you pointed out, Tom, there are a lot of assets and resources that support that Amazon volume, but as we glide down the volume, we will also be gliding out those assets and resources which gives us the margin expansion that we've explained. Now I'll turn it over to Brian so he can explain how the cost will come out."
},
{
"speaker": "Brian Dykes",
"content": "Sure. Thank you. And Tom as we said before, clearly there's a lot of stakeholders that are involved here, and we needed to make this announcement so we can engage with those stakeholders. But you're absolutely right in your intuition that this is going to require a reconfiguration of the network so that we bring the fixed asset base, the buildings, the vehicles, the aircraft, in line with the new volume levels, and we'll give you a lot more color on how we're going to roll that schedule out on the first quarter earnings call, once we have a chance to engage all the stakeholders involved. But I do think that is the key here, that is the mission, and quite frankly, it's already underway with our team."
},
{
"speaker": "Carol B. Tomé",
"content": "And one reason for a glide down over 18 months, rather than six months because we wanted to make sure that we didn't strand cost. Now, clearly our labor costs will flex with volume. As volume goes up, we have more hours, as volume comes down, we have less hours. So that's just part of the DNA of how we operate our business. But we have I think proven in 2024 that we can close buildings, because with network of the future, we did just that. We closed down 11 buildings with improved service. Nando, would you like to comment on that?"
},
{
"speaker": "Nando Cesarone",
"content": "Sure, thanks. And this question Tom, just to give you comfort here, you'll know that five facilities already in January have been partially or completely closed, and this year we'll have 140 active network of the future projects, 61 of them will go live this year. Of course, just driving up the number of shipments that run through our automated facility. So that gives me a lot of confidence, gives our people a lot of confidence. So we feel good about these moves and we're ahead of schedule."
},
{
"speaker": "Tom Wadewitz",
"content": "Great. Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Jordan Alliger from Goldman Sachs. Please go ahead."
},
{
"speaker": "Jordan Alliger",
"content": "Yeah. Hi, just to follow up on the SurePost side of things, maybe give some sense for how much volume sort of is going to be pulled into the network, can the network, as it's currently constituted today, ready from day one to move all the volume that the post office had done so? And then maybe along with that, can you touch a little bit, is this -- some of this bringing SurePost in house, designed in part at least to replace or infill some of the Amazon business going out in terms of network density? Thanks."
},
{
"speaker": "Carol B. Tomé",
"content": "Well, Jordan, thanks for the question. Let's step back for a moment on SurePost. All SurePost products are sorted through our buildings. We had used the USPS for last mile delivery for a portion of that and through our Engineering and IT matching algorithms, we've been able to redirect a lot of the SurePost volume back into the network. In fact, for delivery by our people. In fact, in the fourth quarter, 50% of the SurePost volume was delivered in the ground network. So as we came to the decision to insource all of it and have it all delivered by our network, it was simply a matter of both service. Up until this year, we had been injecting into the last mile network of the USPS, and the service there was good. But as I think you know, the USPS is changing their operating model, and as a result of those changes, we were going to have to insert upstream into their sorting facilities, and we were very concerned about service deterioration. At the same time, they were going to increase their cost to us, and that value proposition of an increased cost as well as deteriorating service, well, that didn't work for us. So in the middle of December we determined that we would insource 100% of the SurePost volume, which we have done. And I'm pleased to say that's gone very well for us. Yes, we have a few more delivery stops per car, but interestingly, we aren't driving more miles. So when we look at the financial impact insourcing SurePost, we feel very good that it's actually not going to have a material impact to our business at all. Now, we did make a GRI increase, I will admit, but from an operating perspective, it's going swimmingly well and Nando would you like to add?"
},
{
"speaker": "Nando Cesarone",
"content": "Yeah, sure. So Jordan, there's multiple opportunities for us to match shipments now, as we control that volume over multiple days. We've also adjusted our algorithm to really target stops or stop matching to 100 feet of a regular stop. And certainly this helps us smooth the daily dispatch for our employees. So resources in terms of spiking one day versus another, we're able to flatten that and keep the staffing picture very linear for the company. In addition to that, of course, we're exploring different ways on how we can move the volume through slower networks, because it is an economy service as we look at rail and how we leverage rail across the country, as well as ground movements to make sure that we're hitting our service portfolio. Early days show, as Carol had said, mileage index looks good, packages per car look good, the just overall performance right now just really proud of the team, and they continue to try to optimize this service as we go forward."
},
{
"speaker": "Brian Dykes",
"content": "And Nando, if I could just add one thing, because I think it relates to the prior question as well, because I think the investments that we have made in the network and the technology allowed us to insource almost 1.5 million stops within a matter of weeks. I think it's a testament to the operators, but also a testament to the agility that we've created into the network, and that will help us as we move forward with the reconfiguration we're undertaking. The other thing I do think is important that you should know is that we have included some expectation that there could be some churn, right, with the GRI and the changing service. There are some customers that this might not work for, and we've taken that into account in our forecast."
},
{
"speaker": "Jordan Alliger",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of David Vernon from Bernstein. Please go ahead."
},
{
"speaker": "David Vernon",
"content": "Hey, good morning. So a couple questions for you here on this, on sort of the guidance and the growth outlook. When you think about the 10.8% margin that we're going to have for full year 2025, Brian, is there any way to think about what that number would look like if you had sort of adjusted the network at the start of the year, I'm just trying to get a sense for what the run rate level of margin would be if you didn't have the deleveraging that would ultimately come with lower volume? And then Carol, can you maybe talk about what the growth picture looks like X the glide down, there's a lot of concern in the market right now from investors around the organic or lack of organic growth in the small package business and I'm just trying to get a sense for what -- how you guys are thinking about the growth outside of the glide down in the next two years? Thank you."
},
{
"speaker": "Carol B. Tomé",
"content": "Happy to."
},
{
"speaker": "Brian Dykes",
"content": "Sure. So why don't I take the margin question first, and Dave, I think what we've built into our forecast is we are going to be taking the fixed cost out commensurate with the volume drawdown as we go through the course of the year. Now, that will also accelerate as we go into 2026 and you'll see an improvement margin and as we said, we expect to get to the 12% as we go through 2026. I think what's really important is you take a step back and you look at what's going on, even though volume is going to decline relatively significantly in the U.S., rev per piece is going to go up 6% and that will be a combination of customer mix, product mix, but also the continuation of a good base pricing discipline that we've shown in the first quarter. And by taking this, I would say, relatively non-nutritive volume, we're unlocking the ability for us to control our margin profile as we move forward and really push it not just to the 12% but beyond as we move forward, we grow in the areas where it's most important for us."
},
{
"speaker": "Carol B. Tomé",
"content": "And David on the growth algorithm, the small package market excluding Amazon is projected to grow in the low single digits in 2025 and we project to take share. One area of share will be on SMBs. We're really proud of the performance we've seen with our SMB growth, nearly 29% of total business in the U.S. in 2024. We're going to take that up to 32% in 2025, ROA to 35% in 2026 and beyond. That's just one aspect of growth. We can look at it through a customer segment, or we could also look at it through capabilities. And this is what we're really focused in right now is focusing on complex logistics that differentiate us away from the rest of the competition. How did we grow SMBs, because we've invested in our digital access platform. We've invested in pricing architecture of tomorrow, which is moving us from the art of pricing to the science of pricing, allow us to put more potential bids through deal manager, winning more with less discounting, providing better service for that customer. We're also growing into the healthcare space, we're growing into the B2B space through store replenishment. We created a store replenishment system in 2004 with 15 retailers and almost 3000 stores across the nation, helping them with time definite delivery into their stores, which helps drive their productivity. So we're going to take share in this in the slower growth market, but we're not going to cap our margin, because had we not accelerated the Amazon volume down, we would be capping our margin in a slow growth market. So now we have an opportunity to grow and grow margin too. Now you might put the map together for David."
},
{
"speaker": "Nando Cesarone",
"content": "David, I think it's important, because you're absolutely right. There's a lot of moving parts on how we go from 2024 to 2025. But if you look at the change in the revenue, the 91 to the 89 take SCS out of it, because that's really related to Coyote, and you've got about 1.5 billion of revenue decline associated with Coyote. And you just look at the domestic business, look the actions that we're taking with our largest customer, we are going to draw down revenue about $2.5 billion. And then we've got growth, right, that's going to plug that gap of over $1 billion, which as Carol said, is really focused in SMB enterprise, and these differentiated capabilities that are going to allow us to grow in the market and take share."
},
{
"speaker": "David Vernon",
"content": "Alright, thanks. And if I could just squeeze one more in here, Carol, I think your point about share, the post office is raising rates to you and lowering service levels. Is it fair to think that they're doing that to the broader market as well which kind of increases some of the share take opportunity or is that not the right way to think about it?"
},
{
"speaker": "Carol B. Tomé",
"content": "I think that's absolutely the way to think about it."
},
{
"speaker": "David Vernon",
"content": "Thank you."
},
{
"speaker": "Carol B. Tomé",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Stephanie Moore from Jeffries. Please go ahead."
},
{
"speaker": "Joseph Hafling",
"content": "Good morning. This is Joe Hafling on for Stephanie Moore. I maybe wanted to stick on that point on the SurePost and USPS. In the past, you had talked about handing off that final mile being really high ROIC for you guys. I guess, what's changed and maybe how you guys are operating the network now and bringing those volumes in house that you feel comfortable, kind of bringing in all those volumes and can still see good returns?"
},
{
"speaker": "Carol B. Tomé",
"content": "Well, it first starts with service. We pride ourselves on service. We have the leading on time service of any competitor. And if you don't deliver on that value proposition, you can lose the business. So we wanted to first deliver service, but then we wanted to make sure that we can make a buck on this business too. So Nando you might just reemphasize how we're operationalizing the insourcing."
},
{
"speaker": "Nando Cesarone",
"content": "Yeah, sure. So in the past, we'd really have only one shot to match a shipment to a UPS shipment, and that was the morning of arrival. Now we've got multiple days, and our technology is able to see through those days to match as many as we can. In fact, I think last year around 30% plus match. We're in the 50s now, and we continue to refine that number as we start looking at proximity deliveries to UPS already scheduled ground packages. And again, I think one of the bigger ones is just smoothing or the ability to smooth dispatch across the week, which avoids any spikes and therefore we don't need to staff up to one day of the week. In reality, we staff to the entire week, which brings its own inefficiencies. And look, we've got the best dispatch technology that any company would want to have, and we are utilizing it to the fullest extent and we don't mind what we see in terms of results right now. I think they've done a great job being efficient and putting that volume into our network."
},
{
"speaker": "Carol B. Tomé",
"content": "And Matt, you might talk about how we are priced relative to the market."
},
{
"speaker": "Matt Guffey",
"content": "Yeah, so as Carol mentioned, look, we came out with the 9.9% GRI and we made sure that we aligned the value to service. Number one, what was most important is to protect the service of our customers that we just highlighted. But I'd ask you just to remember a couple things, SurePost is a product in our full portfolio. So when our customers buy, they don't just buy the SurePost product they also buy our ground residential, which is our premium offering. So both of these, the product was designed and once the way we price it to be, it's an economy product that is less time sensitive. But both ground residential and ground SurePost will provide service and reliability to our customers, and we price accordingly to the value."
},
{
"speaker": "Brian Dykes",
"content": "And Joe on the ROIC point, I just want to point out, one of the things we take a lot of pride in is getting the most out of our assets at UPS. And you can see from our CAPEX forecast, we are not going to be adding assets for this volume. It fits into the network, and as Nando said we are able to work it into the dispatch. And we are focused on managing the capital base and driving ROIC higher, which you see in our 2025 guide."
},
{
"speaker": "Carol B. Tomé",
"content": "Yeah, we anticipate based on the numbers we've just laid out for you today, that our return on invested capital will grow about 300 basis points year-on-year."
},
{
"speaker": "Joseph Hafling",
"content": "Great. Thanks so much for the thoughtful answer, guys."
},
{
"speaker": "Carol B. Tomé",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Ken Hoexter from Bank of America. Please go ahead."
},
{
"speaker": "Ken Hoexter",
"content": "Hey. Great. Good morning. Can you qualify what Amazon revenues were for the full year, I know this was the first time you gave a mid-year at 11.5%. I don't know if you gave a final year, but as Amazon takes back those volumes, can you maybe talk about competition now in different segments, I guess you've always said, the reason why they stick with you is you do different things for them, such as returns, pickups, things that they rely on you. Does this mean we should expect an increasing amount of competition in areas that you kind of had kind of moat around as your specialty versus the market, and how should we think about that from a competitive standpoint? Thanks."
},
{
"speaker": "Carol B. Tomé",
"content": "Yes, so for the full year, Amazon made up 11.8% of our total company revenue. From a competitive perspective, I think it's important to note that Amazon will remain a customer of UPS when we finish our accelerated glide down on those areas that are a win for us and a win for them. They have a one-way model as you know, and we can handle things today that they can't handle. Amazon, when you think of them as delivering packages, you think of them as a vertically integrated retailer, because that's what they are, ignoring their AWS business, but that's what they are, it is a vertically integrated retailer who needs some help with some things, and we're going to provide that help for them in a more nutritive fashion, when we reach the accelerated glide down. I will tell you Ken, this was not their ask, this was us, this was UPS taking control of our destiny. We'll be working with them, of course, on the accelerated glide down because they've got to figure out how to catch some of this volume. But we are not anticipating changes in the competitive environment as a result."
},
{
"speaker": "Ken Hoexter",
"content": "Great. I guess if I could throw a follow in, the pace of the consolidated, the facility shutdowns, Nando you were talking about how you've already started that. Is there kind of numbers you can throw out, maybe update us on how quick you can get some of those out?"
},
{
"speaker": "Nando Cesarone",
"content": "Yeah, Ken, as I mentioned before, we've got a lot of stakeholders that we need to talk to related to the network reconfiguration. We're going to lay that out for you on the first quarter call. It's fair to say it will accelerate as we go through the year, especially in the second half and then into the first half of 2026. But give us until April, and we'll lay that plan out for you."
},
{
"speaker": "Ken Hoexter",
"content": "Great. Thanks. Appreciate the time."
},
{
"speaker": "Carol B. Tomé",
"content": "Thank you."
},
{
"speaker": "Nando Cesarone",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Ari Rosa from Citigroup. Please go ahead."
},
{
"speaker": "Ariel Rosa",
"content": "Hey, good morning. So a lot of changes underway. Carol, I was hoping maybe you could paint a picture for us of how you envision the future of UPS, say five or 10 years from now. And specifically, you talked about some of these growth areas, maybe you could give us some color on how you see kind of the TAM of those growth areas, whether it's healthcare, SMB, and what role UPS plays within that market, such that the top line revenue growth doesn't experience the material decline that I think a lot of people are perhaps concerned about this morning? Thanks."
},
{
"speaker": "Carol B. Tomé",
"content": "Yeah. Thank you for that question. I love to talk about our future, because I think our future is very bright. We are leaning into the segments of the market that value our end to end network, but we're doing it through differentiated capabilities. And so when you think about the future of UPS, think about complex logistics where we are providing solutions for the segments of the market that no one else has. Think about RFID tagging, which started as a productivity initiative for us, has turned into an inventory management opportunity and benefit for our upstream customers. Think about healthcare. Healthcare is such an opportunity for us. The healthcare market growth slowed down a bit in 2024. The market grew 2.5%, we grew 5%, so our healthcare revenue for the year about $10.5 billion. We've got plans to take that to $20 billion by 2026 and the TAM, the addressable market just in complex is over $80 billion. To break down that $10.5 billion for you, we've got $5 billion in complex, we've got $1.5 billion in clinical, and we've got about $4 billion in non-complex. So we are going to over index on the complex and clinical over the next several years. As we think back now on these differentiated opportunities, international diversification is also an opportunity for us. A couple of years ago, we realized that manufacturers in China were moving to a China plus one strategy where they weren't exiting China, but they were moving manufacturing to other locations, like Vietnam. So we got ahead of it. We expanded our operations and we see in these trade lanes where we expanded operations, 20% growth, 30% growth. So international diversification is another opportunity for us. So this is not a company that's shrinking. This is a company that's gliding down its largest customer, but it's not a company that's shrinking. It's a company that's growing. Now we laid out some revenue targets and operating margin targets a year ago in March. We're going to hit the operating margin targets. We are absolutely confident on that. We will reset the revenue targets once we get through all of this, because we need to give you color and clarity as to where we're taking the top line. But there's plenty of growth ahead for us. A differentiated UPS, complex logistics which is the premium part of the market."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Chris Wetherbee from Wells Fargo. Please go ahead."
},
{
"speaker": "Chris Wetherbee",
"content": "Hey, thanks. Good morning, guys. Carol, maybe I can pick up on that last point. I think the 2026 question is an important one, and I get the margin mix up as a result of some of the glide down here. But I guess as we think about this process, I mean, is there a way you can give us comfort that we won't be sort of in a flattish or maybe down earnings scenario for a multi-year period of time, so I guess, in other words, maybe more directly, can you grow earnings in 2026 and I guess if you can, can you walk us through maybe some of the parameters, I know you want to lay them out in more detail in April, but I think just given sort of the magnitude of what we're talking about here, some help around kind of guide points for 2026 I think are important?"
},
{
"speaker": "Carol B. Tomé",
"content": "And I think that's absolutely a fair question. And as I talked about this last night, so we are like someone is going to ask this question, we need to come out and do that for you. Not going to do it on today's call. We need to come out and do that for you in a thoughtful way, so we can give you the TAMs, we can show you how we're growing. We can do that in a thoughtful way. Brian -- we'll figure out a time to do that this year, maybe at the end of the first quarter. We'll figure out a time to do that. But is there any color that you want to share right now?"
},
{
"speaker": "Brian Dykes",
"content": "Yeah. And Chris, and while we will absolutely lay out 2026 I just want to make sure that we're also clear on what 2025 is going to look like, because, we do have both plans as we draw down the volume, we'll be taking fixed costs out. We also have Efficiency Reimagined that we talked about that's going to drive $1 billion in cost savings through process improvement. That's also underway. We're starting to see results from it, and it's an exciting program because it makes us a much more agile organization. So as we progress through the quarter, we will expand domestic operating margin in every quarter of this year, right. We will expand it every quarter of this year, and we will finish with almost 130 basis points better than we finished last year. That's going to accelerate as we go into 2026 and we'll lay that out for you on the coming call."
},
{
"speaker": "Carol B. Tomé",
"content": "We're growing profit dollars, not just margin. We're growing profit dollars, and I think we're not shrinking the profit dollars, we're growing the profit dollars."
},
{
"speaker": "Chris Wetherbee",
"content": "And that's something we can think about in 2026 as well?"
},
{
"speaker": "Carol B. Tomé",
"content": "Yeah, absolutely, because we will accelerate the cost out related to the fixed cost."
},
{
"speaker": "Chris Wetherbee",
"content": "Okay, that's helpful. Thank you."
},
{
"speaker": "Carol B. Tomé",
"content": "Yeah."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Scott Group from Wolfe Research. Please go ahead."
},
{
"speaker": "Scott Group",
"content": "Hey, thanks. Good morning. Carol, you said a few times that this business has been very dilutive to margin. I'm just wondering, like, would you characterize this as a mid-single digit margin, a low single digit, a no margin business, that's the first thing? I totally get the mix impact here. But when I just think about price, right, if we're losing 10%, 15% of the volume, and we to some extent, need to backfill that does that in any way, change your pricing discipline? And then last thing I know, I'm asking a lot, but last thing, do you think we should just assume that the other 50% of this business goes away in a few years, when the contract comes up again?"
},
{
"speaker": "Carol B. Tomé",
"content": "So I'll answer the last part first, I don't think so. Think about returns. We have 5200 UPS store locations that make it very convenient for customers of Amazon to return their Amazon packages. We do that very, very well for Amazon. So there's a place of harmony if you will between our two companies. So I don't think it will go all away. I think we're landing at the right spot with this accelerated guide down. I think it would be inappropriate for me to talk about the profitability of any account. This is extraordinarily dilutive, and I'll leave it at that. And perhaps you could back in to the number if you look at the percentage of revenue and the volume that we described, and that might help you think about the dilution. Brian, anything you want to add to that."
},
{
"speaker": "Brian Dykes",
"content": "And Scott, I also wanted to because you asked about pricing discipline. And I think this is a really important point because we recently figuring the network to the new volume level. So we are not chasing volume in order to fill empty capacity. The capacity will adjust to the new volume level. And that’s really a key point because we have some pricing discipline in the second half of 2024. We saw great revenue per piece growth in the fourth quarter and that is going to extend into 2025 and be a portion of the rev per piece improvement that we see. That pricing discipline is implemented. We've got processes in place, and we absolutely are going to continue to keep that going forward."
},
{
"speaker": "Scott Group",
"content": "So you think you can reduce capacity, one for one with the volume drop here?"
},
{
"speaker": "Brian Dykes",
"content": "Yes."
},
{
"speaker": "Carol B. Tomé",
"content": "Yes."
},
{
"speaker": "Scott Group",
"content": "Thank you guys. Appreciate it."
},
{
"speaker": "Carol B. Tomé",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Ravi Shankar from Morgan Stanley. Please go ahead."
},
{
"speaker": "Ravi Shankar",
"content": "Great. Thank you. Just a few things, you quantified the Amazon revenues a couple of times now. Can you quantify what percentage of the U.S. domestic volumes are Amazon because I think that's pretty important stat for doing the math here? And also to your point on the returns, I think Amazon did start trialing an in house return program last year. Do you see risk to that scaling up over time as well?"
},
{
"speaker": "Brian Dykes",
"content": "So Ravi, on the volume, if you think around 20% of the volume in the U.S. network 2025 depending on the time and the price, look on the returns and I'll let Matt talk a little bit about our returns portfolio in a second. But what I would say is, there's a lot of return solutions in the market. Here's what I know, our returns growth continues to grow with UPS Store. We have a great footprint. We have a great customer experience. And Matt, maybe you want to talk a little bit about how we've been adding to that."
},
{
"speaker": "Matt Guffey",
"content": "Yeah, I think just Carol hit on it. When you think about the physical footprint that we have in the United States, 5200 stores give us access in the proximity to very, very close to most consumers in the U.S. And just the overall experience, right, is the key component. Returns in reverse logistics is hard to do, and this gives us a capability and we continue to build on that. Let me just give you one other example, though we've also added if you remember, we acquired Happy Returns. This compliments that returns experience, because now not only do you have the physical, but you can also do the digital, which is a no box, no label, which drives a much better experience for the consumer, for UPS, and for our customers as well. So we continue to add to this and believe that we have the best in class returns portfolio."
},
{
"speaker": "Carol B. Tomé",
"content": "And I might dimensionalize the glide down in a different way, just to help you in the modeling between 2021 and 2024 on average, we glide -- the glide down was about 250,000 packages per day per year. Between 2024 and 2026 on average and of course, this is not the average, it is just an average, but the average between 2024 and 2026 will be 1.2 5 million packages per day per year. So five times as fast as what we did before."
},
{
"speaker": "Operator",
"content": "So your next question comes from the line of Brian Ossenbeck from J.P. Morgan. Please go ahead."
},
{
"speaker": "Brian Ossenbeck",
"content": "Hey, good morning. Thanks for taking the question. Just a couple of follow-ups here. Given that big impact on volume and I'm assuming Amazon was a pretty big peaker during peak season. Can you talk about the broader implications for the network for peak season, I know you can give us more update in April after I'm assuming you speak to the teamsters about this big change, but can you give us a sense in terms of what may be complications you can encounter with that, can you still reach Sunday delivery with SurePost? Thank you very much."
},
{
"speaker": "Carol B. Tomé",
"content": "So from a peak perspective, we'll operate peak like we do every other year. We won't have as many leases I suspect but we will operate just like we do any other year. Nando, would you like to add?"
},
{
"speaker": "Nando Cesarone",
"content": "So regarding peak, we stretch our network with variable costs. So we'll rent equipment. We'll set up temporary sort facilities. A lot of that's not going to be required. We'll lease aircraft, we won't need to. We rent tractors and trailers and shifters and all that stuff from our vendors, and clearly as the volume settles, that's an opportunity for us to not rent those pieces of equipment this peak season. So I think we've built that little hedge for ourselves with the variable cost that we're just going to pull all that back in."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Bascome Majors from Susquehanna. Please go ahead."
},
{
"speaker": "Bascome Majors",
"content": "Carol and Nando, I think we've seen more change in the parcel space in the last two years than the prior 15. Can we talk another big picture question here, when we roll out to 2027-2028 number one, do you think that we've seen the last of the big shoes to drop on some of the changes to the competitive landscape, cost structures, that sort of thing with you and your competitor or could there be more seismic shifts? And you already talked a bit on a previous question about where you think UPS wins in that long term landscape, can you talk a little bit about your competitors, like, where do FedEx ground and Ground Economy win and have an advantage, where does USPS ground advantage win, where do the regional or gig economy players win, just to think about the competitive landscape more holistically, longer term? Thank you."
},
{
"speaker": "Carol B. Tomé",
"content": "Well, there's a lot to that question, and we were focusing our comments today pretty much on 2025 and cheating in a little bit to 2026 but happy to think big picture on 2027 and 2028. I think the world is changing and the rate of change is accelerating. It's hard to imagine a big shoe to drop. I don't think we fully understand the impact of generative AI and what it can mean for productivity amongst industries broadly. Certainly it is an opportunity for us to drive productivity and a better customer experience. Would it put us at a competitive disadvantage to anyone, I can't see that. In fact, I think we're ahead of most companies in this space, but I need to be mindful that that's changing. We need to be mindful that trade follows policy, and tariffs aren't necessarily good for trade. So there may be changing trade lanes. I don't know if it's a big shoe to drop, but it could be changing trade lanes, but we do know of the largest trade lanes out in the world, they are in Asia, and we're expanding our air hub in Hong Kong, and building new and Philippines. So we're going to be ready to take advantage of these changing trade lines, however, they may come about. There's a lot of opportunity for UPS to grow in the differentiated logistics, complex logistics world. The capabilities that we are enabling throughout our business, it creates stickiness with customers like we've never seen before. Perhaps that's a big shoe to drop, because our churn improved more last year than it's been since I got here. So from a competitive positioning perspective, I do believe stickiness puts us at a point of differentiation. Now, perhaps when we come back Brian and do the addressable markets and where we're going to grow and the revenue, we can talk more about our competitive positioning. But trust me on this, we take every competitor and we tear it apart to understand where we may have a gap and how we might need to fill that gap. I'll give you two examples, in Europe last year, we didn't have an economy product, and that was a problem for us. So our IT team, working with our pricing team and our operating team in Europe, they fast tracked that didn't they Kate."
},
{
"speaker": "Kate Gutmann",
"content": "Sure did, growing double-digit."
},
{
"speaker": "Carol B. Tomé",
"content": "Growing double-digit. We needed to offer a weekend solution. What did we do on weekend, Kate?"
},
{
"speaker": "Kate Gutmann",
"content": "Rolled it out, first mover in Canada and now in Europe and major countries, especially in Western Europe, and both of them exceeding the revenue targets and doing better on the cost side of it, because we just built it into our regular efficiencies that we do around the world."
},
{
"speaker": "Carol B. Tomé",
"content": "So if we see a gap that we need to fill, we do it."
},
{
"speaker": "Bascome Majors",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Bruce Chan from Stifel. Please go ahead."
},
{
"speaker": "Bruce Chan",
"content": "Yeah, thanks operator, and good morning everyone. I think it's very encouraging to see some of the proactive changes here, and maybe I'll just focus in on SPSF because it strikes me that the RFID initiative is very helpful in optimizing your assets to some of these fairly significant market developments. Looks like you're underway in Phase 2. So maybe what's the target for rollout across the entire package car fleet and any comments that you have around the timeline, especially in the Phase 3 would be great?"
},
{
"speaker": "Carol B. Tomé",
"content": "So Nando, would you like to take that?"
},
{
"speaker": "Nando Cesarone",
"content": "Yeah, so we've got a schedule, of course prepared, a dedicated team to execute the changes as we talk about the changes to the Amazon and other changes here with SurePost. That schedule is completely linked to our financial plan, and we have full confidence that we can execute those changes. In addition to what Carol mentioned earlier, especially with RFID tagging, we've got an opportunity to pull customers in where the stickiness just becomes a real big discussion and decision if they ever want to really disconnect from that technology, because it's going to not just help delivery of packages, but also their back office environment, which we're really excited about."
},
{
"speaker": "Carol B. Tomé",
"content": "We should be rolled out this year. And from a customer stickiness perspective, Matt, you can give a couple of examples."
},
{
"speaker": "Matt Guffey",
"content": "Yeah, yeah. So what Nando just highlights and Carol framed is it's really important, because we do get from RFID, we get some productivity benefits and efficiency benefits. But from a customer value proposition, it's resonating very, very well. When you think about how you connect this to our total value proposition in the B2B or commercial space, we typically think industrial and high tech in some of these areas, but retail is a big driver through store replenishment, and this has really enabled us to win in this space. We brought over and if you heard Carol in her opening comments, she highlights this, but 15 retailers that we've already on-boarded, and I would -- large enterprise retailers in the United States that really love the RFID capability, because they have inbound visibility to what's hitting their docks, and it allows them then to spread their workforce and how they inbound that volume. It also, again, it complements us from a commercial perspective, because we can deliver many packages to just one location. The last piece I would add on to that which when you couple this together, is we're able to give these retailers inbound delivery windows, and it allows them that flexibility, so you have the physical capability, but then you have the visibility through RFID. And we believe we're just on the edge of something great here to work with our retailers to continue to grow."
},
{
"speaker": "Carol B. Tomé",
"content": "So it improves their stockings, it reduces their labor hours. It's a win, win, win. So we'll continue to lean into that in a big way. And we're ahead of the game here when we look around the competitive landscape around the world."
},
{
"speaker": "Bruce Chan",
"content": "Great. Thank you."
},
{
"speaker": "Carol B. Tomé",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Brandon Oglenski from Barclays. Please go ahead."
},
{
"speaker": "Brandon Oglenski",
"content": "Hi, good morning, and thank you for taking my question. Carol, maybe just a quick two part one here on capital, given that you are right sizing the domestic network right now, what would be the right level of maintenance CAPEX for the business and is 3.5 the level you took it to this year, which is, I think, a pretty drastic cut from where you thought you'd be a year ago, is that sustainable? And then I guess, in that same context, how prudent is a $1 billion share repurchase this year with anticipated dividend payments of 5.5 billion, especially when your payout ratio looks like it's going to be approaching 80% of trailing earnings when I think you're targeting something closer to 50? Thank you."
},
{
"speaker": "Carol B. Tomé",
"content": "So on the capital side, Brian, I'll let you address that, and then I'll talk about the allocation of shareowners."
},
{
"speaker": "Brian Dykes",
"content": "Sure. Yeah, Brandon, and thanks for the question, because capital management is very important to us. You see, we have brought down the capital now. What I will say within that CAPEX plan, we're fully funding network of the future, and I think along with this, in concert with the network reconfiguration, that's going to allow us to take that 63% of volume process through automated facilities up significantly as we rationalize less efficient conventional capacity. So we're fully funding that and we're moving forward with it. Where we are able to tighten up is the volume drawdown will allow us to operate with quite frankly, fewer vehicles, fewer aircraft, and fewer buildings. And that's what we're -- that's what we're anticipating. I think, as you think about going forward, we will be managing the capital base. So thinking about CAPEX in line with depreciation is where we think that we're going to need to manage it as we continue to automate, but also manage the capital base as we improve ROIC. That's realistic. And if you go back to Europe and kind of before we were allocating a lot of capital into a specific customer, that's kind of where we were."
},
{
"speaker": "Carol B. Tomé",
"content": "And to your question about, is it prudent to buy back shares, and what about your payout, and isn't it too high? I think it's important to note that we have a very strong liquidity position. We had a benefit from 2024 on a tax payment that we will pay in 2025 but if you push that tax payment back into 2024 we're actually generating more cash in 2025 than we did in 2024, strong liquidity with access to capital. From a dividend payout perspective, we're targeting 50% of earnings, and we're higher than that. It's important to note, however, that it's distorted because of the below the line, non-cash pension expense, and if you ignore the non-cash pension expense, the payout ratio isn't as high as it appears at its base. So plenty of liquidity to pay the dividend and on the share repurchases, the way we're thinking about it today is our compensation plans are dilutive from an EPS perspective, so $1 billion just basically protects the dilution. What Brian and I have talked about is, why don't we debt finance that because with the yield on the stock and the after tax cost of the debt, it's a really good trade, because the after tax cost of the debt is slower than the yield on the stock. So that's what we're thinking about in terms of how we would fund a share repurchase."
},
{
"speaker": "Brandon Oglenski",
"content": "Thank you."
},
{
"speaker": "PJ Guido",
"content": "And Greg, we have time for one more question."
},
{
"speaker": "Operator",
"content": "Okay, that question comes from the line of Jon Chappell from Evercore ISI. Please go ahead."
},
{
"speaker": "Jonathan Chappell",
"content": "Thank you. Good morning. Just quick market one. I understand that you implemented the GRI for SurePost, Brian, you talked about strong RPP growth of 6% for U.S. domestic, which is obviously going to be a big mix impact as well. But we're kind of hearing in the market and Carol highlighted some of the challenges on kind of core volume of some pricing pressure overall, just on core organic business. Are you seeing any of that, is there a little bit more competitive spirit out there, I guess, to kind of maintain and/or grow share, just given some of the challenges in the core markets?"
},
{
"speaker": "Carol B. Tomé",
"content": "I think our fourth quarter results are proof positive of the strength of our pricing approach. We had very strong keep rates on our base rates, as well as our holiday demand surge charge. Our GRI on our core business is 5.9% for 2025. We're going to keep probably 50% of that. So the 6% RPP growth, you can break it down, a third, a third, a third, can't you Brian, why don’t you go ahead and do that?"
},
{
"speaker": "Brian Dykes",
"content": "That's right. So if you think about where that is coming from, Carol is exactly right. It's about a third from the strong base race and look, there's nothing sexy about it. This is a grind, and Matt and I spend every Monday morning going through how we're seeing the market evolve, the pricing, and looking at how customer is performing. And we've created a lot of discipline around that, so it's a rational price environment, but we're getting really smart about how we do it, and that helps us get the key. Matt, I'll let you elaborate on it in one second. On the mix, on the other pieces, though, you've got a third that base rate. You've got a third that's customer mix driven, right. So, as Carol said, our focus on SMBs is allowing us to win there. And when you look at it, we won through peak and SMBs, and we also won it through peak on premium products, right, which is the other third of the rev per piece improvement. Matt, do you want to add anything?"
},
{
"speaker": "Matt Guffey",
"content": "I think you hit on two points that are important. One is, we just put a lot of rigor and discipline behind the pricing -- our pricing practices here and we'll continue that. To Brian's point, it is an interesting stat, because in Q4 we really leaned in on the premium segment. 60% of our wins in Q4 were in the premium segment. And that's focused on the products that value our end to end network what Carol highlighted as complex. The last thing I would just highlight is, look, we've talked to you about schedule tomorrow, which is our pricing technology. And we've talked to you about Deal Manager, which allows us the ability to leverage pricing signs for SMBs. Now with Deal Manager it's in the fourth quarter. 96% of our deals we've been able to price up to $10 million all came through Deal Manager, which allows us speed, we can turn time and we can customize them unique for the customers. So it's given us a lot of flexibility to drive the right value for our customers, but also align our costs and our prices."
},
{
"speaker": "Jonathan Chappell",
"content": "Thanks."
},
{
"speaker": "Operator",
"content": "I will now turn the floor back over to your host, Mr. PJ Guido."
},
{
"speaker": "PJ Guido",
"content": "Thank you, Greg. This concludes our call. Thank you for joining and have a great day."
},
{
"speaker": "Operator",
"content": "Ladies and gentlemen that does conclude your conference for today. Thank you for your participation and for using AT&T Teleconference. You may now disconnect."
}
] |
ups | 2,024 | 3 | [
{
"speaker": "Operator",
"content": "Good Morning, my name is Greg Alexander, and I will be your facilitator today. I would like to welcome everyone to the UPS Third Quarter 2024 Earnings Conference Call. [Operator Instructions] It is now my pleasure to turn the floor over to your host, Mr. PJ Guido, Investor Relations Officer. Sir, the floor is yours."
},
{
"speaker": "PJ Guido",
"content": "Good morning, and welcome to the UPS third quarter 2024 earnings call. Joining me today are Carol Tome, our CEO; Brian Dykes, our CFO and a few additional members of our executive leadership team. Before we begin, I want to remind you that some of the comments we'll make today are forward-looking statements within the Federal Securities Laws and address our expectations for the future performance or operating results of our company. These statements are subject to risks and uncertainties, which are described in our 2023 Form 10-K and other reports we file with or furnish to the Securities and Exchange Commission. These reports, when filed, are available on the UPS Investor Relations website and from the SEC. Unless stated otherwise, our discussion today refers to non-GAAP adjusted results. For the third quarter of 2024, GAAP results include an after-tax net gain of $36 million or $0.04 per diluted share, comprised of a $152 million gain from the divestiture of our Coyote Logistics business, net of transformation strategy costs of $116 million. Transformation strategy costs consisted of after-tax costs of $81 million related to our Fit to Serve program and $35 million related to our Transformation 2.0 program. Additional detail on our transformation costs and initiatives as well as a reconciliation of non-GAAP adjusted amounts to GAAP financial results is available in today's webcast materials. These materials will also be available on the UPS Investor Relations website. Following our prepared remarks, we will take questions from those joining us via the teleconference. [Operator Instructions] Please ask only one question so that we may allow as many as possible to participate. You may rejoin the queue for the opportunity to ask an additional question. And now, I'll turn the call over to Carol."
},
{
"speaker": "Carol Tome",
"content": "Thank you, PJ, and good morning. On our last earnings call, we said that the second quarter would not only be the bottom, but a turning point for our performance and that we would return to revenue and profit growth in the third quarter, which we did. I would like to recognize and thank UPSers for their hard work and efforts. Their relentless focus on driving productivity while ensuring excellent customer service allowed us to deliver these results. In the third quarter, we faced a macro environment that was slightly worse than we expected. In the U.S., online sales slowed and manufacturing activity was lower than we anticipated. This slowdown in manufacturing activity was also true outside of the U.S. as we continue to see lower industrial production weigh on volume in certain geographies. But the macro-environment didn't prevent us from growing revenue and profit. As we leaned into the parts of the market that value our end-to-end network and we drove expense leverage through ongoing productivity initiatives. In the third quarter, our consolidated revenue was $22.2 billion, an increase of 5.6% versus last year. Consolidated operating profit was $2 billion, up 22.8% from last year and consolidated operating margin was 8.9%. In the U.S., this was the second consecutive quarter of average daily volume growth, and it was our highest year-over-year ADV growth rate since the first quarter of 2021. In International, average daily volume growth finished flattish and continued the upward momentum we've seen since the first quarter of this year. And in SCS, air and ocean forwarding contributed to strong revenue growth. Looking at the U.S., during the quarter, we focused on growing certain pockets of commercial business and grew B2B volume by nearly 1% compared to last year. One of the areas of commercial focus was retail B2B. Our B2B routes are in retail. In fact, we deliver merchandise to over 20,000 retail outlets across the country. To serve these customers, we offer a store replenishment with delivery window solution that provides retailers daily inventory replenishment within a two-hour window. Within this solution, we also provide visibility to the number of packages scheduled to be delivered. Our store replenishment solution, along with our RFID technology enables retailers to reduce stockouts and more efficiently run their receiving operations. This is just one example of how our customer-focused capabilities are enabling us to win new commercial volume. Now that U.S. volume is flowing back into our network, we have heightened our attention to revenue quality with a focus on the segments of the market we want to serve. You will recall that in the second quarter, we saw an unexpected surge of short zone lightweight e-commerce packages flow into our network. In the third quarter, we responded strategically, adjusting our pricing and optimizing our operating plans on a portion of this business. Further, we increased our focus on matching our pricing to the quality and attributes of the service we provide. We did this by leveraging the power of pricing science through our pricing architecture of tomorrow or AOT technology. Our revenue per piece growth rate improved in the third quarter from what we reported in the second quarter, and we expect this trend to continue. On the cost side, our team did an excellent job of managing expenses across the board. As it relates to our two major cost-out initiatives, we are continuing to deliver solid results. Fit to Serve, which was designed to optimize and rightsize our management structure, is slightly ahead of forecast. And with Network of the Future, so far this year, we've completed 45 operational closures, including nine full buildings that have been shut down. I'd like to give you a brief update on our customer-first, people-led innovation-driven strategy, starting with customer-first. As we discussed, we have a goal to become the number one complex healthcare logistics provider in the world. To that end, we said we would pursue certain inorganic opportunities and we have. Last month, we entered into an agreement to acquire Frigo-Trans, a move that will enhance our end-to-end temperature-sensitive healthcare capabilities across Europe. Today, 80% of pharmaceuticals in Europe require temperature-controlled transportation. Frigo-Trans offers pan-European cold-chain transportation as well as temperature-controlled and time-critical freight forwarding capabilities. Plus, Frigo-Trans has temperature-controlled warehousing capabilities with every temperature from cryopreservation, which is minus 196 degrees Celsius to ambience, which is about 25 degrees Celsius. We are targeting to close the Frigo-Trans acquisition in the first quarter of next year. Complex healthcare logistics is a growing business for us and we're continuing to invest in the capabilities needed to accelerate growth. We have dedicated healthcare facilities in 36 countries and provide specialized handling and visibility to our customers through our UPS premier product. In the third quarter, we generated $2.5 billion in consolidated healthcare revenue, which contributed to revenue growth across all three segments. Shifting to International. In time for the holidays, we've made several enhancements. In September, we expanded residential Saturday delivery to the eight largest markets in Europe without an additional charge. This enhancement meets our customers' need for speed, and we now provide a superior service offering. Further, we sped up deliveries to over 35 countries across Asia, Africa and the Middle East. And to meet the expected demand for this year's peak holiday season, we added over 200 flights connecting Asia to Europe and the U.S. Quickly touching on DAP, our Digital Access Program, DAP continues to deliver strong SMB growth in both B2B and B2C segments. In the first nine months of this year, we generated $2.3 billion in global GAAP revenue, and we expect to deliver over $3 billion in GAAP revenue for the full year. As you know, we have been onboarding our new air cargo business with the United States Postal Service. During the third quarter, our network planning teams worked closely with the USPS to ensure the transition progressed smoothly and it did. As of October 1, all contracted USPS air cargo business has been fully onboarded and we expect this business to deliver strong consistent revenue at an attractive margin. Moving to People-led. Since our founding, we've had a culture of driving safe work practices. And by using new technology and tools, we've seen a dramatic improvement in the number of injuries and accidents. For example, in the U.S., this year we've had our best auto safety results in 10 years. The advances in safety were achieved through innovative driver education and training, like our Integrad driver training schools. This focus on safety enables driver achievements like our Circle of Honor, which recognizes drivers with 25 years or more of driving without an accident. Today, our Circle of Honor has grown to nearly 10,000 drivers. Now let's turn to Innovation Driven, which for this call is all about the peak holiday season. This year's holiday season has only 17 shipping days between Black Friday and Christmas Eve. We haven't seen such a compressed peak since 2019. We do peak better than anyone and with six years in a row of industry leading service, we're confident our plans and execution will make that seven. To prepare, we've been collaborating with our customers on daily volume expectations and the timing of their promotions. While our customers are still expecting a good holiday selling season, recently, shippers have tempered their volume expectations. In any case, we'll be ready to deliver and we'll leverage our network planning tools and other proven technologies to control first how the volume comes in. Second, how to flow more volume to our automated facilities. And third, how to adjust the network to operate as efficiently as possible. And talking about efficiency. This year on our peak day, which is December 18th in the U.S. we expect to deliver 2 million more packages than we did on peak day last year, but we'll do it at a higher productivity rate. This will be possible due to the efficiency improvements we've made over the years and the use of seasonal support drivers, many of which are experienced part time UPSers who work inside our facilities. To sum it up, we're ready to deliver another successful peak. Moving to our financial outlook, we continue our better, not bigger approach, enhanced by some bold moves. The addition of the USPS air cargo business and the divestiture of Coyote are recent examples. With these moves, we eliminated a highly volatile truckload brokerage business and added air cargo volume that is predictable and margin positive. Looking at our consolidated revenue outlook in the third quarter, we increased our emphasis on revenue quality resulting in a glide down of certain volume which we expect will continue into the fourth quarter. Given our third quarter results, our latest peak volume expectations, and adjusting for the impact of the Coyote disposition, we now expect consolidated revenue of approximately $91.1 billion for the year and are lifting our consolidated operating margin target to approximately 9.6%. Brian will provide more details. So with that, thank you for listening. And now I'll turn the call over to Brian."
},
{
"speaker": "Brian Dykes",
"content": "Thank you, Carol, and good morning, everyone. This morning, I will cover our third quarter results, review our capital allocation for the year, and then I'll wrap up by providing additional detail for our fourth quarter and full year financial outlook. Starting with our results, in the third quarter, we returned to revenue and profit growth the first time in two years. Looking at our consolidated performance, in the third quarter, we generated $22.2 billion in revenue, an increase of 5.6% compared to the third quarter of last year, with all three of our business segments delivering revenue growth. Consolidated operating profit was $2 billion, an increase of 22.8% versus the third quarter of 2023, and consolidated operating margin was 8.9%, an increase of 120 basis points compared to the third quarter of last year. Diluted earnings per share was $1.76, up 12.1% from the third quarter of 2023. Now let's look at our business segment. In the U.S. domestic segment, our performance in the third quarter was driven by two factors. First was strong volume growth, the highest growth rate we've seen in more than three years. And second was excellent cost management, which resulted in a year-over-year decrease in cost per piece of 4.1%. U.S. Average Daily Volume or ADV increased 6.5% compared to the third quarter of 2023. Looking at product mix in the third quarter, ground average daily volume increased 8.9%, while total air average daily volume was down 6.3%. We continue to see customers shifting down from air to ground and some ground volume is shifting down to SurePost. Within ground, SurePost volume levels rose slightly compared to the second quarter, driven by growth in our Digital Access program. While SurePost volume comes at a lower revenue per piece, given the enhancements we've made to our matching algorithm, we were able to redirect more SurePost packages into our network, driving delivery density. For the quarter, B2B average daily volume was up 0.8% year-over-year, increasing for the first time in two years. Growth was driven by SMBs, which had an increase in B2B average daily volume of 3.8%. B2C average daily volume increased 11% year-over-year and made up 58.3% of our volume, a slight downward shift from the second quarter. In terms of customer mix, we saw ADV growth from both enterprise and SMB customers. SMBs made up 29.4% of total U.S. volume in the third quarter. For the quarter, U.S. domestic generated revenue of $14.5 billion, up 5.8% compared to last year, driven by strong volume growth. As expected, U.S. domestic revenue per piece was down year-over-year. In the third quarter, revenue per piece declined 2.2% year-over-year, but showed a 40 basis point sequential improvement from the second quarter. Breaking down the components, first, we took actions to address revenue quality, which translated into higher base rates. In the quarter, base rates increased the revenue per piece growth rate by 170 basis points. Second, the combination of product mix, lighter weights and shorter zones decreased the revenue per piece growth rate by 300 basis points. And finally, we experienced a 90 basis point decline in the revenue per piece growth rate due to the combination of changes in customer mix and fuel. Turning to costs. As you all recall, the cost of our new labor contract was front end loaded. As of the end of July, we lapped the first year of the contract and for the quarter, Union wage rate growth slowed to 5.2% year-over-year. Productivity is a virtuous cycle at UPS and in the third quarter, we took several actions to drive productivity. Through our Network of the Future initiative, this year, we've completed 45 operational closures, contributing to an 8% improvement in pieces per workforce hour. While 8% might not seem like a big number, that translated into an efficiency gain of 11 million hours. Production improvements, including total service plan offset 50% of the Union wage increase and we continued to see positive trends in our safety performance, which contributed to lower expense. The U.S. domestic segment delivered $974 million in operating profit, a 46.5% increase compared to the third quarter of 2023, and the operating margin was 6.7%, a year-over-year increase of 180 basis points. Moving to our International segment. In the third quarter, our international business grew revenue and operating profit and expanded operating margin for the first time in nearly three years. This performance was driven by strength in exports in 13 of our top 20 export countries. Total international average daily volume growth continued its sequential improvement trend from the second quarter and was about flat to last year. In the third quarter, international revenue was $4.4 billion, up 3.4% from last year, with all regions growing revenue year-over-year. International revenue per piece increased 2.5%, driven by strong base pricing and the positive impact of region and product mix. Touching on costs, total international expense was relatively flat year-over-year, which was achieved by optimizing our network and our ongoing cost management efforts. Operating profit in the International segment was $792 million, an increase of 17.3% year-over-year. Operating margin in the third quarter was 18%, an increase of 220 basis points from a year ago. Moving to Supply Chain Solutions. In the third quarter, revenue was $3.4 billion, up 8% year-over-year. Looking at the key drivers, air and ocean forwarding revenue was up 15.1%, driven by strong market demand out of Asia. Logistics delivered revenue growth driven primarily by the impact of the MNX acquisition and onboarding of USPS air cargo contributed to revenue growth in SCS. Partially offsetting these gains was weaker performance at Coyote, our truckload brokerage business and the completion of the sale in mid-September. In the third quarter, Supply Chain Solutions generated operating profit of $217 million, down $58 million year-over-year, primarily driven by our efforts to configure our air network as we onboarded the USPS air cargo business. Now that we have fully onboarded this volume, we expect it to generate consistent revenue and we expect an attractive margin on a consolidated basis. For SCS, operating margin in the third quarter was 6.4%. Walking through the rest of the income statement, we had $230 million of interest expense, our other pension income was $68 million, and our effective tax rate for the third quarter was approximately 21%. Now let's turn to cash and capital allocation. So far this year, we've generated $6.8 billion in cash from operations and free cash flow of $4 billion, including our annual pension contribution of $1.4 billion. We refinanced $1.5 billion in current maturities year-to-date, and we finished the quarter with strong liquidity and no outstanding commercial paper. So far this year, UPS has paid $4 billion in dividends. And lastly, we've completed our targeted $500 million share repurchase program in the third quarter, which brings us to our outlook. In July, we provided an update to our full year financial targets based on global economic forecast and our performance in the first half of the year. Now looking ahead at the full year, we have updated our outlook to reflect three things. First, our third-quarter results and the focus on revenue quality; second, the sale of Coyote; and finally, new softer peak volume forecast from our customers. At the consolidated level, we now expect full year revenue of approximately $91.1 billion. Due to our focus on revenue quality, coupled with the efficiency of our integrated network and our ability to manage costs, we are lifting our consolidated operating margin expectation to approximately 9.6% to align with these new volume and revenue expectations. Now looking at the segments in the fourth quarter. Starting with U.S. domestic, we expect the combination of both volume and revenue per piece growth to increase revenue by 1.5% in the fourth quarter. We expect to generate a fourth quarter operating margin of approximately 9.5%, and we now expect the operating margin in December to be slightly higher than 10%. Looking at International. We expect the positive volume momentum we've experienced throughout the year will continue. With that in mind, we expect fourth-quarter revenue growth to be up mid-single digits year-over-year and we still expect around a 20% operating margin in the fourth quarter. In Supply Chain Solutions, we expect revenue in the fourth quarter of around $3.3 billion, which takes into consideration the disposition of Coyote, and we expect to generate an operating margin of approximately 9%. Turning to capital allocation. For the full year in 2024, we expect free cash flow to be around $5.1 billion after the $1.4 billion pension contribution we made to fund annual service costs. Capital expenditures are expected to be about $4 billion. We plan to pay around $5.4 billion in dividends subject to Board approval. And lastly, we expect the tax rate for the full year to be between 23% and 23.5%. With that, operator, please open the lines for questions."
},
{
"speaker": "Operator",
"content": "Thank you. We will now conduct a question-and-answer session. Our first question comes from the line of David Vernon from Bernstein. Please go ahead."
},
{
"speaker": "David Vernon",
"content": "Hi, good morning, everyone, and thanks for taking the time and taking the questions. So when we think about the ramp here from 3Q into 4Q, the operating profit guidance sort of suggests a close to a 50% bump from 3Q to 4Q. Can -- Brian, maybe can you walk us through some of the drivers of what makes that look realistic? And then if you think about that -- those drivers taking hold, how does that affect sort of the shape of profitability as we carry into 2025?"
},
{
"speaker": "Brian Dykes",
"content": "Sure. Thank you, David, and I appreciate the question. And yes, we do have an increase from Q3 to Q4 on the profit side. And really it's driven by a couple of things. One, as we mentioned, this focus on revenue quality and the moves that we've made to drive revenue improvement, both through pricing policy as well as the take rate that we're seeing on HCS coupled with the acceleration of Fit to Serve and Network of the Future and just the productivity initiatives give us the incremental bump over the normal seasonality. We feel very confident in both of those and we're seeing them actually start to come through in the third quarter and early in the fourth quarter on the revenue side. And you can see from our cost performance, we feel that the Fit to Serve and NOS stuff is sticking very well."
},
{
"speaker": "David Vernon",
"content": "And then how that's going to affect sort of into 2025?"
},
{
"speaker": "Brian Dykes",
"content": "Yes. And so as we roll through '24, you can see that we've raised the consolidated margin. We do expect the domestic margin to be around 9.5%. And now we do expect to exit the year higher than -- slightly higher than the 10% that we guided to before. We'll come back to you as we get through peak on '25, but we want to close out peak first."
},
{
"speaker": "David Vernon",
"content": "All right. Thank you."
},
{
"speaker": "Brian Dykes",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Brian Ossenbeck from JPMorgan. Please go ahead."
},
{
"speaker": "Brian Ossenbeck",
"content": "Hi, good morning. Thanks for taking the questions. Maybe can you expand a little bit more on the softness you're seeing into peak season? What type of themes and concerns maybe you're hearing from the customers as they sort of dialed down their expectations on volume? And maybe within that a broader comment on the pricing and the surcharges ticking if you're getting more pushback on that or seeing more trade-downs at this point? Thank you."
},
{
"speaker": "Carol Tome",
"content": "Well, I'll start with the customer feedback. We work with a little over 100 of our customers who represent 60% of the volume in our network, but 85% of the peak surge. So we develop operating plans for each of these customers. And these plans have been in process now for months. As the year has progressed, they continue to tighten up their forecast and we just received their last forecast on October 2. And their forecast have been tempered and we believe it's driven by a couple of factors. First, external forecast for the holiday season have come in. In fact, the forecast for ESMO in the fourth quarter is now about 3%. Earlier in the year, it had been about 5%. If you look at just the peak part of the holiday season, forecasts are all over the board, candidly from a low of 2% to a high of 11% and SMB Global has it at about 3.5%. Part of this, we believe, is influenced by the tight compressed peak period. There are only 17 shipping days between Thanksgiving and Christmas Eve. And what forecasters and some of our customers are saying is because of the tightness of the shipping season that many customers will go into a store to complete their holiday purchases. The consumer actually is in pretty good shape, but we think there'll be some dynamics in how the consumer shops during the peak season. So it will still be a good peak. In fact, in our prepared remarks, we called out that on peak day, we'll deliver 2 million more packages than we did last year. It will still be a good peak, but just not as dynamic as people thought at the beginning of the year. Whatever happens, we're prepared. We're prepared to handle the volume. And then on the pricing surcharge, we're seeing a really good take rate on the pricing surcharge for the holiday, I should say. And maybe Matt Guffey is here. Matt, perhaps you want to comment on the holiday surcharge?"
},
{
"speaker": "Matt Guffey",
"content": "Yes, absolutely. So first off, we're working closely in collaboration with all of our customers. Carol talked about the top 100, which are extremely important just due to the peakiness that they bring during the season. But we've really worked again. We've got a good structure and a process in place where we can manage our holiday demand surcharge at the customer level and we have a lot more flexibility to work with them as we go through the peak season. Look, at the end of it, it's all about us creating -- continuing to drive value and -- with our customers and to deliver a great peak. So we're staying close on the forecast, but also working very closely with them on this holiday demand surcharge."
},
{
"speaker": "Carol Tome",
"content": "And we're seeing a good keep rate on…"
},
{
"speaker": "Matt Guffey",
"content": "Very -- yes, very, very good keep rate, probably one of the best keep rates we've seen, so."
},
{
"speaker": "Brian Dykes",
"content": "And Brian, I would just add that we're on our plan, if you remember, there were changes because of the compressed peak that opened the peak -- the holiday demand surcharge to a larger set of volume, right, and that's what drives some of the incremental outperformance year-over-year that you're seeing."
},
{
"speaker": "Carol Tome",
"content": "Yes."
},
{
"speaker": "Brian Ossenbeck",
"content": "Okay. Thank you very much."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Chris Wetherbee from Wells Fargo. Please go ahead."
},
{
"speaker": "Chris Wetherbee",
"content": "Hi, thanks. Good morning. I wanted to drill down a little bit on the cost improvement on a per piece basis in domestic, so down about 4%. It was better than what we were looking for. I guess maybe two pieces to the question. How do you think about that progress potential in the fourth quarter? And then maybe widening out a little bit with some of the initiatives that you're working on bigger picture about managing the footprint as well as maybe the headcount, how do we think this can trend as we move into 2025?"
},
{
"speaker": "Carol Tome",
"content": "So why don't you take the fourth quarter question and then we'll turn to Nando for some thoughts."
},
{
"speaker": "Brian Dykes",
"content": "Great. Yes, thank you. And yes, it's a great question because the cost performance in the third quarter was outstanding, right? And I think there's a couple of dynamics that are going on. As we said in our earlier remarks, we lapped the contract at the end of July, right? So you start to see that high wage inflation that we talked about in the second quarter as being 12%, now coming down to 5.2% and we will now get a full clean quarter of wage inflation at a normalized level in Q4. But also, as we mentioned, we've accelerated Fit to Serve and are now outperforming our forecast as well, as you'll see from the Network of the Future discussion that -- we've closed more sorts and we've closed more buildings. So we're pulling that forward, which helps in the cost performance. As we carry into Q4, we do expect to have strong cost performance. We'll probably be up about 1% per piece, which is still going to be less than our rev per piece growth rate. So we'll maintain a positive spread, but it'll be a little bit more normal as you go through it. Nando, you want to talk a little bit about network in future now we're pulling things forward?"
},
{
"speaker": "Nando Cesarone",
"content": "Yes. Thanks, Brian. And look, you may be asking how are we able to have 45 operational closures and nine buildings that we've closed. We are moving much more volume about 5% through our automated facilities and we're also making sure that our legacy of production indices are performing the way we expect them to perform. The teams are doing an excellent job allowing us to really shrink the network and be a lot more productive. Safety of course helped. And at the end of the day, it comes down to hours and people, and we were down about 11 million hours compared to the last year. So really just an excellent job all around. And the last thing I would say is there's nothing that we're overlooking so every piece of our business, from car wash to automated dispatching, we are prepared for all of it and looking and scrutinizing all of that cost and finding some good improvements there."
},
{
"speaker": "Carol Tome",
"content": "All the while maintaining outstanding service levels, which is job number one for UPS. And just to put the 5% number that Nando mentioned into perspective, he's talking about automated volume through our hubs, right. And we now processed 63% of the volume in our hubs in some sort of an automated way. That's up 5 percentage points from a year ago. That's pretty good."
},
{
"speaker": "Brian Dykes",
"content": "Absolutely. And look, we've got 21 active projects here in this quarter. You would think it's peak season. Why would we take that undertaking? We have full confidence that that's going to provide very good productivity improvements. And then next year, we're accelerating and pulling in the number of projects that we can execute in 2025."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Tom Wadewitz from UBS. Please go-ahead."
},
{
"speaker": "Tom Wadewitz",
"content": "Yes, good morning and congratulations on the strong results. I wanted to ask a bit about, Carol, you started the call. I think you commented about some industrial economy weakness. You're clearly doing some idiosyncratic -- excuse me, idiosyncratic things that are going well. How do you think about as we go into 2025, how much of margin improvement would be in your control? And if you don't see improvement in macro, is it reasonable to translate improvement in revenue per piece and network of the future, those things to margin expansion? Thank you."
},
{
"speaker": "Carol Tome",
"content": "Well, I think our team has done a masterful job of managing a very choppy environment over the past several years, actually. And as we think about our business outside the United States, we saw improvement in every quarter this year. In fact, our export business grew in the third quarter and domestic was down just slightly. So, Kate, maybe you want to talk about how you would manage the business outside the United States if the industrial production remains softish?"
},
{
"speaker": "Kate Gutmann",
"content": "Yes, absolutely. And I think the quarter was a good example of that. The macro indicators have come down, but yet we've expanded the revenue, profit and margin in the international business and posting an 8% margin. We intend to continue to run those same plays. Let me go into a few. Just as Nando indicated, on the domestic side, 60% of our volume goes through automated hubs and that's for the domestic and transporter of all of our large international volume markets. And then on the air side of the house, we continue to show that revenue quality matters, especially when you have expensive assets and we align with demand. So we had strong rev per piece for international we held our cost CPP flat and so delivered operating leverage. We would continue to do that into the next year."
},
{
"speaker": "Carol Tome",
"content": "And in-markets that are soft to win, you gain share. And you gain share not by dropping price, but by actually increasing your capability. And our Saturday delivery is one example of that. We are the only carrier that offers standard Saturday delivery at no charge in these eight markets. And that's driving some nice performance, isn't it, Kate? We just started it."
},
{
"speaker": "Kate Gutmann",
"content": "It really is. And so Europe and Canada exceeding expectations, unlocking more of the customer share of wallet and in the premium spaces too. So cross border trade we're seeing growth with the expansion of our service out of Asia to Europe as well as throughout intra-Asia we've made the lanes faster and as a result that premium unlock and by the way with rev per piece growing. So we feel good about the equations and we'll definitely continue it."
},
{
"speaker": "Tom Wadewitz",
"content": "Do you -- I don't think I asked the question well. I actually was thinking a little bit about domestic in terms of the margin."
},
{
"speaker": "Carol Tome",
"content": "So I think in the domestic side, productivity is a virtuous cycle here. And as Nando pointed out, there's nothing that's not under review, right. Everything is under review and we continue to drive productivity that exceeds our expectations. Brian, anything you want to add?"
},
{
"speaker": "Brian Dykes",
"content": "Yes, I would just say so. So if you remember, look, we've got a contract that locked up that we have known costs for the next four years for 60% of our domestic cost structure. With the focus on revenue quality and our ability to win more and win new in the places where we really want to, like you saw in the third quarter with commercial and SMB commercial growing -- starting to grow again, we do think we have the ability to: One, continue to take action to drive rev per piece ourselves as well as Carol said, productivity -- production is a virtuous cycle with a known cost structure as we go into '25."
},
{
"speaker": "Carol Tome",
"content": "And we like that commercial business. We -- it's got a more dense delivery metric associated with that, in other words, more packages per delivery. And one way we can win commercial is with new capabilities. So we had a big win in the third quarter and the determining factor for this customer to come into our network were our RFID labels. So that's a new capability that we didn't have before."
},
{
"speaker": "Tom Wadewitz",
"content": "Great. Thank you."
},
{
"speaker": "Carol Tome",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Conor Cunningham from Melius Research. Please go ahead. Conor Cunningham, your line is open. Check your mute button. Okay, we'll move on. We'll go to the line of Jordan Alliger from Goldman Sachs. Please go ahead."
},
{
"speaker": "Jordan Alliger",
"content": "Yes, hi. Morning. Question for you. So a little bit more on the U.S. Postal onboarding. If I could maybe if you could share some of the experience. I know you had the upfront step up costs, but as it's still, a few weeks in, perhaps talk about how the operations are going there. Is it delivering on the profit levels that you had talked about and just any general thoughts around how that's going to contribute going forward? Thanks."
},
{
"speaker": "Carol Tome",
"content": "Well, as you point out, Jordan, we did have a bit of a transition in the third quarter. The USPS contract with their previous carrier expired October 1st. And we didn't want to wait until October 1st to onboard that volume because peak is right around the corner. So we agreed with the USPS that we would operationalize this service to them, while over-time, they onboarded their volume. And it was over-time, actually, we didn't get much weight until September. So there was a mismatch between our operational model and the volume. But now the volume is all in. So the fourth quarter is going to look a lot different than the third quarter did. And from a performance perspective, Nando, you just met with the Postmaster General. And so tell us what he said."
},
{
"speaker": "Nando Cesarone",
"content": "Sure. So as early as yesterday, we meet face-to-face and yesterday the purpose was peak planning. So both teams face-to-face in DC and we're working really well. Professionals on both sides that have executed a very difficult plan and made it look very, very simple. Feedback from the Postmaster General himself has been positive and we see the resources that we've applied are in-line with what we had modeled when we have accepted the business and the contract was negotiated with the USPS. So good things ahead for that contract."
},
{
"speaker": "Carol Tome",
"content": "And I just can't overemphasize the heavy lift here. In fact, it was over 50 million cubic feet that we had to take into our network in the third quarter and there'll be more obviously in the fourth. So job well done by our team in working with the USPS as well."
},
{
"speaker": "Nando Cesarone",
"content": "Absolutely."
},
{
"speaker": "Jordan Alliger",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Bascome Majors from Susquehanna. Please go ahead."
},
{
"speaker": "Bascome Majors",
"content": "Thanks for taking my questions. Just to follow up on another piece of the postal service relationship. Can you talk about where you are in negotiating the delivery service agreement that enables SurePost in Sunday delivery with their effort to renegotiate some of those contracts? And maybe along with that, what challenges does that create either on cost-to-serve or Sunday delivery operations, but also what opportunities might that create for your own trucks to deliver more packages in the marketplace in a world where the post office is seeking to retain more upstream business and push customers into that? Thank you."
},
{
"speaker": "Carol Tome",
"content": "Well, thanks for the question. And Matt, why don't you take on this question?"
},
{
"speaker": "Matt Guffey",
"content": "Yes. So first-off, so we -- to Nando's point, we had an opportunity to meet with the PMG yesterday. We continually work to find a mutually agreeable agreement for both USPS and UPS. More work to be done, but we are moving very, very quickly and hopefully, we'll have this to a close in very short order."
},
{
"speaker": "Carol Tome",
"content": "And to your question about what challenges and what opportunities, I think it's some and some. I think it's some and some. And so once we get this contract agreed to, we'll show you what those sum and some are, but we're confident we can work through this."
},
{
"speaker": "Bascome Majors",
"content": "In the expiration, I believe you've said before, it's at year-end. Can you confirm roughly when we should hear more on that and what the go forward relationship will be?"
},
{
"speaker": "Carol Tome",
"content": "Yes, you should hear something about it in our fourth quarter earnings."
},
{
"speaker": "Brian Dykes",
"content": "Yes. No impact in the fourth quarter. We'll tell you more about it when we come back with the fourth quarter earnings in January."
},
{
"speaker": "Bascome Majors",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Ari Rosa from Citigroup. Please go ahead."
},
{
"speaker": "Ari Rosa",
"content": "Hi, good morning. I was hoping if you could give us a sense of how much excess capacity you see in the network right now. Just trying to understand how you're thinking about planning kind of given the weaker outlook in terms of both customer demand and also industrial production and some of the weakness in the macro. How do you think about kind of matching resources to that lower volume? And do you think you're carrying excess resources right now?"
},
{
"speaker": "Carol Tome",
"content": "So I think our team has done an excellent job of taking capacity out of the market. In fact, with 45 million -- 45 operational closures, it's about 1 million ADV per day of capacity that we've taken out of the market and we see capacity rationalization happening in other parts of the market as well. Clearly, it's peak time. So we're all adding resources to handle the surge in the holiday, but capacity is coming in."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Scott Group from Wolfe Research. Please go ahead."
},
{
"speaker": "Scott Group",
"content": "Hi, thanks, good morning. So how much, if any, does the new USPS contract help the fourth quarter U.S. margin just with the cost allocation? And then I don't -- Carol, I just -- big-picture, right, you're now saying margins in the U.S. in Q4 are going to be -- they'll be slightly positive. We've now lapped the Teamster contract, yields are now turning positive. That's good. Peak season surcharges. Just big picture, like when do we start to see more meaningful margin improvement? Does that start right away in '25? Or does that take some more time?"
},
{
"speaker": "Carol Tome",
"content": "First, why don't we address the path to the fourth quarter?"
},
{
"speaker": "Brian Dykes",
"content": "Sure, sure. So, hi, Scott, and thank you for the question. So on the USPS contract, so we put a network in place that was all part of the plan. There's no incremental impact to domestic in the fourth quarter from the USPS contract. The cost that we -- the cost that Carol referred to was start-up costs associated with getting the contract stood up that was -- that impacted SCS, doesn't impact domestic. And in the fourth quarter, we'll see SCS go back to 9 -- about 9% and domestic to around 9.5%. So I don't think that's going to impact us there."
},
{
"speaker": "Carol Tome",
"content": "No. And then in terms of when are we going to see more meaningful margin expansion, let us get through the fourth quarter and then we'll give you our outlook for 2025."
},
{
"speaker": "Scott Group",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Stephanie Moore from Jefferies. Please go ahead."
},
{
"speaker": "Stephanie Moore",
"content": "Great. Thank you. Good morning. I was hoping you could talk a little bit about our domestic RPP trends throughout the quarter. Maybe if you could talk a little bit about how they trended as the months progressed and really what this means for 4Q and your thoughts into 2025 if you have them? Thanks."
},
{
"speaker": "Brian Dykes",
"content": "Sure. Thanks for the question, Stephanie. Yes, so we saw positive momentum going from Q2 to Q3 in domestic rev per piece. As I mentioned in my earlier remarks, really when you think about what happened in the base rate, in the second quarter, base rate added about 90 basis points of improvement to rev per piece. In the third quarter, that jumped to 170 basis points. Now as we translate into the fourth quarter, we actually expect rev per piece to inflect positive in the U.S. and that's really driven by a couple of things. Look, we talked about actions that we were going to take around specific customers that were enabled by our architecture of tomorrow and the work that we've been doing and investments have been made to create more sensitive demand channels, DAP and AOT and the modifiers. And we're leveraging those in order to make adjustments to help drive rev per piece. The other thing is what we're doing on the surcharging and the GRIs that we will continue to see lift as we go through the fourth quarter and into '25. So look, it's a positive trajectory on rev per piece and it's clearly an area of focus as we move from our year-one to our plus two strategy."
},
{
"speaker": "Carol Tome",
"content": "And pricing architecture of tomorrow is really moving from the art to the science of pricing. And one of the elements of this architecture are modifiers that we use, modifiers that can provide discounts to our customers or modifiers that allow us to increase the price. And I'll just give you a real life example of what happened in the third quarter to help you understand. In the third quarter, we had a discount modifier that we adjusted, basically test the elasticity. We reduced the discount by 25%, which increased the RPP by 12% and reduced the volume by 26%. We liked that trade. And because it's a modifier, it's not a contract that has to be reopened and renegotiated. You just adjust the model. And this is just one element of pricing architecture of tomorrow that we will use not only in the fourth quarter, but in '25 and beyond."
},
{
"speaker": "Stephanie Moore",
"content": "Great. Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Daniel Imbro from Stephens. Please go ahead."
},
{
"speaker": "Joe Enderlin",
"content": "Hi guys, this is Joe Enderlin on for Daniel. Thanks for taking the question. Just wanted to ask another one actually on revenue per piece. One of your peers noted increased price competition in the market. Just are you seeing any of that today? And then do you think we've felt peak trade-down pressures yet?"
},
{
"speaker": "Brian Dykes",
"content": "So I'll start on the price pressures. Look, we -- just in a very price-competitive industry, but we think it's very rational, right? And when you look bid-for-bid and product-to-product, it is very rational. We know we have to win on capabilities and that's where we continue to add. With every customer every day, it's -- you got to deliver service to do it. It starts with us with service and then we add incremental capabilities like RFID to win where we really want to win most. And I point that as Carol mentioned, we've had big enterprise commercial wins through that. We also have seen commercial now grow nearly 1% for the first time this year as we really started to catch that from the contract, that's been a big momentum point. And then specifically, SMB commercial growing 3.8%. Those sorts of things allow -- the capabilities that we have, allow us to win more and win new in those areas that help drive rev per piece growth despite a very competitive rate environment."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Brandon Oglenski from Barclays. Please go ahead."
},
{
"speaker": "Brandon Oglenski",
"content": "Hi, good morning and thanks for taking the question and congrats on growth for the first time in a couple of years here. Good to see. Carol, I think you mentioned something about enterprise customers. And I know in the past, you've talked about glide down. So can you just put that in context as you head into 2025? And then just very quickly on Fit to Serve, I didn't get it, but is that going to incrementally deliver more in the fourth quarter? Thank you."
},
{
"speaker": "Carol Tome",
"content": "So first on the customer glide down, we have, as you know, been in a glide-down arrangement with our largest customer and they continue to be our largest customer. I think it's fair to say that we have seen them drive a lot of the reduction in our air volume. In fact, if I look at the third quarter performance, 100% of the decline in air volume was down about 6.5% that is attributable to the largest customer. So they, like many, trading down from air to ground and in their case, a little bit of ground out to their own network. But we're fine with that because it creates opportunity for us to grow in other areas. And then looking ahead..."
},
{
"speaker": "Brian Dykes",
"content": "And then on the Fit to Serve point, yes, so we do expect about $70 million incremental to go about $350 million in the fourth quarter, and we've seen great progress with that program."
},
{
"speaker": "Brandon Oglenski",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Ken Hoexter from Bank of America. Please go ahead."
},
{
"speaker": "Adam Rakowski",
"content": "Hi, good morning. This is Adam Rakowski on for Ken Hoexter. You noted in the release that you are a - scope of the Fit to Serve initiative, which previously called for a reduction of about 12,000 positions. Could you just expand on what that means? Is there -- has that actually accelerated this quarter? And just any thoughts on how you would expand the scope and what you would target there? Thanks."
},
{
"speaker": "Carol Tome",
"content": "So you're just asking for a status update on Fit to Serve?"
},
{
"speaker": "Brian Dykes",
"content": "Sure. Yes. On Fit to Serve, as we said, we have pulled forward incremental savings opportunities. We are -- we hit the full run rate that we expected. We will have some incremental benefit as we wrap into the fourth quarter, but we're continuing forward with it as planned."
},
{
"speaker": "Carol Tome",
"content": "And to your question, do you have additional opportunities. We are an opportunity rich company. And as you heard from Nando, we're looking at all opportunities to drive a better experience for our customer and actually higher productivity,"
},
{
"speaker": "Brian Dykes",
"content": "Greg, we have time for one more question."
},
{
"speaker": "Operator",
"content": "Okay. Your final question comes from the line of Ravi Shankar from Morgan Stanley. Please go ahead."
},
{
"speaker": "Ravi Shankar",
"content": "Thanks. Good morning, everyone. So maybe just to follow-up on the holiday side, I think you announced a pretty big step up in your hiring for the first time in many years. I know it's a peak compressed -- compressed earnings peak season. But what's the logic behind that, if you're seeing a little bit of a reduction in customer experience or expectations on volumes here, how do we think of squaring that? And is there like a minimum surcharge bogey you guys need to kind of COVID the extra costs? Thank you."
},
{
"speaker": "Carol Tome",
"content": "So last year we announced that we were hiring 100,000 for the peak holiday season and our ADV declined 7.4%. This year we announced that we're hiring 125,000 and our ADV will be positive. So it's not out of the realm of reason that we should hire more people this year than we did last year. But this is what you need to know. We will hire what we need for peak regardless of where the volume actually ends up. We're not going to over hire for peak. We will hire what we need. And what we've done over time, Ravi, is we've added this amazing capability where within just a few -- less than an hour, just a few minutes, we can actually get a job offer out or we can rescind a job offer so we can flex up or flex down the way we need to. And Nando, would you like to add anything?"
},
{
"speaker": "Nando Cesarone",
"content": "Yes. I would just say the number also includes a favorable employee mix. So this year, we're adding -- we're going to increase our helper teams with our drivers by about 10%. That's not a small number. So a big percentage of our volume will be delivered by helpers, seasonal helpers that can deliver at Christmas time and we've amped that up and make sure that we've got every position optimized and that is the number, as Carol had said, and we're going to deliver a great peak season."
},
{
"speaker": "Ravi Shankar",
"content": "Thank you."
},
{
"speaker": "PJ Guido",
"content": "Thank you, Greg. This concludes our call. Thank you all for joining and have a great day."
},
{
"speaker": "Operator",
"content": "Ladies and gentlemen, that does conclude your conference for today. Thank you for your participation and for using AT&T Teleconference. You may now disconnect."
}
] |
ups | 2,024 | 2 | [
{
"speaker": "Operator",
"content": "Good morning. My name is Stephen and I will be your facilitator today. I would like to welcome everyone to the UPS Investor Relations Second Quarter 2024 Earnings Conference Call. All lines have been placed on mute to prevent any background noise and after the speakers’ remarks there will be a question-and-answer period. [Operator Instructions] It is now my pleasure to turn the floor over to your host, Mr. PJ Guido, Investor Relations Officer. Sir, the floor is yours."
},
{
"speaker": "PJ Guido",
"content": "Good morning and welcome to the UPS Second Quarter 2024 Earnings Call. Joining me today are Carol Tome, our CEO; Brian Dykes, our new CFO, and a few additional members of our executive leadership team. Before we begin, I want to remind you that some of the comments we'll make today are forward-looking statements within the Federal Securities Laws and address our expectations for the future performance or operating results of our Company. These statements are subject to risks and uncertainties, which are described in our 2023 Form 10-K and other reports we file with or furnish to the Securities and Exchange Commission. These reports, when filed are available on the UPS Investor Relations website and from the SEC. Unless stated otherwise, our discussion today refers to adjusted results. For the second quarter, GAAP results include an after-tax charge of $120 million or $0.14 per diluted share, comprised of a one-time payment of $94 million to settle an international regulatory matter, and transformation and other charges of $26 million. A Reconciliation to GAAP financial results is available on the UPS Investor Relations website and also available in the webcast of today's call. Following our prepared remarks, we will take questions from those joining us via the teleconference. [Operator Instructions] Please ask only one question so that we may allow as many as possible to participate. You may rejoin the queue for the opportunity to ask an additional question. And now I'll turn the call over to Carol."
},
{
"speaker": "Carol Tome",
"content": "Thank you, PJ, and good morning. Let me begin by welcoming Brian Dykes as UPS's new Chief Financial Officer. With over 25 years of multinational experience with the company, Brian brings deep financial and strategic experience to our executive leadership team. Welcome, Brian. Our second quarter performance was a significant turning point for our company as we returned to volume growth in the United States the first time in nine quarters. I would like to recognize and thank UPSers for their hard work and efforts in delivering these results. At the beginning of the year, we shared our outlook for 2024 based on four key planning assumptions. The first planning assumption acknowledged the front-loading of costs associated with our new labor contracts, which we believed would cause our financial performance to reflect a bathtub effect, with first half 2024 earnings down as much as 30% and second half earnings returning to growth. In the first half of the year, our earnings were in-line with the down 30% scenario. The second assumption was that we would return to volume growth, which we did in the US, during the month of May. Further, while international volume growth in the second quarter was down 2.9% year-over-year, we saw growth in certain markets. The third planning assumption was based on our fit-to-serve initiative to right size our management structure. And we are on track with this initiative to deliver roughly $1 billion in savings by the end of the year. Finally, we said we would explore strategic alternatives for Coyote and we did, leading to a pending sell to RXO, at considerably more than our carrying value. So the key assumptions we used to build our plan are holding with one distinction and that's US volume mix both in terms of product and customer segmentation. During the quarter we experienced a shift toward value products with shippers choosing ground over air and SurePost over ground. And there was also a notable shift in product characteristics with a surge in lightweight short-zone volume moving into our network. We will discuss the full year impact of these shifts in a few moments. But let me first highlight our second quarter results and then provide a few updates on our longer-term strategies. In the second quarter, consolidated revenue was $21.8 billion, a decline of 1.1% versus last year. Consolidated operating profit was $2.1 billion down 29.3% and consolidated operating margin was 9.5%. At our March Investor Day, we set forth our declarations to become the premium small package provider, the premium logistics orchestrator, and the Number #1 complex healthcare logistics provider in the world. To that end, we said we would pursue certain inorganic opportunities and we have. As you've seen, we just announced our plans to acquire Estafeta, a leading domestic small package provider in Mexico. This is a big win for UPS and it's a big win for our customers. By combining Estafeta with the end-to-end services we already have in Mexico and connecting it to the global reach of our integrated network, we will greatly enhance our logistics orchestration capabilities for customers that are shifting manufacturing and distribution closer to the United States. We are targeting to close this acquisition by the end of this year. Let me share a few other strategic updates starting with customer first. In healthcare we just opened our first dedicated healthcare facility in Dublin, Ireland. This 82,000 square foot facility provides storage and fulfillment for a range of complex pharmaceutical and healthcare products. And in the Netherlands, we increased the size of our flagship facility in Roermond to now more than 235,000 square feet, including expanded ultra-cold storage capabilities to support the growing market of complex biopharma products. Looking at SMBs, we continue to add partners to our Digital Access Program or DAP, meeting small businesses where they are. In the first six months of this year, DAP generated $1.5 billion in revenue and we are well on our way to achieving our 2024 DAP revenue target of over $3 billion. And because speed will always be important to our customers. In the US, we expanded our weekend service offering to six additional markets. With this service, we provide deliveries one day earlier than competitors who don't offer weekend pickup services. In fact, we are the only private US-based carrier that provides both commercial and residential pickup and delivery services on Saturday as a general service offering. Outside of the US, we are continuing to enhance our portfolio to support our customers as they balance the need for speed with cost. For example, in record time, we launched enhancements to our worldwide economy service globally. This is an e-commerce solution for non-urgent cross-border shipment. Here we created a true door-to-door service with customs clearance and delivery fees baked into the solution, making the experience simpler for the shipper and the receiver. In Asia, over the last several quarters, we've made a series of network enhancements with the latest being in Taiwan. Because Europe is a top three export destination for Taiwan, we've expanded our capacity by 30% and extended pickups to as late as midnight. These enhancements enable our customers, including high-tech manufacturing and automotive shippers, to better serve their European customers by reaching their destination in just two business days. And in supply chain solutions, we've expanded our supply chain operations at our Frankfurt Airport Gateway, by adding nearly 25% more warehouse space. This facility is a major SCS hub for central Europe where it connects all transportation modes. In this expansion, we can now provide even greater flexibility to the region's growing technology and healthcare industry. And importantly, also in SCS, we are onboarding the new USPS Air Cargo business with plans to be fully implemented before peak. The onboarding has gone well and we continue to expect this business to be margin accretive for the company. Now let's turn to innovation driven and progress with Network of the Future. In the first half of 2024, we completed 35 operational closures, which included closing five buildings. And we are on plan to complete an additional five operational closures in the second half of this year. Simultaneously, we’re continuing to automate more of our operational tasks. For example, in the US, we are automating the dispatch process for our packaged car and feeder drivers to reduce dispatch staffing by half. We deployed Phase 1 of the project and so far this year we've reduced staffing by 26%. As we continue deployment, we expect to achieve our reduction target by 2026. As a reminder, these actions are outside of fit-to-serve and are part of Network of the Future. Lastly, touching on Smart Package Smart Facility, which is our RFID solution, we are moving from a scanning network to a sensing network. As we've discussed, we're adding RFID readers to our package cards, but we're not stopping there. We're moving upstream. First, we are enabling customers to print RFID labels themselves. Second, we are installing readers at customer dock doors. This will enable immediate visibility as our trailers are loaded for pick-up. This solution provides a significant competitive advantage to us and to our customers. Moving to our financial outlook, Brian will provide more details but let me share a few highlights. First, while we have entered into an agreement to sell our Coyote business, we are retaining Coyote revenue and earnings in our outlook until the transaction is consummated. Second, while our first half earnings were in-line with the low end of the guidance we provided, our revenue came in just short of the low-end. Given the current volume momentum we are now experiencing in our business, we are resetting our revenue guidance, taking us to the midpoint of our original revenue guide. But for operating profit, as we look to the back half of the year, in the US, we expect the same volume mix characteristics as we had in the first half of the year, which compresses revenue per piece growth. While we still expect an operating profit bathtub effect with solid earnings growth in the back half of the year, the growth rate will not be as high as we projected at the beginning of the year. Accordingly, we are adjusting our full year operating margin guidance to reflect the nature of the volume flowing through our US Network. As a result, we now expect consolidated revenue of approximately $93 billion and a consolidated operating margin of approximately 9.4%. Importantly, we expect to exit the final month of 2024 with a US operating margin of 10%, which creates a solid footing as we drive the US business to a longer-term operating margin target of 12%. One last comment before I hand the call over to Brian. We believe it is important to have a disciplined and balanced approach to capital allocation with the first uses of capital going back to the business and to pay our dividends and then any excess cash being used for share repurchases. As we have fine-tuned our capital requirements for Network of the Future, we expect to spend less than we originally anticipated. Further, with the pending sale of Coyote, we expect to free up cash that was not in our original guidance plan. As a result, we are restarting our share repurchase program with the intent of repurchasing about $1 billion of shares annually, including roughly $500 million in 2024. So with that, thank you for listening and let me turn the call over to Brian."
},
{
"speaker": "Brian Dykes",
"content": "Thank you, Carol, and good morning everyone. First, I'm very thankful for the opportunity to lead the global finance organization and work with the entire leadership team to achieve the targets we set. We have a lot of opportunity in front of us and the right team to achieve our goals. I'm also particularly eager to meet our investors as I hit the road over the next few weeks. This morning I'll review our second quarter results, provide an update on capital allocation and lastly, provide additional detail for our 2024 financial outlook. First, our results. The second quarter represented an important turning point for our business. In the US, volume inflected positively and it was the last full quarter of the high wage growth rate associated with the first year of our new Teamsters contract. Outside the US, we saw pockets-of-demand improved in each export region driving growth in many of our more profitable lanes. Additionally, through our fit-to-serve initiative, we reduced our workforce by over 11,500 positions which has translated into approximately $350 million in savings for the first half of 2024. And as Carol said we are on track to deliver roughly $1 billion in savings by the end of the year. Looking at our consolidated performance. In the second quarter, revenue was $21.8 billion, a reduction of $237 million compared to the second quarter of 2023. Consolidated operating profit was $2.1 billion, down 29.3%, and consolidated operating margin was 9.5%. Diluted earnings per share was $1.79, down 29.5% from the second quarter of 2023. Now let's look at our business segment. In the second quarter, US average daily volume increased 0.7% year-over-year. This marks a return to positive volume growth for the first time since the fourth quarter of 2021. And sequentially, when compared to the first quarter of 2024, the average daily volume year-over-year growth rate increased by 390 basis points. At the beginning of the year, we expected to see three things in the second quarter; volume growth, growth in B2C and relatively consistent product mix to what we had experienced last year. While we saw strong volume growth in the second quarter led by B2C, it came with a different product mix. For the quarter, B2C volume increased 4.8% year-over-year and made up 58.5% of our volume, an increase of 220 basis points from a year ago. This growth was driven in large part by several new e-commerce customers that entered our network. B2B average daily volume finished down 4.6%. Returns remained a bright spot and increased 3% year-over-year. From a product perspective, we saw customers trade down between services. Specifically, we saw customers shift from air to ground and from ground to SurePost. As a result, total air average daily volume was down 7.8%, while ground average daily volume increased 2.3%. Within ground SurePost average daily volume grew 25%, driven by new shippers product choices, product trade downs and easier comparisons due to last year's decline in volume during our contract negotiations. By enhancing our matching algorithm, we saw an increase in the percentage of SurePost packages redirected to UPS for delivery. As a result, SurePost redirect increase returning to 2020 level. Turning to SMBs. We saw the trend from the first quarter continue with total SMB volume down until June when it flipped positive. And in terms of total volume, SMBs made up 29.7% in the second quarter. For the quarter, US Domestic generated revenue of $14.1 billion, down 1.9% compared to last year. Revenue per piece was down 2.6% year-over-year. Let me break down the components of the revenue per piece decline. Base rates increased the revenue per piece growth rate by 90 basis points. The combination of product mix, lighter weights and shorter zones decreased the revenue per piece growth rate by 310 basis points. The remaining [40] (ph) basis point decline in the revenue per piece growth rate was due to the combination of changes in customer mix and fuel. Turning to costs. Total expense increased 3.2% in the second quarter. Union wage rates increased 11.7%, driven by the contractual increase that went into effect in August of last year. The US Domestic team took several actions and executed on productivity initiatives to partially offset the increase in compensation rate. We leveraged total service plan and network planning tools to reduce total operational hours by 1.4%, while volume grew 0.7%. Through Network of the Future, we had 17 operational closures in the second quarter, bringing our year-to-date total to 35. And because we're routing more volume through our automated facilities, we've permanently closed five buildings so far this year. We lowered block hours by 12.5% versus last year and we recorded our best auto safety results in 10 years, driving a better outcome for our people and a better long-term cost picture for UPS. Putting it all together, due to the actions we took in the second quarter, we held the cost per piece growth rate to only 2.5% even as union wages increased nearly 12%. This is the lowest cost per piece growth rate we've seen in more than three years. The US Domestic segment delivered $997 million in operating profit, down 40.7% compared to the second quarter of 2023, and the operating margin was 7.1%. Moving to our International segment. The second quarter was a turning point for our International business well. For the first time in 10 quarters, 11 of our top 20 export countries demonstrated year-over-year average daily volume growth, including several key markets in Europe. At the region level, Asia grew average daily volume and revenue in the quarter. And in the Americas regions, we continue to see solid signs of the shift in nearshoring. Looking at volume in the second quarter, International total average daily volume was down 2.9% year-over-year which is half the decline we saw in the first quarter of this year. About three-quarters of the decline in the second quarter came from lower domestic average daily volume, which was down 4.4%, primarily driven by Europe. On the export side, average daily volume declined 1.5% year-over-year. However, on a sequential basis from the first quarter, export average daily volume improved 210 basis points. While overall export average daily volume was down in Europe, in Germany, our largest export market, outbound grew 1%. In Asia export average daily volume increased 1.7%. And within Asia, export volume on the China to US trade lane increased 20.6%. This is the third consecutive quarter of volume growth on this lane, which is our most profitable lane. And looking at the Americas region, export average daily volume increased 5%, which was the sixth consecutive quarter of growth. As we see the shift in nearshore and continue to take hold, our announced acquisition of Estafeta will further enhance our end-to-end services in Mexico. In the second quarter, International revenue was $4.4 billion down 1% from last year, primarily due to the decline in volume. Revenue per piece increased 2.4%, driven by strong base pricing and the positive impact of region and product mix. In the second quarter total International expense was relatively flat year-over-year. Here we leverage the agility of our integrated network to manage block hours down 2.1% compared to last year. Operating profit in the International segment was $824 million down $78 million year-over-year. Operating margin in the second quarter was 18.9%. Moving to Supply Chain Solutions. In the face of a dynamic market, we remained agile and leaned into areas of growth. In the second quarter revenue was $3.3 billion, up 2.6% year-over-year. Looking at the key drivers. Within international air freight, strong e-commerce demand particularly in China outbound, drove an increase in volume and lifted market rates as demand outpaced capacity, resulting in an increase in revenue. On the ocean side, total volume and revenue was down year-over-year. However toward the end of the quarter, demand on Asia outbound lanes improved and drove market rates higher. Our truckload brokerage business known as Coyote, continued to face market pressures, which drove revenue down. And then logistics revenue grew driven by the impact of MNX and Health care. In the second quarter, Supply Chain Solutions generated operating profit of $243 million, down $93 million year-over-year reflecting market conditions, Operating margin was 7.3%. Walking through the rest of the income statement, we had $206 million of interest expense. Our other pension income was $67 million. And our effective tax rate for the second quarter was 23.4%. Now let's turn to cash and capital allocation. Year-to-date, we've generated $5.3 billion in cash from operations and free cash flow of $3.4 billion. We finished the quarter with strong liquidity and no outstanding commercial paper. In May, we successfully issued $2.8 billion of debt to refinance $1.6 billion in current maturities which will shore up additional liquidity and support our acquisition strategy. And in the quarter, we announced that we would be outsourcing the asset management portion of our pension plan in order to focus squarely on our core business, while adding more expertise and oversight that will benefit UPS retirees. Lastly, so far this year UPS has paid $2.7 billion in dividends, which brings us to our outlook for the second half of 2024. Global economic growth forecast remained relatively unchanged in the back half of 2024. According to S&P Global, global GDP is expected to grow 2.7% for the full year 2024 and US GDP is expected to grow 2.4%. Additionally, as we've discussed we still expect the US small package market excluding Amazon to grow by less than 1%. Looking at our business in the first half of 2024, revenue was below our expectations and operating profit was at the low end of the range we provided and finished down about 30%. Based on our performance in the first half of the year combined with our expectation that the product shift we experienced in the US will continue through the rest of 2024, we have updated our guidance. This includes moving to a point estimate because it represents our best view of the many moving parts within our business. We now expect consolidated revenue to be approximately $93 billion, and because the volume characteristics are different from what we originally anticipated, we now expect a consolidated operating margin of approximately 9.4%. Our guidance includes roughly $1 billion in savings from fit-to-serve. And as Carol mentioned, Coyote revenue and operating profit remains in our guidance and will until the transaction is executed. Looking at the segments. In US Domestic, we anticipate back half 2024 revenue growth of around 5%, driven by strong volume growth. As you update your models for US Domestic there are a few things to keep in mind. First, we expect average daily volume to grow by mid-single digits. Second, we’ll anniversary the first year of the Teamsters contract on August 1. Next, product mix is expected to continue to pressure revenue per piece. However through expense management and slowing labor inflation, we expect to grow third quarter operating profit by double digits and exit the year with a US operating margin of 10%. And lastly, we expect a strong peak driven by volume growth and demand surcharges. Within the International segment, our full year and second half outlook remains consistent with what we provided at the beginning of the year. For the second half of 2024, we anticipate volume growth rates will inflect positively and the revenue growth to be in the mid-single digits. Operating margin in the second half of the year in the International segment is anticipated to be approximately 20%. And in Supply Chain Solutions, in the second half of 2024, we expect revenue to be over $7 billion and an operating margin in the high-single digits. Included in our guidance is the newly won air cargo business from the USPS, which will be fully onboarded by the end of the third quarter. And lastly, we expect the tax rate to be approximately 22% for the remainder of the year. Turning to capital allocation. For the full year in 2024, we expect free cash flow to be around $5.8 billion before any pension contribution. We've tightened our capital expenditure forecast and now expect to spend about $4 billion. We plan to pay out around $5.4 billion in dividends, subject to Board approval. And given our strong liquidity, while we originally had not planned to repurchase shares, we now plan to repurchase approximately $500 million of shares this year. With that, operator, please open the lines for questions."
},
{
"speaker": "Operator",
"content": "Thank you. We will now conduct a question-and-answer session. Our first question will come from the line of Tom Wadewitz of UBS. Please go ahead."
},
{
"speaker": "Tom Wadewitz",
"content": "Yeah. Good morning. I wanted to see if you could offer some more thoughts on what's happening with domestic package volume and the mix effect. If I look at the core ground, so excluding SurePost it looks like you saw a decline sequentially. So let us say, 2 point -- excuse me, 12.3 million pieces a day in 1Q to 11.7 million, if I exclude SurePost. So do you think -- is that just market weaker? Or is that kind of competitive performance? So just wanted to see if you could offer more thoughts on what's happening in domestic package volume. And then maybe why -- what are key levers to see that mix performance improve, as we look at second half. Thank you."
},
{
"speaker": "Brian Dykes",
"content": "Yes. Thanks, Tom for the question. I think when you look at the domestic volume performance from the second quarter and then going forward. In the second quarter, there was really two big impacts that were driving the change. One is we did see customers favoring our more economical products, so going from air-to-ground, and within ground, from ground to SurePost. And that was across the broad base of customers. We also saw an acceleration of new entrants, new e-commerce customers that were coming into the market that are quite frankly running a different model than our traditional customers and are highly leveraging our SurePost product. So we saw an acceleration of SurePost. The growth rate is also complicated as you think about what happened in the second quarter of last year because of the type of customers that diverted early. As we were approaching the Teamster contract, it does also skew the growth rate. As we move forward and you see -- you can see it in our forecast and within the guide, that we do expect that mix to rationalize as we move towards the end of the year. And we've got line of sight to that in our pipeline and are working to actively pull those through as we kind of balance the mix of products going into the second half."
},
{
"speaker": "Carol Tome",
"content": "And maybe a couple of other comments about just the volume. As you saw our commercial business was down year-on-year, although the rate of decline has moderated greatly. As we look to the back-half of the year, we expect that to improve. Our pipeline is quite robust. So we expect to see good movement in that space."
},
{
"speaker": "Tom Wadewitz",
"content": "Great. Thank you."
},
{
"speaker": "Operator",
"content": "Our next question will come from the line of Jordan Alliger of Goldman Sachs. Please go ahead."
},
{
"speaker": "Jordan Alliger",
"content": "Yeah, hi. Good morning. Just again on the trade-down from more premium products to economic products, what changes customer behavior to go back? And is it simply the economy? And then what are your thoughts on sort of the B2B side of the equation which I guess is still under pressure? Do you anticipate a step up with more of a focus on just-in-time inventory, a need to move things quicker from that end? And when would you think that timing could look better? Thanks."
},
{
"speaker": "Carol Tome",
"content": "On the B2B front, as we discussed it was down year-on-year. Part of that was because of customers who left us during the contract negotiation that have not returned. They left us, they locked themselves into long-term contracts and they have not yet returned. That just gives us an opportunity to win them back for the excellent service that we provide. We've also seen some dynamics within the B2B space occur recently within poolers, companies going out of business like overnight which gives us an opportunity to bring that business back into our network. It's already starting to flow. And as I mentioned, the pipeline of commercial accounts is robust. So we expect that to improve dramatically in the back half of the year. On the RPP, it is really interesting. We've had these new e-commerce entrants into the United States. And their volume, well, it is exploded. It was certainly more than we anticipate flowing into our network. So in -- to your question, is this a phenomenon forever? I don't know. It depends on what consumer demand will be. But we are going to focus on the parts of the market that really value our end-to-end service and expect to see some of the pressure that we saw on the RPP in the second quarter moderate. And Brian, maybe you can give a little bit more color on what we think the RPP will look like in the back half of the year."
},
{
"speaker": "Brian Dykes",
"content": "Yes. So as Carol mentioned, yes we do expect our RPP growth to moderate in the back half. And actually, as we move from kind of the negative 2.6% that we are at to almost approach breakeven as we get towards the end of the year. And there is a couple of pieces of that. Carol had mentioned the B2B piece. I would say, the bright spot within B2B is returns, that improved 3%. And we are seeing uptake with the addition of Happy Returns into the portfolio. And as that pipeline builds and we start to see that pull through, that continues to accelerate our B2B business. The other thing I would say is that we do have a strong pipeline of ground-ready products. And what happens with the SurePost product is, it allows you to get new customers in, leveraging that. We get the integration into their systems, we get the pickup process set up, and they become part of the UPS portfolio but then allows us to expand that as we go through the cycles."
},
{
"speaker": "Carol Tome",
"content": "And maybe one other comment about SurePost because the question may be, do you like that product. We actually like the product. It provides a steady solution for us. We also through our matching algorithm, we can redirect the packages back into the ground network. And in fact, the redirect percentage was 40%. So that's returning back to levels we saw during the COVID."
},
{
"speaker": "Jordan Alliger",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Our next question will come from the line of Ken Hoexter of Bank of America. Please go ahead."
},
{
"speaker": "Ken Hoexter",
"content": "Hi, great. Good morning. Hello Brian, I guess the spread of margins, can you talk about kind of the reaction we should see in third quarter? I guess typically, we see maybe 100 basis points pullback. I just want to get seasonality or kind of flow that we should expect through the year. And then I think you mentioned the 90 basis points of pure pricing. I want to understand the margin impact there. Is that just a fraction of GRI? Has that shifted as well? Thanks."
},
{
"speaker": "Carol Tome",
"content": "So maybe I'll talk about the RPP and then you can talk about the margin. So on the base pricing, there are many dynamics on the base pricing. First, we were up against very tough comparisons from a year ago. Why? Well, you'll recall that our volume declined in the United States in the second quarter by almost 10%. And this was related to noise around the labor contract negotiation. If you look at who declined during that time frame it was predominantly dual-sourcers, who are low GRI customers. So last year's base pricing was a bit artificially inflated because it is just the mix change. If you roll forward now to this year, what you see in the base pricing is, okay the tough comparisons year-on-year, as well as new entrants that don't have a GRI because they are starting to ship with us for the first time. And then finally, if you zoom out and say well, what's the keep rate looking like on those customers who have a GRI? The keep rate is looking at about 50%. So as we get past this time frame and get into an easier compare, that's why we think our base rates can improve dramatically in the -- from where it was in the second half. And maybe you can talk about the margins."
},
{
"speaker": "Brian Dykes",
"content": "Yes. And Ken I'll give you a little bit of shaping for how we think the second half is going to go because we do have confidence in how we are going to be able to pull-through the margin. First, if you think about in the US from Q3 to Q4, we expect ADV to be up around kind of mid-single digit. We do -- as we just talked about, the decline in RPP growth will moderate, so about negative 1.5% in the third quarter, negative 5% in the fourth quarter. And as we get to peak and we see the holiday demand surcharges, we expect that to get even better. And we expect op-profit to be up kind of double digits in Q3. And then December as Carol mentioned before, we're going to hit a 10% operating margin. In International, Q3 ADV is kind of flat to slightly positive year-over-year, with Q4 up mid-single digits and the RPP growth of 1% to 2% year-over-year in the second half. Our Q3 op margin is in the high teens and then getting to over 20% in Q4. So continuing that strong momentum in International. And then we expect a mid-teens revenue growth in SCS and stronger year-over-year profit growth in Q3 and Q4 with the second half up about 20%. And look, I think we've got a lot of confidence that we can pull through the second half forecast for a couple of reasons. One is we've got line of sight to the volume. We've shown the volume has been building. We've got a line of sight to the volume that we need to deliver the top-line. And that helps offset some of the RPP growth, and you can see that in the guide. On the cost side, fit-to-serve is on track. We have reduced 11,500 or 90% of the resources that we had anticipated. And then we've also got line-of-sight to revenue improvements that are in the pipeline as well that are going to help us drive better profitability as we get into the second half. So we absolutely feel confident that we are back to the point of revenue growth, profit growth and back to margin expansion in the US."
},
{
"speaker": "Carol Tome",
"content": "And just one other piece of color, don't forget that we are anniversarying our labor contract on August 1. So the pressure associated with that contract moderates dramatically in the back half."
},
{
"speaker": "Brian Dykes",
"content": "That's right."
},
{
"speaker": "Ken Hoexter",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Our next question will come from the line of Ravi Shanker of Morgan Stanley. Please go ahead."
},
{
"speaker": "Ravi Shanker",
"content": "Thanks. Good morning. Two parter if I may, please. Given -- I mean, you've done a pretty good job of kind of managing your largest customer in terms of size. Will you be looking to also meter the growth from these new e-commerce customers as part of better, not bigger if the mix is not being helpful? And second question is can you help us dimension the size of returns in your operation either in terms of volume or revenue please? Thank you."
},
{
"speaker": "Carol Tome",
"content": "So first in terms of our largest customer we have a very good relationship with that customer, and the revenue for the quarter was at 11.5% of total revenue, so about the same as it was a year ago. And we look forward to continuing to optimizing the relationship we had with that customer. In terms of the new e-commerce entrants that have come into our network, we’re focused on serving the segments of the opportunities that really respect our end-to-end network, and we will continue to do that. One reason why we are leaning so hard into health care, another reason why we are leaning so hard into SMBs. And I couldn't say enough goodness about our SMB business, particularly our digital access program where the revenue grew 7.7% year-on-year. We now have 38 partners around the world in that program and over 5.8 million shippers on the program. Returns Brian, do you want to comment on that?"
},
{
"speaker": "Brian Dykes",
"content": "Yes. So Ravi we don't -- returns rolls up into our B2B product and also into the ground commercial breakout that we give. Look returns is a portfolio that UPS has had for a long time that we continue to add to and be a leader in. It's one that we've continued to see growth in B2B even when we have, had pressures in other parts of the business. And it leverages not only are kind of single piece returns and technology capabilities that enable customers to integrate with their process, but also the UPS store footprint which allows us to have a very unique returns offering. Now when you add Happy to that, we are able to do consolidated returns, it really becomes a unique portfolio that provides growth in B2B."
},
{
"speaker": "Carol Tome",
"content": "And Matt Guffey is here. Maybe, Matt, you want to comment on Happy Returns and how that's going -- the integration is going."
},
{
"speaker": "Matt Guffey",
"content": "Absolutely. So Happy Returns integration has been extremely important. Remember, we made that acquisition last November. We turned on all 5,200 stores in a matter of eight weeks, which gives us great scale. And with this to Brian's point, it's just not about the digital capabilities, but it is also about that physical footprint and the experience that you can drive for not just the consumer but also the shipper. So we continue to see growth from the Happy Returns portfolio and -- but it also complementary to the single piece returns as well. So as we think about no box, no label and consolidation, we are also doing the no box, no label single piece. So it allows consumers and shippers to get the benefit on -- and managing the rules on how they want the returns to come back to them."
},
{
"speaker": "Ravi Shanker",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Our next question will come from the line of Scott Group of Wolfe Research. Please go ahead."
},
{
"speaker": "Scott Group",
"content": "Hi, thanks. Good morning. So Brian can you just clarify, you are saying that US package EBIT will be up double digits. Are you sort of pointing us towards that -- around that 10% growth rate and then just because double digits is going to obviously mean a lot. And then bigger picture, Carol. At the Analyst Day, you talked about industry oversupply, we are seeing negative yields. It doesn't feel like there is a lot of pricing power right now. But in that context, your -- the peak season surcharges coming are really big. And we were surprised by the magnitude of them. So I guess my question is like are we at an inflection point where you think you can start pushing price more aggressively? And this is a turn? Is this just a unique quarter with a compressed peak? I just want to understand the peak surcharges seem to go in contrast with what we are seeing in underlying price and yield right now. And I just want to understand if we are at a turning point."
},
{
"speaker": "Carol Tome",
"content": "Well, let's talk about the margin first and then we will talk about peak."
},
{
"speaker": "Brian Dykes",
"content": "Yes. So Scott I think what I was talking about was the shaping of Q3 to Q4. And in Q3 yes, we expect domestic package EBIT to be up in the 10% to 15% range. And then for the -- and then it will moderate a little bit. The growth will moderate a little bit in Q4 as the comp levels out. And Carol, do you want to --."
},
{
"speaker": "Carol Tome",
"content": "I'll be happy to talk about peak. So it is a condensed peak. It is the most condensed peak since 2019. There are only 17 days between Thanksgiving and Christmas. And as we look at the volume projections for peak, we’re expecting on our Peak day, which is December 18, has the highest volume ever in our network. Now when you have that kind of volume flowing to your network, you actually have to charge to service them well because you have to hire people and lease aircraft and delivery vehicles so on and so forth. So we think that the prices are going to stick because of what the environment is telling us from a demand perspective. I would also say candidly, they are up against very easy comparison last year. Because, as you recall, well we peaked, volume was declining in the network. So the year-over-year comparisons and the fact that this peak is tight gives us confidence. That being said we also have an opportunity to price -- moving from the art of pricing to the science of pricing through the new tools that we have been talking to you about. Pricing architecture of the future gives us the opportunity to use modifiers and price that creates opportunities for value for our customers, as well as value for ourselves. That plus deal manager, which has been a huge home run for us. We are winning more deals at less discounts than we have in the past. And Matt, maybe I'll turn it back over to you for a comment on price."
},
{
"speaker": "Matt Guffey",
"content": "Yes. So first off, we think we are competing in a rational pricing environment today. And to Carol's point, I think about it in three segments, once she hit on some of the mediums. We also talked about our Digital Access Program, where we have the ability to leverage the architecture of tomorrow. And the way to think about the technology, if I could just to give you context, is the technology gets dynamic pricing across all customer segments and all channels. So we've leveraged it to win in the Digital Access Program, Carol highlighted deal manager. How you think about now moving forward, which I think is really exciting for us is now we have the ability through the modifiers that she highlighted, to dynamically priced across our enterprise customers to better align our price to our cost to serve, while also providing the best value for our customers."
},
{
"speaker": "Carol Tome",
"content": "So hopefully, that's helpful, Scott."
},
{
"speaker": "Scott Group",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Our next question will come from the line of David Vernon of Bernstein. Please go ahead."
},
{
"speaker": "David Vernon",
"content": "Hi, good afternoon or good morning and thanks for taking my question. So Carol, when you came in, there was a lot of focus on value over volume. But here we are guiding down the back half on really easy comps through growth in lower-value volume. Has something changed to your focus for the company? Like what should investors take away from this sort of -- what seems like a pivot towards chasing volume again?"
},
{
"speaker": "Carol Tome",
"content": "Yes. So we are not chasing volume. We actually accepted new customers into our network of with certain volume expectations that blew up on us. We are not chasing it. It is just their demand was much higher than we had anticipated. And so we are laser focused -- focusing on the segments of the market that value our end-to-end network. Better not bigger has not gone away. We'll be managing through this. We need to manage through it and we will be managing through it. So don't read anything into this other than we had new customers come in to our network whose volume blew up. And we were able to serve that with the best on-time service of any carrier."
},
{
"speaker": "Brian Dykes",
"content": "And Carol, if I can just add one thing because I think the value of the volume is also very important. And while we had a lot more shippers in the network, it is important to reinforce this point that SurePost rides in the same theaters and the same hubs that all the other packages do and it helped us drive incremental productivity. Our cube utilization was up in the feeder network. Our hub productivity was up, our preload productivity was up. And when you look at what that does with cost per piece, the US business was able to hold cost per piece to a 2.5% growth rate in the face of a 12% increase in compensation rate. So that alone is huge. Then you layer on top of that the impact it can have on the delivery side with the redirect and really driving stop-and-route density. It's -- the volume generates productivity improvements throughout the entire network, now we have the ability to manage as we move forward."
},
{
"speaker": "David Vernon",
"content": "So I mean, I guess I appreciate that. But when you think about the guidance you just gave for 3Q being 10% to 15% off a really low base, it just doesn't seem like it is dropping to the bottom-line. And that's what investors are looking to capitalize your earnings, not necessarily productivity or cost per piece growth."
},
{
"speaker": "Carol Tome",
"content": "Yes. No we appreciate that. We do. There are a number of actions that we can take to address this. But we thought it was important to provide guidance today. Is that the most realistic view of the back half of the year. It doesn't mean that this is the future of our company. In fact, as we mentioned we will exit the US with a 10% operating margin. That's a significant change from where we have been."
},
{
"speaker": "David Vernon",
"content": "Got it. Thank you for the time."
},
{
"speaker": "Carol Tome",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Our next question will come from the line of Chris Wetherbee of Wells Fargo. Please go ahead."
},
{
"speaker": "Chris Wetherbee",
"content": "Yeah. Thanks, good morning. Maybe touching on that last response, Carol. What are some of the things that you can do to adjust to the network changes that we're seeing and the product mix changes that we're seeing? Is your ability to pull forward fit-to-serve, cost takeout some of the other network structure changes? I guess just how do you fix profitability running at that low level as it is right now?"
},
{
"speaker": "Carol Tome",
"content": "So one way is to accelerate Network of the Future. And I get a review from the team every two weeks on what we are doing in that regard, while we committed to five additional closures in the back half of this year, I think there is an opportunity to do more. Nando, would you like to comment on that?"
},
{
"speaker": "Nando Cesarone",
"content": "Yes, there sure is. And look -- I would just say the operators and the engineers are in tiptop shape right now. And our network is matching to the actual activity that is occurring. But I will tell you there is additional opportunity. As we've closed 35 operational operations this year, we've got additional in the second half. But also, we are starting online 23 new projects that is going to drive additional automation into our efficiency. And so as you start to see the efficiency unfold, we talked about the hours versus the volume, our air volume versus block hours. And of course there is a lot of discussion about SurePost, we're up 300 basis points, making sure we are matching that product with every other package in our network to reduce our operational costs. So as we find those opportunities, we continue making sure we're pressing forward. And for what it's worth, the value of all of that is one, very efficient, very safe and pleasing network to our customers."
},
{
"speaker": "Carol Tome",
"content": "And Kate, the same is true outside of the United States. So what cost down activities are you focused on?"
},
{
"speaker": "Kate Gutmann",
"content": "Yes. So Carol, I think the important move that we made at the start of the year that is playing out in the second half, and you can see it in the margins, of course is the flattening of our structure. We actually – we are focused on how do we speed up from the customer to the decision-making. And we eliminated a whole layer throughout the world, and we are getting great feedback both from the customer, as well as from our people. One example of that also playing off of what Matt talked about with deal manager, we have actually shaved off two weeks of pricing time internationally. International is very complex. Every bid is different countries and different cost structures. To be able to do that and get it down now into two-day turn time or less for our SMBs, that's why we're seeing an over 60% SMB mix in the international arena as well. So both sides of the profit equation."
},
{
"speaker": "Carol Tome",
"content": "Productivity is a virtuous cycle here at UPS. I think we've shown that we can drive cost out, and we will continue to do that."
},
{
"speaker": "Operator",
"content": "Our next question will come from the line of Bruce Chan of Stifel. Please go ahead."
},
{
"speaker": "Bruce Chan",
"content": "Hi, thanks operator. And good morning everyone. Brian, you talked a little bit about the line of sight on volumes in the back half. And I'm wondering if maybe you could give us a bit more color on where RPP or yield trends have been moving into the third quarter so far. And I ask this because I think we saw a little bit of a deterioration, maybe a surprise deterioration on those metrics. Last quarter, it seems like that was not expected. So I'm just kind of curious, what makes you so confident that mix issues and the trade down issues that surprised us have kind of stabilized here and won't continue to deteriorate? And then maybe just worth a shot here, but is it possible to talk about what domestic volume growth would have been without that e-commerce customer?"
},
{
"speaker": "Brian Dykes",
"content": "So certainly, on the first point around the RPP growth rate, I think when you take a look at the second quarter you do have to remember the comp is a big issue in the second quarter. And we did see quite a shift from Q1 to Q2. And as we go into Q3 and Q4, we do expect the growth rate to moderate -- sorry, the negative growth rate to moderate. So it will improve to about negative 1.4% in the third quarter negative 0.4% in the fourth quarter and that will continue to improve as we go through the back half. There is a couple of things that are going on there. One is we absolutely have line-of-sight to new customers that are going to be coming on that normalize the mix of volume that we have. And also we have seen the wave of these kind of new entrants come into the market, and the volume levels are stabilized. And we are working with those customers on what those forecasts look like in the back-half, so we have better line-of-sight to that. Related to your second question we invited these customers into our network. I think the idea of what they would look like if they weren't there, it doesn't really matter right? Because they are there -- we found a way to make this volume very efficient within our network. And look, we'll continue to grow in the places of the market that are growing faster."
},
{
"speaker": "Carol Tome",
"content": "And just on the line of sight question, we've really tightened up the visibility as to when we win an account versus when it actually comes into the network. I will say we -- our visibility there wasn't as sharp as it should have been, so we've gotten much better now. And we are holding everyone accountable for getting the cardboard onto the package car. And that makes a -- well it may not be cardboard, it may be a poly bag, but the package on to package car. So I feel much better than I have over the past several years, candidly in terms of our visibility on onboarding."
},
{
"speaker": "Bruce Chan",
"content": "Okay, great. Thank you."
},
{
"speaker": "Carol Tome",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Our next question will come from the line of Brian Ossenbeck of JPMorgan. Please go ahead."
},
{
"speaker": "Brian Ossenbeck",
"content": "Good morning. Thanks for taking the question. Carol, following up on the pipeline. You mentioned that several times in terms of the visibility, the types of customers, the confidence coming through there. Maybe you can elaborate on that last comment, given just how that one large customer or e-commerce customer surprised the upside when volumes blew up. And then separately, can you give us an update on the USPS contract, how it is going so far, any surprises and whether or not that was a big contributor to the updated '24 guide. Thank you."
},
{
"speaker": "Carol Tome",
"content": "Yes. So to be perfectly clear, there were two new e-commerce customers that came into our network. And you can imagine who they are. These are new e-commerce shippers in the United States whose volume has been quite explosive. We are working through those relationships as we speak. As it relates to the USPS, Nando, would you like to comment on how that's going?"
},
{
"speaker": "Nando Cesarone",
"content": "Sure. I think because with regard to the USPS, both teams are actually face-to-face planning and executing so far close to 50% of the change. And we'll continue pushing forward. We'll be fully implemented in terms of the UPS network in place to serve the USPS on September 8 and contract really starts officially 10/01, where we'll see the -- all of the volume come over to UPS. So far, in recognition of two parties getting together for the first time in this regard, there's been some bumps but nothing systemic. So it's working out really well on both sides, professionals from the USPS and UPS, really doing some good work there."
},
{
"speaker": "Brian Ossenbeck",
"content": "Great. Thank you."
},
{
"speaker": "Operator",
"content": "Our next question will come from the line of Conor Cunningham of Melius Research. Please go ahead."
},
{
"speaker": "Conor Cunningham",
"content": "Hi everyone. Thank you. I was hoping you could provide some color just on revenue contribution for Estafeta and then maybe price paid. And then just bigger picture, how you are viewing the M&A landscape now. Are you happy with the portfolio? How are the returns of the businesses that you have or are acquiring holding up right now? Thank you."
},
{
"speaker": "Carol Tome",
"content": "So we're super excited about the Estafeta announcement. Acquiring companies in Mexico isn't easy. The team has worked very hard to get us to this point, and we'll work through all the closing conditions. We hope to have the acquisition closed by the end of the year. Together UPS and Estafeta will be a $1 billion plus business. So this firmly cements our leadership position in North America and we couldn't be more excited about it. Do you want to take the second part of the question?"
},
{
"speaker": "Brian Dykes",
"content": "Yes, certainly. And then, Kate maybe you want to talk about the broader piece of it. But I think Estafeta, just to give you a little bit of context, it covers 95% of the population in Mexico with 145 facilities. So this is a fairly large business. It does about 325,000 pieces a day. So it gives you context of where it fits into the portfolio. And it fits very firmly within our near-shoring strategy. And Kate, do you want to add anything on that?"
},
{
"speaker": "Kate Gutmann",
"content": "Yes, absolutely. So think about first of all, that 300,000 pieces, all those shippers. They need a transporter, a cross-border solution that is quality and that has access to the best small package network in the US. That's what we give it. So it's the additional packages. I'll answer that other part of the question on our track record with the acquisitions. If you look back at Marken, also Bomi, onto MNX all of them are meeting their business cases, as well as their synergy both on the revenue and cost side of the equation. Because what it does is opens up again this end-to-end opportunity to these premium customers. We expect the same thing we are ahead of the supply chain shift into Mexico. Our supply chain cross-border business is up double digit. So this will only help with us that as well."
},
{
"speaker": "Carol Tome",
"content": "And I know you asked about the purchase price. We typically won't disclose the purchase price, but I can give you a hint. Brian said that we accessed the debt capital markets in the second quarter and raised some additional debt capital for growth. It is about $1.2 billion. We are not spending $1.2 billion on the business. So that gives you a sense of where the purchase price is going to be."
},
{
"speaker": "Brian Dykes",
"content": "That's right."
},
{
"speaker": "Carol Tome",
"content": "And in terms of the portfolio of assets that we have -- we looked at strategic alternatives for Coyote. We are delighted to reach an agreement with RFO to sell Coyote to that business, at a great value, higher than our carrying value, and the multiple on EBITDA was over 12 times. So I was really pleased with the value that we received or will receive when we close that transaction. And we are always looking at the portfolio of assets, are there other things that we can optimize or monetize. So we are never done. But there's nothing large that would need to be talked about today."
},
{
"speaker": "Brian Dykes",
"content": "Stephen, we have time for one more question."
},
{
"speaker": "Operator",
"content": "Our final question will come from the line of Bascome Majors of Susquehanna. Please go ahead."
},
{
"speaker": "Bascome Majors",
"content": "Thanks for taking my questions. If you go back to the trade down discussion in the SurePost, can you talk a little bit high level about how that business moves through your network? And what's different about it that better matches the cost of that package with the lower yield for that package? And just extending that a little bit further if SurePost is a higher mix of the domestic business than you'd expected longer-term, what nuance changes would there need to be with the network to make that a better fit? Thank you."
},
{
"speaker": "Carol Tome",
"content": "Well, SurePost is a great product in many ways. As I mentioned, it is a Sunday solution for us, and we are -- with our matching algorithm able to redirect volume. So it's delivered in our ground network. Maybe, Nando you want to give a little bit more color at how does that work?"
},
{
"speaker": "Nando Cesarone",
"content": "Yes, sure. And as Brian mentioned earlier, I mean, SurePost is going to flow through our network, regular feeders, regular hubs, sortation. What we are working on and very close to solving is looking ahead more than one day, so we can match even more of those SurePost shipments. So right now, if a package shows up at a destination, that particular morning, we will match that package with other deliveries for that day. The option moving forward is to look for additional matching opportunities, and we are very close to that solution so we can actually look further out. In total, as I said before, we're matching a lot more, about 3% more than last year. And each one is offsetting the cost and providing profitability to that shipment or that delivery, if you will to that one location."
},
{
"speaker": "Carol Tome",
"content": "So that matching capability then creates more delivery density, which is a big value unlock for us. We've talked about in the past, every 10 basis points of improvement is a couple of hundred million dollars. So this is an important initiative to make this product even more attractive to us over time."
},
{
"speaker": "Bascome Majors",
"content": "Thank you."
},
{
"speaker": "Carol Tome",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "I would now like to turn the conference back over to our host, Mr. Guido. Please go ahead."
},
{
"speaker": "PJ Guido",
"content": "Thank you, Stephen. This concludes our call. Thank you for joining and have a good day."
}
] |
ups | 2,024 | 1 | [
{
"speaker": "Operator",
"content": "Good morning. My name is Stephen Dye, and I will be your conference facilitator today. I would like to welcome everyone to the UPS Investor Relations First Quarter 2024 Earnings Conference Call. All lines have been placed on mute to prevent any background noise. And after the speaker's remarks, there will be a question-and-answer period. [Operator Instructions]. It is now my pleasure to turn the floor over to your host, Mr. PJ Guido, Investor Relations Officer. Sir, the floor is yours."
},
{
"speaker": "PJ Guido",
"content": "Good morning, and welcome to the UPS first quarter 2024 earnings call. Joining me today are Carol Tome, our CEO; Brian Newman, our CFO, and a few additional members of our executive leadership team. Before we begin, I want to remind you that some of the comments we'll make today are forward-looking statements within federal securities laws and address our expectations for the future performance or operating results of our company. These statements are subject to risks and uncertainties, which are described in our 2023 Form 10-K and other reports we file with or furnish to the Securities and Exchange Commission. These reports, when filed, are available on the UPS Investor Relations website and from the SEC. Unless stated otherwise, our discussion refers to adjusted results. For the first quarter of 2024, GAAP results include a total charge of $110 million, or $0.13 per diluted share, comprised of after-tax transformation and other charges of $75 million and a non-cash after-tax impairment charge of $35 million, driven by plans to consolidate certain acquired brands within our healthcare portfolio. A reconciliation to GAAP financial results is available on the UPS Investor Relations website and also available in the webcast of today's call. Following our prepared remarks, we will take questions from those joining us via the teleconference. [Operator Instructions] Please ask only one question so that we may allow as many as possible to participate. You may rejoin the queue for the opportunity to ask an additional question. And now, I'll turn the call over to Carol."
},
{
"speaker": "Carol Tome",
"content": "Thank you, PJ, and good morning. Let me begin by thanking UPSers for doing what they do better than anyone, and that's deliver industry-leading service. Through the first quarter, UPSers continued to execute our strategy by focusing on growth and efficiency and exemplified our purpose of moving our world forward by delivering what matters. Moving to our results, the first quarter turned out as we expected, starting with a decline in average daily volume. U.S. average daily volume, or ADV, declined year-over-year, but the rate of decline slowed as the quarter progressed, ending with March down less than 1%. And on a sequential basis, the ADV decline rate in the first quarter showed marked improvement compared to the fourth quarter of 2023. This improving performance is primarily due to the efforts of our sales team to win and pull through new volume into our network. Outside of the U.S., the ADV decline rate also improved sequentially compared to the fourth quarter of last year, and we saw pockets of export growth in certain markets and lanes. For the first quarter, consolidated revenue was $21.7 billion, a decline of 5.3% versus last year. Operating profit was $1.7 billion, down 31.5% compared to last year, due for the most part to higher labor costs associated with the first year of our Teamster’s contract. Consolidated operating margin was 8%. Our operating profit performance was a bit better than we expected due to higher productivity. At our Investor and Analyst Day last month, we shared our three-year targets and how we intend to reach them under our Better and Bolder approach. We are reimagining our network through Network of the Future, and we are leaning into the parts of the market that value our end-to-end integrated network. For example, we recently announced that UPS will become the primary air cargo provider for the United States Postal Service. Under this contract, we will move most of the USPS’ air cargo within the United States. The USPS air cargo business fits beautifully with our strategy to grow our B2B business. To win, we put together an innovative and differentiated solution that leverages our integrated network and existing assets. The USPS air cargo business will contribute to top-line growth and be accretive to consolidated and U.S. domestic operating margins. Brian will share more details, including what to expect during the transition period and where this will show up in our financial reporting. Moving to our strategic update, through our customer-first, people-led, innovation-driven strategy, we are investing to grow in the premium parts of the market and drive efficiency. Let me give you a few recent examples. Starting with customer-first. Through our on-demand network, we are expanding our addressable market with capabilities like no-box, no-label returns, through Happy Returns, and the convenience of our more than 5,200 UPS store locations. During the first quarter, our overall returns volume in the U.S. increased 1.4%, and Happy Returns more than quadrupled its ADV in the first quarter. Returns are attractive to us for a couple of reasons. First, they are typically B2B movements, and as a result, drive pickup and delivery density. Second, our frictionless offering creates customer loyalty and repeat business. We are also expanding our addressable market with capabilities like big and bulky deliveries through Roadie. In the first quarter, we launched RoadieXD, which adds cross-dock capabilities to RoadieXL. Our cross-dock solution brings the digital and physical together for long-zone deliveries of bulky items, such as grills and furniture, that do not fit in the UPS small package network. This is enabling us to unlock additional revenue opportunities in the highly fragmented $60 billion big and bulky market in the U.S. It's still early days, but this is a large opportunity for us to grow quality revenue and profit and serve the needs of our customers. As we laid out at our Investor Day, our long-term target is to grow our U.S. S&D volume penetration to 40%. DAP, our digital access program, is one of the tools we will use to reach this target. Recently, we enhanced our DAP pricing capabilities by launching a solution we call Fast Lane. With Fast Lane, we can optimize rates and target attractive volume growth, whether it be by partner, by product, or by customer segment, all of which can drive revenue per piece growth. We can even target volume growth by geography to drive density. Prior to Fast Lane, rate and other adjustments in DAP could take months. Now we can make them in a matter of days or even hours. In terms of results, in the first quarter, DAP revenue grew by 3% year-over-year. And in 2024, we expect to generate over $3 billion in global DAP revenue. Speaking of S&D, over the last year, we've gained traction on improving the customer experience across 16 journeys. Take pickups. We redesigned our process and deployed new driver dispatch technology. This resulted in a 74% reduction in pickup concerns and a Net Promoter Score, or NPS, of 48 for this journey, which is an all-time high for UPS. And for our international customers, our next-gen brokerage solution is making it easier for S&Ds to navigate the ins and outs of exporting, as evidenced by a 40% decline in custom brokerage holds since April of 2023. Turning to healthcare, we aim to become the number one complex healthcare logistics provider in the world. Healthcare companies are innovating, and so are we. Our latest example is the opening of LabPort at Worldport, our global air hub in Louisville, Kentucky. LabPort is unique. It's an end-of-the-runway, state-of-the-art facility built specifically for lab customers. By being at Worldport, we can deliver urgent air packages to our lab customers well before the sun comes up, so they can provide diagnostic results by early morning. And in terms of healthcare revenue, in the first quarter, revenue from our healthcare portfolio reached $2.6 billion. Outside the United States, we're continuing to enhance our network to grow our premium international business. Our most recent example is the launch of Next Day flights between Shenzhen, China, and Sydney, Australia. The addition of these flights enables faster import and export movements between 11 Asian markets in Australia. And now, exports from Australia can even reach Europe by the next business day. This enhancement further enables us to serve our customers, particularly those that are in high-tech manufacturing and healthcare, as they are shifting their supply chains in response to changing international trade flows. Now, let's turn to innovation-driven. As we've discussed, Network of the Future includes physical and digital changes that will deliver benefits in the short-term and the long-term. Smart Package, Smart Facility, our RFID solution, is a great digital example. We are moving from a scanning network to a sensing network. Following last year's Phase 1 deployment to our preload operations, this year, we are installing RFID readers in over 40,000 U.S. package cards, with a balance to be completed in 2025. Package card readers will enable us to further reduce our misloads, which will improve efficiency and the customer experience. The physical aspect of Network of the Future has launched, and in the quarter, we continue to close sorts and flow more volume into automated facilities. Most of the Phase 1 major projects we outlined during our Investor Day have begun and are in the contracting and execution phases. Innovation-driven is also about achieving carbon neutrality by 2050. We recently published our 22nd Sustainability Report, and we are well on our way to achieving our goals. In 2023, our Scope 1, 2, and 3 CO2 emissions declined 8.1% compared to 2022. We operate more than 18,000 alternative fuel and advanced technology vehicles in our rolling laboratory. And the use of alternative fuels in our ground operations reached 28.8% last year, keeping us on track to achieve our target of 40% by 2025. Moving to our outlook, we are reaffirming our previously announced 2024 consolidated financial goals. In 2024, we expect to generate consolidated revenue ranging from approximately $92 billion to $94.5 billion and a consolidated operating margin ranging from approximately 10% to 10.6%. Versus last year, we still expect first half earnings to decline and second half earnings to grow as we lap the first year of the Teamster’s contract, and we still expect to exit the year with a U.S. operating margin of 10%. As we move forward, we are staying on strategy and under our Better and Bolder approach, we are pursuing our declarations to become the premium small package provider and logistics partner in the world. With that, thank you for listening. And now I'll turn the call over to Brian."
},
{
"speaker": "Brian Newman",
"content": "Thanks, Carol. Good morning. In my comments, I'll cover four areas. First, I'll review our first quarter results followed by our 2024 financial outlook. Then I'll provide some comments on our business with the USPS. And lastly, I'll close with a recap of our 2026 targets. While the macro environment in the first quarter showed improvement in some areas, continued soft demand pressured all three parts of our business. Through the quarter, we adjusted our integrated network to match volume levels and drove out expense while maintaining industry-leading service levels. Moving to our financial results, our overall quarterly performance was in line with our expectations. In the first quarter, consolidated revenue was $21.7 billion, down 5.3% compared to the first quarter of 2023. All three of our segments demonstrated cost agility and on a combined basis, drove DAP expense by $414 million in the first quarter. This enabled us to deliver $1.7 billion in consolidated operating profit and consolidated operating margin was 8%. Diluted earnings per share was $1.43, down 35% from the first quarter of 2023. Now let's look at our business segments. In U.S. Domestic, we remained focused on controlling what we could control to improve volume growth and drive productivity. In the first quarter, average daily volume was down 3.2% year-over-year. When looking at ADV sequentially, the growth rate showed strong improvement compared to the third and fourth quarters of 2023. B2B average daily volume was down 5.5% compared to the first quarter of last year, primarily driven by declines in the retail and manufacturing sectors. And B2B represented 41.6% of our volume. Looking at product mix and in line with recent trends, we continue to see a shift from air to ground as customers prioritize cost savings over transit times by taking advantage of our ground services. Compared to the first quarter of 2023, total air average daily volume was down 8.3%. Ground declined 2.3% and within ground, sure post volume grew 10.8%. For the quarter, U.S. domestic generated revenue of $14.2 billion, down 5%. Revenue per piece was relatively flat year-over-year. Looking at the key drivers, base rates increased the revenue per piece growth rate by 240 basis points. This was offset by a couple of factors. First, changes in customer and product mix due to growth in sure post combined with changes in package characteristics decreased the revenue per piece growth rate by 180 basis points. And second, changes in fuel prices decreased the revenue per piece growth rate by 90 basis points. Turning to cost, total expense was down 0.8% or $104 million in the first quarter. Union wage rates increased 13% driven by the contractual increase that went into effect last August. Leveraging technology and the agility of our integrated network, we took several actions which more than offset the increase in compensation. We leveraged total service plan and network planning tools to reduce total operational hours by 6.6%, which was more than the decline in average daily volume. We closed 18 sorts and reduced operational resources by 4.8% compared to last year. We lowered block hours by 15.2% versus last year. We reduced management and support staff by approximately 5,400 positions year-over-year. In addition, we reduced purchase transportation by 17%, primarily from our continued optimization efforts. And lastly, lower fuel costs contributed to the decrease in total expense. The U.S. domestic segment delivered $839 million in operating profit, down 43.6% compared to the first quarter of 2023, and operating margin was 5.9%. Moving to our international segment, the macro environment remained challenged, primarily in Europe and Asia. However, volume growth in the Americas region showed early signs of nearshoring. In the first quarter, international total average daily volume was down 5.8% year-over-year. About two-thirds of the decline came from lower domestic average daily volume, which was down 8.1%, and driven primarily by declines in Canada and major markets in Europe. On the export side, average daily volume declined 3.6% year-over-year primarily due to weak manufacturing activity in Europe. In Asia, export average daily volume was down 4.8%, which was an improvement from the fourth quarter of 2023. Within Asia, export volume on the China to U.S. lane increased 12.8% and showed steady growth for the second consecutive quarter. More than offsetting the overall decline in Asia, nearshoring became evident as export average daily volume in the Americas region increased 3.8%. This was led by SMB customers in Canada and Mexico, leveraging our cross-border ground service. In the first quarter, international revenue was $4.3 billion, down 6.3% from last year, primarily due to the decline in volume. Revenue per piece increased 2% and included a number of moving parts. Strong base pricing drove a 360 basis point increase in the revenue per piece growth rate, a decline in fuel surcharge revenue, combined with a stronger U.S. dollar negatively impacted the revenue per piece growth rate by 80 basis points. And finally, lower demand-related surcharge revenue decreased the revenue per piece growth rate by 80 basis points. In the first quarter, total international expense was down $163 million, a decline of 4.4%. Similar to previous quarters, we leveraged the agility of our integrated network to reduce block hours by 6.6%. Operating profit in the international segment was $682 million, down $124 million year-over-year. Operating margin in the first quarter was 16%. Now looking at Supply Chain Solutions, in the first quarter, revenue was $3.2 billion, down 5.3% year-over-year. Looking at the key drivers within forwarding, market rates in international airfreight continue to drive down top-line revenue. On the ocean side, excess market capacity continued to pressure market rates and drove a decrease in revenue despite volume growth. And our truckload brokerage unit continued to face soft demand and market rate pressures. Logistics delivered revenue growth and increased operating profit driven by gains in health care. In the first quarter, Supply Chain Solutions generated operating profit of $226 million, down $32 million year-over-year and an operating margin of 7%. Walking through the rest of the income statement, we had $195 million of interest expense. Our other pension income was $67 million, our effective tax rate for the first quarter was 26.8%. Now let's turn to cash and shareholder returns. In the first quarter, we generated $3.3 billion in cash from operations. Free cash flow for the period was $2.3 billion. We finished the quarter with strong liquidity and no outstanding commercial paper. Also in the first quarter, UPS rewarded shareowners with $1.3 billion in dividends. Turning to our outlook. As Carol mentioned, we are reaffirming our 2024 consolidated financial targets. For the full year 2024, on a consolidated basis, revenues are expected to range between $92 billion and $94.5 billion, and we expect to generate a consolidated operating margin ranging from approximately 10% to 10.6%. Looking at the shape of the year. In the first half of the year, we expect consolidated operating profit to be down between 20% and 30%. And in the back half of the year, we expect volume and revenue growth to accelerate as we lap the diversion we experienced as a result of our labor negotiations. Additionally, our labor cost growth rate will drop substantially. We will also see the majority of the $1 billion in savings from Fit to serve. We still expect revenue per piece to outperform cost per piece. And lastly, in U.S. domestic, we expect to exit the year at a 10% operating margin. Looking at cash flow and capital spending. For the full year in 2024, we still expect capital expenditures to be within our target of around 5% of revenue or $4.5 billion. We're reviewing certain aspects of our pension strategy, and so we expect free cash flow to be within a range of approximately $5.9 billion to $6.7 billion before reflecting any pension contributions. Now let me share more detail about servicing Air Cargo for the USPS. This is good business for us, and we are moving quickly to begin onboarding this cargo. We will leverage our integrated network and existing assets, and we expect the majority of the volume will fit within our current U.S. domestic daytime flight operations. Our operators and engineers are already planning the network to support the complete transition to UPS in the third quarter. In terms of financial reporting, the revenue and expense associated with USPS Air Cargo will show up in the SCS other line in our financial reporting. Adding the USPS air cargo volume to our existing network will result in a higher share of the network cost being allocated to SCS, indirectly benefiting our U.S. domestic segment. We expect to see a benefit to operating margins this year at both the consolidated level and within the U.S. Domestic segment. To wrap up, we are also reaffirming our three-year consolidated revenue and operating margin targets we put forth at our March Investor and Analyst Day. Specifically, we aim to grow revenue to be between $108 million and $114 billion by 2026. The high end of the range includes inorganic opportunities, primarily in health care and international. Additionally, we expect to expand our consolidated operating margin to more than 13% by 2026, which includes expanding our domestic operating margin to at least 12%. And I'll note that the USPS volume is consistent with our better and bolder approach to grow in the parts of the market that leverage our integrated network, and it gives us a strong start to our 2026 targets. With that, thank you, and operator, please open the lines."
},
{
"speaker": "Operator",
"content": "Thank you. We will now conduct the question-and-answer session. Our first question will come from the line of Brandon Oglenski of Barclays. Please go ahead."
},
{
"speaker": "Eric Morgan",
"content": "Hey, good morning. This is Eric Morgan on for Brandon. Thanks for taking the question. I just wanted to ask about the guidance in the first half. I know you mentioned 1Q kind of coming in line with your expectations, but you did call out the 40% decline expectation at the Investor Day. So just wondering if anything happened late in the quarter that drove EBIT above your expectations in the first quarter? And then, are there anything negative going on in 2Q that led you to maintain the first half guidance rather than raise it similar to the 1Q beat. Thank you."
},
{
"speaker": "Brian Newman",
"content": "Morgan, good morning. It's Brian. Happy to take this one. Look, our guidance for the first half of the year remains the same, declining in profit down 20% to 30%. So that's consistent. I did call out at the tail end of the quarter, expected minus 40%. I said consistently that Q1 would be the tougher quarter in the first half of the year. There were two elements that contributed to beating that 40%. One, on the top-line, we did see positive volume momentum going into the end of the quarter in fact, the last couple of weeks were basically breakeven from a volume perspective. I think the last week was about zero percent thereabout. So sequentially, we were seeing improved volume. But the bigger component was just some cost trading between April and March, things like occupancy and maintenance cost shift in terms of when they hit the P&L between March and April. So no change from a guide perspective still down 20% to 30%, some cost timing at the end of the quarter there, but the positive was the trajectory of volume momentum. Thanks, Morgan."
},
{
"speaker": "Operator",
"content": "Our next question will come from the line of Amit Mehrotra. Please go ahead."
},
{
"speaker": "Amit Mehrotra",
"content": "Thanks. Carol, Brian, can you just provide a bit more details on the contribution margins associated with the USPS contract. This was a zero margin business that your direct competitor and somewhat surprisingly is now moving from your direct competitor to you it kind of harkens back to kind of pre-2020 when UPS was less price disciplined. And so can you just wage concerns that this wasn't one on price and just talk a little bit in more detail. I know you're obviously raising some block hours to fund -- to service this volume. But what other costs do you kind of expect to bring on to service this $1 billion, $1.5 billion of incremental revenue. Thanks."
},
{
"speaker": "Carol Tome",
"content": "Well, thanks very much for your question, Amit. And we're delighted to have won the air cargo business from USPS our team put together an innovative solution using our integrated network. And as in contrast to traditional hub-and-spoke models, we don't have to run all of the air volume through our main air hub at Westport. Of course, we will use Worldport, but we will also use our regional gateways. That allows for splits to occur outside of the network, so they'll be built in origin and then we will bypass the main hub and go point to point. This is an integrated solution that's very different than I think the former provider offered. We also will use all of the assets of our integrated network, and that will allow us to actually optimize block hours. Now in terms of the investments that we need to make to services volume, we have plenty of space on our existing aircraft. So we won't be purchasing any aircraft. We will be hiring some pilots but less than 200 pilots, and we factored all of that into the cost model that we built. So this will be margin accretive. It will be EPS great at beginning in year one and through the life of the contract."
},
{
"speaker": "Operator",
"content": "Our next question will come from the line of Tom Wadewitz of UBS. Please go ahead."
},
{
"speaker": "Tom Wadewitz",
"content": "Hi, good morning. I wanted to see Brian or Carol, if you could walk through what are the key pieces of the 2Q versus 1Q ramp in EBIT. And then I guess the same thing for second half. Obviously, you've got Fit to Serve as a significant cost benefit versus 1Q. But I think just trying to figure out how much of the improvement sequentially is based on volume that you have visibility to and how much would be based on anticipation of improvement in the broader parcel market kind of macro improvement. Thank you."
},
{
"speaker": "Brian Newman",
"content": "Hey, Tom, happy to take that. So listen, from a Q1 to Q2 perspective, the shape, if we look at the U.S. we would expect marginal growth from a volume perspective, which relative to past trends, normally, Q1 steps down to Q2 from an absolute volume level. So by maintaining that will be a natural accretion from an EBIT perspective. The big component, though, full year on a run rate basis, the Fit to Serve program will generate $1.3 billion in savings and we're ramping that up in Q2. So that will be a big driver as well as we think about it. And then from a Q1 to the back half of the year, it's the same three components, Fit to Serve. It's the volume lift along with the drivers of RPP and then it's the labor contract lapping, which is the big piece in the back end of the year."
},
{
"speaker": "Carol Tome",
"content": "And maybe just a few more comments on RPP since our RPP in the U.S. was flat in the first quarter. We expect RPP growth as we head towards the back half of the year. Why? Well, first of all, fuel prices were a drag on the RPP in the first quarter. The projection for fuel is that is going to increase. We are also announcing a fuel surcharge later today. So those two components of fuel will be a bonus to RPP as we head towards the back half. We also are going to have a pretty picky peak, we anticipate for fewer operating days this year than last, which means the demand surcharge should be pretty strong this year compared to last year. And then we brought in a lot of SurePost product into our network. We're meeting our customers where they want to go we'll be anniversarying a lot of that in the back half of the year as well. So we don’t expect we love by the way, but we don’t expect to see the drag on the RPP I’m sure costs in the back half, like we said, in the first quarter. Any other color you’d like to provide?"
},
{
"speaker": "Brian Newman",
"content": "I think all those that you stated, Carol, and then the volume growth, obviously, with the comps, it’s going to be a big help to us."
},
{
"speaker": "Operator",
"content": "Our next question comes from the line of Jordan Alliger of Goldman Sachs. Please go ahead."
},
{
"speaker": "Jordan Alliger",
"content": "Hi, good morning. Sort of curious, you mentioned some actions taken in the first quarter, like closing sorts and working on peak purchase transport, et cetera, amongst other things. Can you maybe talk to some additional actions that are helping to drive the profit uplift from here, not related to the volumes and maybe the head count reduction? Thanks."
},
{
"speaker": "Carol Tome",
"content": "Well, productivity is a virtuous cycle here at UPS domestically and outside of the U.S. And I just can’t say enough good things about how our team is running our business. Ours are running under the volume declines, higher productivity and cull utilization packages per hour. We measure productivity in minutes, miles and practice per hour and all across the board, we’re seeing record levels. One different callouts that we’ve been talking about this for a while is safety. Our safety stats, if you will, are the best they’ve been in five years. And of course, if you haven’t run a safer business, where you don’t have as many claims for is comp and auto liability. So a real shout out to our operators. And I certainly might say, why is the productivity getting better? One reason is because our turnover is down. And as people stay in place, we were just more productive. And let me throw it over Nando. Is there anything you’d like to add on the productivity side?"
},
{
"speaker": "Nando Cesarone",
"content": "No, I’m actually quite impressed with our engineers and our operators, I think, the best in the business. And we’re continuing to follow our game plan that we reviewed with you at the investor conference, which is keenly focused on closing down stores, moving volume to our automation and our automated facilities. And in fact, when I talked about pieces per headcount at our conference, we’re actually up 2.7% in March. So we are pushing all of the things that help us be more productive and less reliant on labor."
},
{
"speaker": "Carol Tome",
"content": "And Kate, outside the United States in your word talk about product."
},
{
"speaker": "Kate Gutmann",
"content": "Yeah, absolutely. It is a consistent value at UPS and something that all of us work very hard towards every day. So when you look at the major regions around the world, we’re setting records on our cube utilization both on the ground and in the air. As our margins show, we have a very good handle on expense management and as we’re unlocking more of this segment growth, health care specifically, SMB around the world, it only fuels that further."
},
{
"speaker": "Operator",
"content": "We have a question from the line of Ken Hoexter of Bank of America. Please go ahead."
},
{
"speaker": "Ken Hoexter",
"content": "Hey, great. Good morning. Just international margins were a bit lower than we expected. Just maybe thoughts on increased costs. It sounded like you threw out some impacts of near-sourcing. And then, I guess, Brian, just a clarification. You said you’re moving the U.S. Postal Services will be listed in SCS and benefiting domestic. I just want to understand, are you shifting costs then out of domestic into SCS? Or maybe just clarify that comment there."
},
{
"speaker": "Carol Tome",
"content": "Well, first on the international margin, I think Keith did a terrific job of managing costs in an environment where demand was down. There was a onetime item that we didn’t call out in our prepared remarks. But if you back out that onetime item, the international margin would 17%. The first quarter is usually our lowest margin quarter. So we anticipate that the international business and our planning for the international business to be in the high teens as we told to."
},
{
"speaker": "Brian Newman",
"content": "And then on the tonnage in terms of USPS comes in through SCS other. But because we’re using a lot of the U.S. assets, we allocate cost to that business, and that will have a positive benefit on the domestic margin."
},
{
"speaker": "Ken Hoexter",
"content": "And can you clarify what the one item was there?"
},
{
"speaker": "Carol Tome",
"content": "It was a cleanup really in our revenue data mark, we just had some accounts we wrote off."
},
{
"speaker": "Ken Hoexter",
"content": "Thanks a lot for the time. Appreciate it."
},
{
"speaker": "Carol Tome",
"content": "Yes."
},
{
"speaker": "Operator",
"content": "We have a question from the line of David Vernon of Bernstein. Please go ahead."
},
{
"speaker": "David Vernon",
"content": "Hey, good morning. I got a couple of quick commercial questions for you. Can you talk about how the volume outlook outside issuer post is shaping up? I think you mentioned in a couple of pockets, the second derivative is getting better. But if you could talk about whether you feel better or worse about where volumes are going to end up in the year today versus when you started the year? That would be helpful. And then the second question would be on SurePost, 10% demand for anything in small package is a very high number. When are you going to have a chance to maybe address pricing in that product? Because it does sound like you have what looks like a relative advantage in terms of marketing against the lower end of the e-commerce small package market?"
},
{
"speaker": "Carol Tome",
"content": "So from a volume mix perspective, if I look at the volume that’s in our pipeline, I would say the volume that’s in our pipeline is not sure cost. We’ve got commercial volume in our pipeline, additional enterprise volume in our pipeline. So we’re going to be our customers where they want to go. But the mix is looking very different as we look ahead than it was in the first quarter. And in terms of pricing, I don’t think we’re going to talk pricing on this for this call but we always look for opportunities to optimize our pricing."
},
{
"speaker": "Brian Newman",
"content": "And the headwind we saw from a mix perspective, Carol alluded to this in the back end of the year, we are anniversarying a fair amount of share post from last peak. And so the overlaps won’t drive as big of a headwind."
},
{
"speaker": "Operator",
"content": "We have a question from the line of Scott -- we have a question from the line of Scott Group of Wolfe Research. Please go ahead."
},
{
"speaker": "Scott Group",
"content": "Hey, thanks. Good morning. Brian, the second quarter guide, I guess, implies EBIT down anywhere from 10% to 30%. So any more directional color there? And then on this revenue cost allocation thing with the post office? Is there any way to just quantify what the benefit is to the U.S. margin as you're doing this? And is that already sort of captured in the 10% margin comment for Q4? Or does this now take it up versus what you previously thought?"
},
{
"speaker": "Carol Tome",
"content": "Well, maybe I'll talk about the full year guidance and then you can talk specifically about the second quarter. One of the questions may be, well, why aren't you changing your guidance now that you won this air cargo business and you say it's going to be margin accretive. We were highly confident of the range of guidance that we provided at the end of the year, and we're even more confident now but it's just too early in the year to change the guidance. So once we get through the second quarter, we'll tell you what we think the back half of the year will be. On Q2 alone, why don't you talk about?"
},
{
"speaker": "Brian Newman",
"content": "Sure. Scott, we're maintaining the first half at negative 20% to 30% from a profit perspective. So can choose the element of the range you want to point towards. I think ADV in domestic, we're expecting Q2 to be slightly positive. RPP should be consistent with what we saw flattish in the first quarter as we move out of the headwinds from a mix perspective. And as Carol said, fuel and the PSS in the back end of the year will help us. Cost per piece will get better in Q2 -- I'm sorry, in Q3 when we anniversary the cost of the labor contract, but somewhat similar from a Q2 perspective in the U.S. And then from an ADV perspective, internationally, Kate is looking to see that business improve as we sequentially move over the course of the year. So I guess I would steer you towards the 20% to 30%. We've been very consistent on that from a profit standpoint for the first half and you can squeeze it."
},
{
"speaker": "Scott Group",
"content": "And then any thoughts on that the postal shift and the margin benefit for Q4?"
},
{
"speaker": "Carol Tome",
"content": "So this is what I'd like to do is out, let's get through the second quarter, and then we'll come back and give you more color. I like to get some of it into the network. We've modeled it out. I want to actually see how it performs. So we'll give you more color at the end of the second quarter."
},
{
"speaker": "Scott Group",
"content": "Okay."
},
{
"speaker": "Operator",
"content": "We have a question from the line of Ravi Shanker of Morgan Stanley. Please go ahead."
},
{
"speaker": "Ravi Shanker",
"content": "Thanks, good morning, everyone. Carol, in your opening comments, you mentioned that returns were a good business because they were B2B. I'm a little surprised to hear that because I mean, it almost seems like a C2B type business with pretty high fragmentation in the last mile. So if you can just unpack kind of how that works through the supply chain and kind of the profit contribution of that, that would be great. Thank you."
},
{
"speaker": "Carol Tome",
"content": "So we like to return business a lot. You're right, the consumer typically walks into a UPS store to start the return and we consolidate the returns at the UBS store, and they returned to the shipper. And that would be a B2B return. So if you think about -- I'll use our largest customer for an example, we have returns through our UPS stores with our largest customer. We take in thousands of returns for that customer and package it into one consolidated return that goes back to them. So that's a good business for us. And with Happy Returns, now we were able to offer the same service, which is no box in the label. Same idea, consumer walks in, they make the return, we consolidate it and return it back that's how we think about it being a B2B business, and the margins are very attractive to us. It's density. That's one reason why the margins are so good because you get that."
},
{
"speaker": "Operator",
"content": "Our next question will come from the line of Brian Ossenbeck of JPMorgan. Please go ahead."
},
{
"speaker": "Brian Ossenbeck",
"content": "Hey, thanks. Good morning. I appreciate you taking the question. Maybe one for Carol, one for Brian. Carol, can you just talk about -- I know you don't talk about too much about pricing, but you're increasing the fuel surcharge about another 50 basis points. I think that's on top of 125 in December. So just wanted to see your thoughts on how the market could absorb that with some excess capacity. And do you still feel as sort of a lever in terms of all-in pricing? Then for Brian, maybe you can elaborate on the pension contribution strategy. You talked about -- it sounded like maybe the cash contribution was on hold until some other options were considered. So any more thoughts on that would be helpful. Thank you."
},
{
"speaker": "Carol Tome",
"content": "So on the fuel surcharge as we look to the rest of the year, fuel prices are increasing. And this is not atypical for us to adjust our surcharge on the base of rising fuel costs. You also should know that, that doesn't impact all of our customers. Clearly, some are exempted from this. So in terms of the ability to stick, we think the will stick. And just a comment on the capacity at our Investor and Earnings Day, we said there was about $12 million ADV excess capacity in the market, and that equilibrium is about 6%, you need about 6%. So really, the excess capacity is around 6 million today, and we think that will be fully absorbed by 2025. Now you may say why. Well, we're part of that excess. And so we're closing stores. We're taking capacity out of the market, and our Network of the Future initiative is capacity neutral. Also with our large competitors' consolidation efforts capacity will be leaving the market. And then another player headquartered in Seattle on the regional, I think the capacity will be taken out of the market. So we think all that capacity will be absorbed in the pricing environment is actually very rational."
},
{
"speaker": "Brian Ossenbeck",
"content": "And Brian, just on your secondary question around the pension. I had quoted cash -- free cash flow ex pension of $59 million to $67 million. We do have annual service cost in the $1.4 billion range. So from a modeling perspective, you can use that as a placeholder. But the reality is taking a look at strategic options on pension, a little too a bit of early days to comment on that, but we'll come back later in the year and share our thinking on some of the actions and activities we're pursuing."
},
{
"speaker": "Carol Tome",
"content": "Yeah. Our pensions are very well funded. They're over 90% funded. And it gives us an opportunity to step back on. You just look at our asset liability strategy, our funding strategy. So we thought we should just pause right now, take a look at it and then when we -- if we make any decisions, we'll share that with you."
},
{
"speaker": "Brian Ossenbeck",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Our question will come from the line of Conor Cunningham of Melius Research. Please go ahead."
},
{
"speaker": "Conor Cunningham",
"content": "Hi, everyone. Thank you. Just curious on your expectations for -- I mean, sorry, you talked a little bit about volume inflecting soon. And can you just talk about your expectations in terms of volumes as you move from first half to second half? I think previously, you were talking about flat to up 2% in the U.S. domestic market, then you came in a little bit ahead. Just trying to understand how the back half are to look outside of just comps being pretty easy. Thank you."
},
{
"speaker": "Brian Newman",
"content": "So from an ADV perspective in domestic, I think that's where you're headed with a little bit of a slight tick up in positive volume in the second quarter will likely finish low single-digit decline in the first half, second half we'd expect that to be low single-digit increase. And you can look at it through various different lenses. We're building momentum ever since August, each month is basically getting sequentially better each quarter from Q3, Q4, Q1 improves. We'd expect to see slight positive volume trends in the second quarter. And then just from a comp standpoint, I mean if I go back from a trend perspective, over the last 10 years, our Q3 is generally about close to 300,000 ADV better than Q1. And even if we assume flat from a Q3 to Q1, that would be 4.5% growth. So any way you cut it, we see the back end of the year and most important, it's the visibility on the sales pipeline that we're pulling through and the volume levels we're seeing going into Q2."
},
{
"speaker": "Conor Cunningham",
"content": "Super helpful. Thank you."
},
{
"speaker": "Operator",
"content": "Our next question will come from the line of Jonathan Chappell of Evercore ISI. Please go ahead."
},
{
"speaker": "Jonathan Chappell",
"content": "Thank you, good morning. Brian, you'd mentioned the $1 billion of productivity that you expected to see in the full year '24 guide. Can you just tell us where that stands after the first quarter and how we think about the cadence throughout the rest of the year? Is it front half loaded? Or is it kind of extrapolated evenly by quarter?"
},
{
"speaker": "Brian Newman",
"content": "Yeah. The initiative is progressing slightly ahead of plan. Reductions began in March and will continue through I2. We’d expect more than 80% of the resource reductions to be complete by I2. We’re on track to that $1 billion that I mentioned. And at a full annual run rate going into next year, we’d expect $1.3 billion. So there’ll be some benefit early part of next year."
},
{
"speaker": "Jonathan Chappell",
"content": "Great. Thank you."
},
{
"speaker": "Operator",
"content": "Our next question will come from the line of Daniel Amaro [ph] of Stephens Incorporated. Please go ahead."
},
{
"speaker": "Unknown Analyst",
"content": "Yeah. Thanks, good morning, guys. Thanks for the questions. Wanted to follow up on the USPS contract. Carol, the air cargo, I think, should come into your network in the fourth quarter. I think first, any business coming in sooner than that, just to clarify, and then looking at 4Q in the outlook, are there any minimum volume component to the agreement? I mean, obviously, that customer has moved a lot of freight out of the air network as it looks to save costs by using ground. It still looks like ground is cheaper out there. So how do you protect for more of that volume leaving the air cargo market into maybe slower transit time, similar to the rest of your business? Thanks."
},
{
"speaker": "Carol Tome",
"content": "Well, clearly, we want to get all the volume on boarded before peak. That’s in their interest in our best interest. We will onboard the volume as we can. Our teams are in Washington, D.C. working with the postal service hand-in-hand as we build our operating plan."
},
{
"speaker": "Operator",
"content": "Our next question will come from the line of Bascome Majors of Susquehanna. Please go ahead."
},
{
"speaker": "Bascome Majors",
"content": "Yeah, thanks for taking my questions. As you work on cash flow with the pension strategy stuff you've talked about that we might hear more about late this year. Can you talk a little bit about the dividend? If you look at your payout guidance, it implies roughly $13 in earnings at the dividend level that you're paying now. Is there an opportunity to start to raise it more meaningfully before the earnings power of the business gets there? Or do you think we need to wait and get more increases like we saw this year until the business is supporting that more literally? Thank you."
},
{
"speaker": "Carol Tome",
"content": "We have a disciplined approach when it comes to capital allocation. The first use of our cash, as you know, is to invest back into our business and the second is to pay our dividend. We have a targeted dividend payout ratio of 50%. We are higher than that. It's our intent to earn back into a 50% payout ratio over time. We have no intent to cut the dividend to make that math work. We're going to earn back into it and the dividend is an important part of the value proposition. So we just raised the dividend and we look to, of course, subject to board approval, we look to raise the dividend every year. Any color you'd like to add here?"
},
{
"speaker": "Brian Newman",
"content": "Just, Carol, this year marks the 15th consecutive year we've increased the dividend, and we're committed to a stable and growing dividend. So we will earn back into that, but certainly committed to it."
},
{
"speaker": "Carol Tome",
"content": "And I feel to respond to Daniel's question about minimum levels within the USPS contract. I'd like to throw that over to Matt. Matt, did you answer your question?"
},
{
"speaker": "Matt Guffey",
"content": "Yeah, absolutely. So thank you, Carol. First of, yes, we do set minimums in the contract. As we built this, we identified a win-win for both the USPS and for us it's just imperative that, one, we not only have it on the protection for our side and our business on what we're bringing on but also for the USPS because we want to make sure, as Carol mentioned, that we're onboarded before peak season, and we're bringing this on as quickly as possible, and we're working collectively with them. Nando and the team have done a great job with their operational team. And to Carol's point, we're meeting with them every week in DC to continue to onboard that volume to make sure it's a smooth transition."
},
{
"speaker": "Carol Tome",
"content": "Thanks, Matt."
},
{
"speaker": "Operator",
"content": "Stephanie Moore of Jefferies. Please go ahead."
},
{
"speaker": "Stephanie Moore",
"content": "Hi, good morning. Thank you. I wanted to touch back on the volume commentary. If you can maybe discuss in your eyes, what drove the improvement as the quarter progressed and your expectations into 2Q. How much of this was from kind of actions within your own control? And then at the same time, maybe areas where the underlying environment is improving some over kind of what we've experienced over the last year. And in that case, where you've seen that improvement in the macro. Thank you."
},
{
"speaker": "Carol Tome",
"content": "Well, I give a shout out to our sales team. The improving volume trends are in large part due to their hard work and efforts. You may recall at the beginning of the year, we said the growth in the market wasn't going to be very growthy this year. So the fact said, we're able to see sequential improvement in the magnitude that we're seeing is really because of our sales team. We are winning new. We are gaining additional penetration of existing customers. We are meeting customers where they want us to be. And our sales team will continue to do that around the world. And that's one reason that we're confident in the volume projection that Brian did share."
},
{
"speaker": "Operator",
"content": "Our next question will come from the line of Bruce Chan of Stifel. Please go ahead."
},
{
"speaker": "Bruce Chan",
"content": "Hey, thanks. And good morning everyone. Carol, just back to your DAP comment from the beginning of the call. I know that's big part of your S&D growth efforts. You said you grew 3% in the first quarter. And I can't help but notice that that's materially [indiscernible] you said the plan was over $3 billion and then at the Investor Day, you said materially over $3 billion. So I just want to know if there's something happening that's driving a slower growth outlook for DAP."
},
{
"speaker": "Carol Tome",
"content": "Yeah. Thanks for the question. And I think I got it, you broke up a bit, but it’s generally about DAP. So last year, in the first quarter, our DAP revenue grew 51% and our volume grew 61%. So we didn’t expect to repeat that kind of growth in the first quarter of this year. And so we were very pleased with how the DAP portfolio performed in the first quarter because it was in line with our expectations. We had anticipated a slower growth in the first quarter because there were a couple of our partners that we were working on amending the teens and fees. So we expected the growth rate to be slower and then to pick up as we move into the second quarter and the rest of the year. The projections for the DAP around the world, and we’re seeing great growth outside the United States, by the way. The projections for the DAP portfolio by the end of the year is in excess of $3 billion."
},
{
"speaker": "Bruce Chan",
"content": "Okay, that’s very helpful. Thank you."
},
{
"speaker": "Carol Tome",
"content": "Yes."
},
{
"speaker": "Operator",
"content": "Our next question will come from the line of Scott Schneeberger of Oppenheimer. Please go ahead."
},
{
"speaker": "Scott Schneeberger",
"content": "Thanks very much. Good morning. Carol, could you give us an update on your SMB progress. Curious how you're trending towards the long-term target domestically? And then also, how does international compare? You've spoken in the past about making nice progress there. Just curious, how does that compare to domestic right now? And what type of aspiration can you achieve longer term? Thanks."
},
{
"speaker": "Carol Tome",
"content": "Yeah. So we're right now at about 29% as of the end of the first quarter. And as we look towards the end of this year, we should be over 30 in the low 30s. So we're trending nicely. And Kate outside the United States how's SMB performance?"
},
{
"speaker": "Kate Gutmann",
"content": "Yeah. Our history outside the U.S. is in SMB. So we have a 62% share of SMB, and this is now where we're implementing debt. So we're only going further. As Carol said, our DAP program and small package around the world is resonating with our SME shippers as they look for ease and access. So that's excellent. And then I'll just also say in our freight business, we have a DAP like service, which is our forwarding hub, and it's actually well ahead of plan as well. So SMBs are showing that they really need access through the digital platforms, and it's resonating very well."
},
{
"speaker": "PJ Guido",
"content": "Hey, Stephen, we have time for one more question."
},
{
"speaker": "Operator",
"content": "Our last question will be a follow-up from the line of David Vernon of Bernstein. Please go ahead, sir."
},
{
"speaker": "David Vernon",
"content": "Thanks for coming back to me. I just wanted to ask about -- you mentioned the pricing environment being kind of rational. Could you elaborate on how effective the GRI has been this year? What's the stick rate there? And as you think about the underlying performance in domestic yields ex some of the mix headwinds, could you talk a little bit about the trajectory or the rate of change through the quarter?"
},
{
"speaker": "Brian Newman",
"content": "Yeah, Dave, we had expected about a 50% keep rate. We saw a 240 -- roughly 250 basis points in the first quarter. So generally, in line with expectations. We'd expect that base rate to continue over the course of the year. I think Carol hit on a couple of the key points around the other elements of pricing. There's a fuel piece. There's PSS in the back -- in the peak season and then there's the mix component that we've been talking about the focus on commercial on SMB and health care. So all those things combined give us confidence that we'll deliver a low single digit from an RPP second half of the year."
},
{
"speaker": "David Vernon",
"content": "Okay. Thank you."
},
{
"speaker": "Carol Tome",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "I will now turn the floor back over to our host, Mr. P.J. Guido. Please go ahead, sir."
},
{
"speaker": "PJ Guido",
"content": "Thank you, Steven. This concludes our call. Thank you for joining, and have a good day."
}
] |
uri | 2,024 | 4 | [
{
"speaker": "Operator",
"content": "Good morning and welcome to the United Rentals' Investor Conference Call. Please be advised that this call is being recorded. Before we begin, please note that the company's press release, comments made on today's call and responses to your questions contain forward-looking statements. The company's business and operations are subject to a variety of risks and uncertainties, many of which are beyond its control and consequently, actual results may differ materially from those projected. A summary of these uncertainties is included in the Safe Harbor statement contained in the company's press release. For a more complete description of these and other possible risks, please refer to the company's annual report on Form 10-K for the year ended December 31, 2024, as well as to subsequent filings with the SEC. You can access these filings on the company's website at www.unitedrentals.com. Please note that United Rentals has no obligation and makes no commitment to update or publicly release any revisions to forward-looking statements in order to reflect new information or subsequent events, circumstances or changes in expectations. You should also note that the company's press release and today's call include references to non-GAAP terms such as free cash flow, adjusted EPS, EBITDA and adjusted EBITDA. Please refer to the back of the company's recent investor presentations to see the reconciliation from each non-GAAP financial measure to the most comparable GAAP financial measure. Speaking today for United Rentals is Matt Flannery, President and Chief Executive Officer; and Ted Grace, Chief Financial Officer. I will now turn the call over to Mr. Flannery. Mr. Flannery, you may begin."
},
{
"speaker": "Matthew Flannery",
"content": "Thank you operator and good morning everyone. Thanks for joining our call. We are pleased to report our solid fourth quarter results yesterday as the year culminated with record revenue, EBITDA and EPS. We again saw growth across our construction and industrial end markets as well as continued strong demand for used equipment. Our team doubled down on being the best partner of choice for our customers. Our diligence on safety, coupled with unmatched service, technology and operational excellence translated into the results we reported. Importantly, all of this sets the foundation for our future growth. Today, I'll discuss our fourth quarter results, followed by our expectations for 2025 and finally, recap why we are excited about the H&E acquisition we announced a few weeks ago. Then Ted will discuss the financials in detail before we open up the call for Q&A which we will keep focused on United Rentals as a stand-alone company. Our plan remains to update the investment community on the combined companies after the transaction closes which is still expected by the end of our first quarter. So with that, let's start with the fourth quarter results. Our total revenue grew 9.8% year-over-year to almost $4.1 billion. And within this, rental revenue grew by 9.7% to $3.4 billion, both fourth quarter records. Fleet productivity increased by 4.3% as reported and 2% ex Yak. Adjusted EBITDA increased to a fourth quarter record of $1.9 billion, translating to a margin of over 46%. And finally, adjusted EPS grew year-over-year to $11.59, another fourth quarter record. Now let's turn to customer activity. We saw growth in both our gen rent and specialty businesses. Specialty rental revenue impressively grew more than 30% year-over-year and even without Yak, a strong 18%. These results were driven by rental revenue across all businesses with a combination of solid same-store sales growth and an additional 15 cold-starts putting us at 72 for the full year. And as a reminder, these specialty cold-starts are a key element to accelerating our growth in this high-return segment. By vertical, we continue to see similar trends to the rest of last year with non-residential growth helping to fuel construction and industrial growth driven by manufacturing and power. And we saw new projects across data centers, chip manufacturing, sports stadiums and power to name a few. Now turning to the used market which continues to exhibit strong demand. We sold over $850 million of OEC in the quarter which was a record for any quarter in our history. The depth and health of demand in the used market is allowing us to rotate our existing fleet to ensure we can serve our customers' needs efficiently. This is evident through our full year CapEx of over $3.7 billion. And as a result, we drove free cash flow of nearly $2.1 billion which translated to a very healthy free cash flow margin of over 13%. The combination of our industry-leading profitability, capital efficiency and the flexibility of our business model enables us to generate meaningful free cash flow throughout the cycle and in turn, create long-term shareholder value. To that end, we returned over $1.9 billion to shareholders last year through a combination of share buybacks and our dividend. And while we paused our share repurchase plan ahead of the H&E closing, I'm pleased to announce we'll be raising our quarterly dividend by 10% year-over-year to $1.79 per share. Now let's turn to 2025 which we expect to be another year of growth, again, led by large project growth. Customer optimism, backlogs and feedback from our field team, combined with the demand we're carrying into the new year, all support our guidance. This was reinforced at our annual management meeting which we held earlier this month in Houston, Texas. Where we discussed how a key element of our culture is the quality of people who work for United Rentals. And this was on full display in Houston, as over 2,600 team members came together to focus and engage on being the partners of choice for our customers through our differentiated value proposition. Finally, I'd like to reiterate what I said 2 weeks ago when we announced our intent to acquire H&E. We're very excited to combine 2 complementary businesses. The transaction checks all 3 boxes we require when evaluating M&A: Strategic, financial and cultural. Growing the core is a key component of our strategy and I'm really thrilled to have the opportunity to add high-quality capacity, meaning people, fleet and real estate to the United Rentals team. This will allow us to better serve customer demand over the long term. It will also accelerate our growth, all while generating compelling returns for our shareholders. It's really a win-win outcome. Things remain on track for a first quarter close and there are no further updates to provide you today. In closing and building upon what I just discussed with our latest acquisition announcement, we remain focused on being the best rental company in the industry. Our unique value offering, industry-leading technology and our go-to-market approach, combined with our capital discipline, give me confidence that we're well positioned for both customers and shareholders for the long term. We continue to progress towards our 2028 aspirational financial goals which we laid out in May of '23 and look forward to delivering on these results as we continue to execute our strategy. With that, I'll hand the call over to Ted and then we'll take your questions. Ted, over to you."
},
{
"speaker": "Ted Grace",
"content": "Thanks, Matt and good morning, everyone. As Matt just shared, we had a strong finish to the year, setting both fourth quarter and full year records for total revenue, rental revenue, EBITDA and EPS which supported the attractive returns and significant free cash flow we also generated in 2024. So with that said, let's jump into the numbers. Fourth quarter rental revenue was a record at $3.42 billion. That's a year-on-year increase of $303 million or 9.7%, supported again by growth from large projects and key verticals. Within rental revenue, OER increased by $177 million or 6.9%. Breaking this down, growth in our average fleet size contributed 4.1% to OER, while fleet productivity added another 4.3%, partially offset by assumed fleet inflation of 1.5%. Also within rental, ancillary and re-rent grew by 22% and 30% respectively, adding a combined $126 million to revenue driven primarily by strong growth in specialty and hurricane-related work in the quarter. Turning to our used results. As Matt mentioned, we took advantage of a strong market to sell a record amount of fleet in the fourth quarter, generating proceeds of $452 million at an adjusted margin of 48.9% and a recovery rate of 53% on assets that were almost 8 years old on average. Moving to EBITDA, as I mentioned, adjusted EBITDA was a fourth quarter record at $1.9 billion, translating to an increase of $91 million or 5%. Within this, rental gross profit increased 7% contributing an additional $136 million year-on-year. This was partially offset by used where the ongoing normalization of the market drove a 9% decline in used gross profit dollars translating to a $21 million headwind to adjusted EBITDA in the quarter. SG&A increased by $36 million year-over-year which was in line with revenue growth, so good efficiency there. And finally, the EBITDA contribution from other non-rental lines of businesses increased $12 million, driven largely by strong new equipment sales. Looking at profitability. Our fourth quarter adjusted EBITDA margin was 46.4%, implying 210 basis points of compression. I'm sure we'll dig into this during Q&A, so I thought it might be helpful to frame some of the key factors here. The combination of used and stronger-than-expected new equipment sales were together about 80 basis points of year-on-year headwinds. Said another way, excluding these 2 factors, our adjusted EBITDA margin would have been down about 130 basis points with flow-through a little better than 33%. Closer to the core and as you just heard me highlight, we had higher growth in ancillary and re-rent revenue that, as you know, come with lower margins. If we also adjust for these, our EBITDA margin would have been down about 60 basis points with implied flow-through of roughly 40%. While this is modestly below our long-term goal, it reflects our continued investment in key aspects of our strategy, including specialty, technology and capacity to support the long-term growth of our business during what we view as a slower phase of the cycle. And lastly, our adjusted earnings per share was a fourth quarter record at $11.59. Shifting to CapEx; fourth quarter gross rental CapEx was $469 million. Moving to returns and free cash flow. Our return on invested capital of 13% remained well above our weighted average cost of capital, while full year free cash flow totaled a robust $2.06 billion. Our balance sheet remains very strong with net leverage of 1.8x at the end of December and total liquidity of over $2.8 billion. I'll note, this was after returning a record of over $1.9 billion to shareholders in 2024, including $434 million via dividend and $1.5 billion through repurchases that reduced our share count by over 2.1 million shares. So to wrap up both the quarter and the full year, we were very pleased with the results our team achieved in 2024. Now let's look forward and talk about our 2025 guidance which I'll remind you, is standalone, meaning it does not include any contribution from H&E. As you've seen from the press release, we anticipate another record year. Total revenue is expected in the range of $15.6 billion to $16.1 billion, implying full year growth of 3.3% at midpoint. Within total revenue, I'll note that our used sales guidance is implied at roughly $1.45 billion or a mid-single-digit year-on-year decline on a percentage basis. This, in turn, implies a little faster growth within our core rental revenue, call it, mid-single digit on a percentage basis. Within used, I'll add that we expect to sell around $2.8 billion of OEC translating to recovery rate in the low 50s versus the mid-50s in 2024 but in line with pre-pandemic norms. Our adjusted EBITDA range of $7.2 billion to $7.45 billion. At the midpoint, excluding the impact of used, this implies flow-through in the 40s and flattish adjusted EBITDA margins versus as reported flow-through of around 30% and approximately 50 basis points of margin compression at the midpoint of guidance. On the fleet side, our gross CapEx guidance is $3.65 billion to $3.95 billion with net CapEx of $2.2 billion to $2.5 billion. Within this, we peg our 2025 maintenance CapEx at around $3.3 billion, implying growth CapEx of roughly $500 million at midpoint. And finally, we are guiding to another year of strong free cash flow in the range of $2 billion to $2.2 billion. Turning to capital allocation. One of the benefits of our balance sheet strategy and free cash generation are the flexibility they provide to invest in growth opportunities when they arise. As you know, we intend to capitalize on this through the pending acquisition of H&E where we will invest almost $5 billion at targeted returns well above our cost of capital. As previously shared, we are pausing our buyback program ahead of H&E and we intend to utilize our free cash flow in 2025 to reduce our leverage from roughly 2.3x on a pro forma basis to a goal of around 2x within 12 months of close. Finally, consistent with our strategy to return excess capital to our shareholders, I am very pleased to reiterate that we are increasing our quarterly dividend by 10% to $1.79 per share, translating to an annualized dividend of $7.16. So with that, let me turn the call over to the operator for Q&A. Operator, please open the line."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Our first question will come from Steven Fisher with UBS."
},
{
"speaker": "Steven Fisher",
"content": "Congratulations on a nice year. Maybe you could just touch upon the bigger than usual ancillary and re-rent. What's the main activity driving that? Was that sort of more shifting of equipment around that you got fees on? And maybe what's the next -- the expectation for the next few quarters on that, if you could even forecast it? And I suppose the bigger picture question here is on the margin side, what would you have to see in order to get flow-through back into the kind of 50% plus range?"
},
{
"speaker": "Ted Grace",
"content": "Sure. I'll start, Steve and then Matt can jump in. So on ancillary and re-rent, I think there are a couple of things. Certainly, the storm-related opportunities were a big part of both, probably more so in re-rent than ancillary, although there was definitely a benefit in ancillary. And then within ancillary, the other thing we've talked about all year is some of the benefits we've had in specialty. So in terms of setting things up, breaking them down and those kinds of services that relate to some of the new businesses we're in, those obviously have seen kind of sharp growth in '24 and that's contributed to that outperformance versus, call it, OER. Does that help on the first question?"
},
{
"speaker": "Steven Fisher",
"content": "Yes."
},
{
"speaker": "Ted Grace",
"content": "On the second question, I think there are a couple of things. I mean certainly, relative growth rates matter. I think I made the comment just a couple of minutes ago that we think we're in the slower growth phase of the cycle. And the reason that's important is it drives relative fixed cost absorption. So as we get through '25 and we do expect to accelerate thereafter, that obviously drives good absorption that helps drive better flow-through. At the same time, in this environment, we've talked about making very intentional investments in things like cold-starts and technology that have been marginal drags. We think those have been excellent investments with great ROI. That's why we've called them out and been pretty clear that we don't want to forgo those opportunities just for the sake of an arbitrary flow-through goal. So Matt, anything you'd add there?"
},
{
"speaker": "Matthew Flannery",
"content": "No, I just -- we still always drive towards holding strong margins and Ted could take you through it. But within this guide, right, ex used sales, we expect to have margins, right, similar to year-over-year comps."
},
{
"speaker": "Ted Grace",
"content": "Yes. And that's a good point. Just I'm not sure you asked it specifically but if you -- in my comments, I made the point that if you back out used, flow through would be in the mid-40s and we've had flat margins which we view is very good performance in this environment. I'll remind people, as much as inflation has subsided, it's certainly not going backwards. So we still have a decent amount of inflation we're absorbing. So to deliver these kinds of results, does take hard work."
},
{
"speaker": "Steven Fisher",
"content": "Great, that's helpful. And then just maybe on the pipeline of large projects. I'm curious how that looks today relative to a year ago? What do you see as the differences in the large project landscape this year versus last year?"
},
{
"speaker": "Matthew Flannery",
"content": "Yes. I'd call it very similar with the addition of that we're carrying in demand from projects that are ongoing. So when you add that to some of the newer projects that are planned to come out of the ground, we feel good about this segment and certainly feel good about our alignment to serving that part of the business. So I would call it overall, really the whole demand environment, very similar to what we experienced in '24 and our guide, right? So we feel good about the year going forward."
},
{
"speaker": "Operator",
"content": "Our next question will come from Blake Greenhalgh with Bank of America."
},
{
"speaker": "Blake Greenhalgh",
"content": "First one would be just cadence of growth in first half. Are you guys baking anything that's more second half weighted?"
},
{
"speaker": "Matthew Flannery",
"content": "So we won't get into quarterly guidance. But if you just think about CapEx as a starting point, right, we expect to spend CapEx on a similar cadence, more historically normal cadence that we did in '24. From there, there's nothing that I would call out, certainly not back weighted. We think it will flow with normal seasonality of our business. And more importantly, our customers demand, right?"
},
{
"speaker": "Blake Greenhalgh",
"content": "Great. And then on power, there's been a lot of discussion this week about renewables, grid data centers. Can you remind us how big that business is for you guys? And anything you're hearing for '25 that you want to talk about?"
},
{
"speaker": "Ted Grace",
"content": "Yes. So in its entirety, power is, call it, about 10% of our total revenue. Within that, solar and wind are a relatively small fraction. So those are not markets that move the needle terribly in our power business. So hopefully, that helps give you some sense."
},
{
"speaker": "Matthew Flannery",
"content": "Yes, regardless of the political environment and all the pontificating on what's going to happen, there's a need for that grid to continue to be upgraded. There was long before chips and data centers and there's going to be going forward with or without the same level of chips and data centers. We're not concerned about this. This is a segment we focus on and we feel really good about."
},
{
"speaker": "Operator",
"content": "Our next question will come from Jerry Revich with Goldman Sachs."
},
{
"speaker": "Unidentified Analyst",
"content": "This Clay [ph] on for Jerry. First question here. What was the specialty organic growth in the quarter? And if you could talk to the color on the dispersion between the individual business lines within specialty, that would be great?"
},
{
"speaker": "Matthew Flannery",
"content": "We don't really get into the individual business lines too much. I'll say specialty, as you saw, showed great growth of 30%. But as I said in my opening remarks, even ex Yak, 18%. And that would be what we call organic growth. Admittedly, there's some cold-starts in there. So that's inclusive of that. But really strong growth that we feel good about. And this has been going on for quite a few years, just double-digit growth in specialty and as we add new products, as we have in the last couple of years through acquisitions, getting further dispersion of that footprint is another big driver of growth. And we think that will continue on and we'll probably do another 50-plus cold-starts in 2025 to add to that opportunity."
},
{
"speaker": "Unidentified Analyst",
"content": "Great. Super helpful. And then I guess, just expanding on the options for 2025. I know, not wanted to speak directly to the individual product lines but just curious if there's -- which ones are performing stronger relative to that average?"
},
{
"speaker": "Matthew Flannery",
"content": "Well, I wouldn't say performing stronger, they are all growing strong. I would say that you can think about where the growth is more pronounced, specifically in the cold-starts is the products that we've added over the last couple of years. So think about the General Finance acquisition and specifically here in the U.S. with Pac-Van, we continue to exceed those goals that we had to double that business in 5 years. And cold starts will be a part of that as well, continue and expand their footprint. With Yak, our most recent new product line, they're ahead of schedule on our goals to double their business in 5 years. So they're really doing well. And that's been a lot of organic growth. We haven't even broadly gotten to growing the footprint. So that's future opportunity that we're going to do there. And our ROS business, right, our Reliable Onsite business continues to grow organically and through cold-starts. So those are the 3 I'd point out. But with all that being said, one of our most mature ones is power and they're growing tremendously by adding new products and just continuing to grow their footprint. So it's pretty much across the board, Clay."
},
{
"speaker": "Operator",
"content": "Our next question will come from Tim Thein with Raymond James."
},
{
"speaker": "Tim Thein",
"content": "Matt, maybe just starting on fleet productivity. The target that you outlined in terms of the ability to outrun inflation of 1.5%, I think still believe in that in terms of realistic target for '25? And then maybe as part of that, is there an area where maybe there's, I don't know, better opportunity in terms of whether it's time or rate? And maybe you could just speak to that in terms of how you're thinking about just the broader fleet productivity setup for '25?"
},
{
"speaker": "Matthew Flannery",
"content": "Yes. So we feel really good about the performance of the team. And as you know, we won't do it quantitatively but qualitatively, we talked about back this time last year. If we were able to repeat 2023 time utilization, we'd feel really good. And we're able to do that. And so the team executed well and that's embedded in our expectations for 2025 and in this guidance. And then from there, you look at the other 2 variables, we still believe this is a constructive rate environment, really at a necessity. When you think about the amount of fleet inflation that we've all absorbed -- the whole industry has absorbed over the last couple of years, the industry needs to get price to continue to eat into that. So I think you've seen that and I think that will continue on. And then the variable is mix which is really an output depending on, right, the amount of products that grow faster, what we do with different business lines. And there's a bunch of things in there. You guys have gone over them before. But that will be the variable. And we do believe it will be positive, meaning we will be able to exceed that inflation. In its simplest form, fleet productivity is can you grow your rent revenue faster than you can grow your fleet growth and that's embedded in our guidance and we will do that again this year."
},
{
"speaker": "Tim Thein",
"content": "Got it. Okay. And then just with the impact of M&A, obviously, as the company has grown a couple of hundred million, isn't what it used to be, United. But is there a way, Ted, just to think about that in terms of the contribution as to what we can expect from the deals done in the back half of the year, presumably that's driving some benefit? Any way to help us in terms of what that may translate from a revenue perspective in '25 as you annualize that?"
},
{
"speaker": "Ted Grace",
"content": "So we don't get too specific breaking out, obviously, the smaller deals. You would have seen there was something on the order of $300 million of deals we did, most hit late in the quarter, so there really wasn't much benefit in the fourth. In terms of rolling forward, it was a combination of gen rent and specialty. So you can think about what multiple you'd want to apply to EBITDA and figure out what kind of margin that would imply. It's not a huge part of the growth. It will contribute. These are nice deals. We're excited about them but it's not going to be very impactful in the scheme of our guidance."
},
{
"speaker": "Matthew Flannery",
"content": "More importantly, it's all embedded within our guidance."
},
{
"speaker": "Operator",
"content": "Our next question will come from Kyle Menges with Citigroup."
},
{
"speaker": "Unidentified Analyst",
"content": "This is Randy [ph] on for Kyle. Looking at the guide for gross CapEx, gross CapEx up a little in 2025, could you give some color on what areas you're growing OEC during the year and any areas you plan to pull back a little bit?"
},
{
"speaker": "Matthew Flannery",
"content": "Yes. So we're not really expecting to pull back on any, Randy. As we told you, we had really strong utilization of our fleet. And we think the demand environment is going to remain similar. So no reason to pull back on anything. You could imagine when you think about our growth CapEx, we talked about specialty growth and specifically the cold-starts, they'll get an overweighted amount of the growth CapEx which just to take you through that math since we haven't talked about it yet, we plan to sell about $2.8 billion worth of OEC this year. The replacement on that -- if you think about the stuff that we bought 8 years ago, it is about 20% more now, will be about $3.3 billion. That leaves at the midpoint, about $500 million of growth CapEx. And you could imagine as we think about it, more than its fair share of that will go to support our specialty growth."
},
{
"speaker": "Unidentified Analyst",
"content": "Got it. And then, another quick one. Can you just give some color on what kind of changes you've seen in customer behavior and sentiment following the election and then maybe more recently on some of Trump's executive orders?"
},
{
"speaker": "Matthew Flannery",
"content": "So we -- I'll take the first part, Ted could take the second. We could -- we had strong customer sentiment and more importantly, our field teams have been feeling good about the year all throughout '24. That's why we came out with the guide we did even though maybe there were winds blowing the other way for some folks. We see the same thing coming into this year. So our customers feel good about it. Our leadership team feels good about it. And we're really not going to overreact to the new cycle of the day. I think having that extra touches into the customer really gives us confidence in our guide and what our plans are. Ted, you could touch on the other part, if you'd like?"
},
{
"speaker": "Ted Grace",
"content": "Yes. In terms of any impact of executive orders, I mean aside from people may have whiplash, I don't think there's been too much. I do think at the end of the day, you look at our customers, you look at their sentiment, I would say it's improved since the election. And I think that's people's perception that you've got a government that's going to be pro-growth, wanting to invest in America. They've been pretty clear about that. Certainly, our customers are well positioned to support that growth and we're well positioned to support them in that endeavor. So whether it's areas of infrastructure, onshoring, certainly power, energy, obviously, Stargate was a big announcement, there's a lot of different things that will continue and/or be incremental that we think are going to be exciting opportunities in '25 and beyond. So Matt, I don't know if you want to share anything?"
},
{
"speaker": "Matthew Flannery",
"content": "No, you covered it well."
},
{
"speaker": "Operator",
"content": "Our next question will come from Angel Castillo with Morgan Stanley."
},
{
"speaker": "Unidentified Analyst",
"content": "This is Brendan [ph] on for Angel. In your press release, just diving more into that customer optimism. So you noted that in your press release, we've talked about it here today on the call. Just curious how much of that's actually translating to greater activity today? And then in any areas where it hasn't resulted in an uptick in activity yet, can you describe maybe what customers are waiting for, whether it's greater certainty around interest rates policy, labor availability or just anything else that you would like to call out, please?"
},
{
"speaker": "Ted Grace",
"content": "Yes, I'll do my best there. But to be clear, it's a sentiment-based measurement, right? So it's not measuring kind of what they're doing today. What it asks them is on a forward 12-month basis, what are your expectations for your own growth. From that standpoint, you've got an improvement in net responses, right? It's a diffusion-based index. So it's certainly something that would support the guidance we've introduced. It's hard to say too much more because we don't get granular beyond that in that kind of survey. But I guess the other thing is people feel good about, I think, just the broader environment. I mean you're beyond the election, I think people are expecting more accommodative monetary policy out of the Fed, that will be good for the economy. A lot of the things that people have been positive on remain on track. And so it's that -- I guess it's the culmination of all those things coming together that drive the economy but certainly feels like things are heading in a positive direction."
},
{
"speaker": "Unidentified Analyst",
"content": "Okay. I guess dovetailing on that, so you noticed that -- you rather noted that you have a similar pipeline for the new large projects. What does your guidance contemplate for the small kind of local markets that have been more interest rate challenged?"
},
{
"speaker": "Matthew Flannery",
"content": "I would say, generally, right, speaking generality similar. Some markets have more growth opportunities than others, no different than in '24, whereas the previous year as we had talked so much about broad-based. We're really selecting who we wanted to send the fleet to, not who didn't need it. So this -- the great thing about our model and really the rental model overall is the fungibility of these assets to move them, not just from vertical but from geography. And that's what we're doing. And I think we do it pretty effectively which is why we were able to keep these high levels of time utilization over the past 2 years and we expect to do the same this year."
},
{
"speaker": "Operator",
"content": "Our next question will come from Ken Newman with KeyBanc Capital Markets."
},
{
"speaker": "Ken Newman",
"content": "I know you guys don't want to talk too deep on the segments, in particular but 2024 was a bit of a softer rental revenue growth year for gen rent. I'm curious if the guide assumes a similar growth profile in '25? And I guess, additionally, on top of that, if there's any way to quantify what you think the impacts from mix are that's implied in the margin guide?"
},
{
"speaker": "Matthew Flannery",
"content": "So when we think about gen rent and first specialty growth, I mean, you guys have seen the numbers and we talked about '25 being similar. So yes, at the outset, you could assume similar. The great news is we have flexibility within our, let's call it, $3.8 billion at the midpoint within that CapEx, not just the $500 million of growth but even the rest of it, the $3.3 billion modeled replacement. So we can move the appropriate assets to the appropriate markets to feed whatever growth there is. And that's really about all the color I can give you. Other than that, we will continue to feed the specialty footprint growth and cold-start growth and really, they're double-digit growth they've had for 10 years plus."
},
{
"speaker": "Ted Grace",
"content": "I think on the second part of your question, Ken, I think from a mix standpoint, to Matt's point, '25 is likely going to look similar to '24. So I don't think we're looking for an appreciable shift in mix. If that helps answer the question to a degree."
},
{
"speaker": "Ken Newman",
"content": "Yes, that's very helpful. And then maybe just dovetailing off the prior question here right before me, is there a way to talk about the magnitude of demand between the national and the local accounts, particularly as I think about just the rate differential between those two? Obviously, I know you don't want to talk about fees [ph] but they've had a little bit more challenges on the rate side. Curious if you're kind of seeing a similar dynamic."
},
{
"speaker": "Matthew Flannery",
"content": "Yes. As you know, we don't get into the specific components of rate time and mix. But we've had -- we've driven positive fleet productivity. And that's really why we put them all together because it shows up in different ways with different products and with different customers. We've talked about do national accounts have -- do they leverage your spend? Of course, they do. But the truth is everybody. It's a competitive market out there and we participate actively in it and appropriately for each level. So there's nothing I'd call out specifically to any customer segment. It's just not something that's as differentiated as maybe what people think about on the outside."
},
{
"speaker": "Operator",
"content": "Our next question will come from Scott Schneeberger with Oppenheimer."
},
{
"speaker": "Scott Schneeberger",
"content": "On infrastructure bill and those funds flowing, we talked to high level about large projects and I think that would be in both but more large. What are you seeing there? Are you seeing those funds flow? It sounds like you're expecting the same in '25 as you were in '24 but I want to carve out that piece specifically out of -- away from mega projects, away from small local projects."
},
{
"speaker": "Ted Grace",
"content": "Yes, Scott, I'll take a crack at that. Certainly, we continue to see nice growth in infrastructure in terms of figuring out where the funding is coming from. That's a much more difficult process. I think if you look at some of the information that have been released right ahead of the change of administration, I think there was still something like $300 billion from IIJA that had yet to be allocated. So there's $200 billion that has been allocated. I think it's a fraction of that that's actually been spent. So we continue to feel really good about the opportunity that's underpinned by a lot of that spending that God knows the country needs the investment and it certainly had bipartisan support. So, our expectation that will continue to be a good area for us."
},
{
"speaker": "Scott Schneeberger",
"content": "Appreciate that. And just to the extent you can answer, what -- I assume you just made a large acquisition. There's going to be integration time on that. Could we not -- and you said what you want to do with leverage and everything and pause the stock buyback. Could we assume that there won't be any more sizable activity prior to the end of the year and just maybe some commentary on what the pipeline look like for M&A? Obviously, you went with H&E but do you have a very -- still a very large and existing pipeline? And any additional thoughts on that?"
},
{
"speaker": "Matthew Flannery",
"content": "Yes. I mean we have a very strong team that's constantly working that pipeline. And I would say it's been consistently strong, right, for a couple of years now. And as you see, we only execute on a few of them. You could imagine this is a pretty big deal. We'll have a lot to absorb here and that will be our focus. And as Ted mentioned, we're going to focus on getting that leverage back to the midpoint. So that will be the priority. If a nice deal tuck-in comes in, that's with a new product line, then we'll have to look at that and see how that fits into the overall strategy and would we want to do that. We'll always work the pipeline and then we'll make the appropriate decision that what makes sense for our business at that given time. And there certainly is a period here where we're going to absorb -- we're going to be focused on absorbing this large acquisition."
},
{
"speaker": "Operator",
"content": "And at this time, it appears we have no further questions in queue. I will now turn the call back to Matt Flannery for any additional or closing remarks."
},
{
"speaker": "Matthew Flannery",
"content": "Well, thank you, operator and everyone on the call, we appreciate your time, glad you could join us today. Our Q4 investor deck has the latest and greatest update. And as always, Elizabeth is available to answer your questions. So until we talk again in April, stay safe. Operator, you can now end the call."
},
{
"speaker": "Operator",
"content": "This does conclude today's call. Thank you for your participation. You may disconnect at any time."
}
] |
uri | 2,024 | 3 | [
{
"speaker": "Operator",
"content": "Good morning and welcome to the United Rental’s investor conference call. Please be advised that this call is being recorded. Before we begin, please note that the company’s press release, comments made on today’s call, and responses to your questions contain forward-looking statements. The company’s business and operations are subject to a variety of risks and uncertainties, many of which are beyond its control and consequently actual results may differ materially from those projected. A summary of these uncertainties is included in the Safe Harbor statement contained in the company’s press release. For a more complete description of these and other possible risks, please refer to the company’s annual report on Form 10-K for the year ended December 31, 2023, as well as to subsequent filings with the SEC. You can access these filings on the company’s website at www.unitedrentals.com. Please note that United Rentals has no obligation and makes no commitment to update or publicly release any revisions to forward-looking statements in order to reflect new information or subsequent events, circumstances or changes in expectations. You should also note that the company’s press release and today’s call include references to non-GAAP terms such as free cash flow, adjusted EPS, EBITDA, and adjusted EBITDA. Please refer to the back of the company’s recent investor presentations to see the reconciliation from each non-GAAP financial measure to the most comparable GAAP financial measure. Speaking today for United Rentals is Matt Flannery, President and Chief Executive Officer, and Ted Grace, Chief Financial Officer. I will now turn the call over to Mr. Flannery. Mr. Flannery, you may begin."
},
{
"speaker": "Matthew Flannery",
"content": "Thank you Operator, and good morning everyone. Thanks for joining our call. As you saw yesterday afternoon, 2024 continues to play out as we expected. We were pleased with our third quarter results, which continued to reflect growth across both our construction and industrial end markets. Our updated guidance reaffirms our expectations for another year of profitable growth, which we were able to deliver thanks to our more than 27,000 team members. Their hard work enables us to support our customers with world-class service and innovative solutions, all while keeping safety as priority number one. As you’ve heard me talk about before, we continue to double down on being the partner of choice for our customers. We’re helping them solve for their goals across safety, productivity and sustainability through our compelling value proposition. Importantly, not only does our business model enable us to best serve our customers but it also generates strong shareholder value. Today, I’ll discuss our third quarter results, our expectations for the rest of this year, and share some examples of how we continue to innovate and rapidly respond to customer needs, and then Ted will discuss the financial details before we open up the call for Q&A. Let’s start with the third quarter results. Our total revenue grew by 6% year-over-year to almost $4 billion, and within this rental revenue grew by over 7% to $3.5 billion, both third quarter records. Fleet productivity increased by 3.5% supported by our focus on capital efficiency and continued industry discipline. Adjusted EBITDA increased to a third quarter record of $1.9 billion, translating to a margin of almost 48%; and adjusted EPS grew year-over-year to $11.80, another third quarter record. Now let’s turn to customer activity. We saw growth in both our gen rent and specialty businesses. Specialty rental revenue grew an impressive 24% year-over-year and a strong 15% even if you exclude the benefits of the Yak acquisition. Our cross-selling efforts helped fuel growth across all of our product offerings, and furthermore we added 15 cold starts in the quarter, putting us at 57 year to date. By vertical, third quarter trends were similar to the second quarter. We saw growth in both construction led by non-res and our industrial end markets, with particular strength in manufacturing. It will come as no surprise that we again had multiple new projects in the quarter across data centers, airports, healthcare, and battery manufacturing, to name a few. Now turning to the used market, which remains healthy, and as Ted will elaborate on, we sold a third quarter record amount of OEC, which speaks to the strength of demand, while our margins primarily reflected the ongoing normalization of the market. As we replace this equipment and buy additional fleet to meet our customer needs, we spent almost $1.3 billion on capex in the third quarter. We continue to see opportunity to put fleet on rent and our full-year guidance reflects a tightened capex range with the midpoint unchanged. Year-to-date free cash flow is over $1.2 billion. We’re on track to hit our full-year goal, which translates to a free cash flow margin in the mid-teens. Our industry-leading profit margins, focus on capital efficiency, and flexible business model translates to strong free cash generation and ultimately provides us the ability to create long term value for our shareholders. Finally, capital allocation - we returned nearly $500 million to shareholders in the quarter via share buybacks and our dividend. Our balance sheet is in excellent shape, and we’re on track to return nearly $2 billion this year. As we wrap up 2024, we’re focused on continued execution and delivering another year of records across revenue, adjusted EBITDA and earnings. Our updated guidance, which maintains the midpoint for revenue, EBITDA, and rental capex, reflects just that. We have good momentum heading into 2025, which is setting up to be another year of growth based on what we see and sense today. The tailwinds for a multitude of large, complex projects are still in the early innings, and we believe we’re uniquely positioned as the partner of choice with our customers. To support these initiatives, we continue to make investments in optimizing operations for both ourselves and our customers. For example, we’re investing in our next generation telematics products which help customers gain new insights into their own operations and allows our technicians to prioritize their workflow and best manage our fleet. Elsewhere on the innovation front, we recently announced a great example of a customer supporting technology. Our ProBox OnDemand is a Bluetooth-enabled automated tool tracking system which ensures workers have the right tools where and when they need them, and tracks tools in real time to significantly reduce worksite loss. Both of these examples demonstrate our culture of innovation and continuous improvement, but taking care of our people and helping our communities are also key elements of our culture. I was very pleased with how quickly our team reacted in the aftermath of the devastating damage caused by both Hurricanes Helene and Milton. In both instances, we were immediate to respond, putting our proven United Rentals playbook to work and providing our customers with the support needed to start the clean-up and rebuild process. To wrap things up, 2024 remains on track with ’25 setting up to be another year of growth, which we’ll discuss in greater detail in January. We continue to deepen our relationships as we partner with our customers, not only providing them the equipment they require but also helping them solve their other challenges. The combination of our competitive advantages and flexible business model coupled with our focus on profitable growth, strong free cash flow, and smart capital allocation positions us to drive long term and sustainable shareholder value. With that, I’ll hand the call over to Ted before we take your questions. Ted, over to you."
},
{
"speaker": "Ted Grace",
"content": "Thanks Matt, and good morning everyone. As Matt just highlighted, the year continues to play out as expected with third quarter records achieved in total revenue, rental revenue, EBITDA and EPS. Looking ahead, our reaffirmed guidance at the midpoint across all metrics reflects our continued confidence in delivering another year of solid growth, strong profitability, healthy returns, and significant free cash flow. As importantly, we remain focused on prudently allocating capital to help maximize shareholder value. With that said, let’s jump into the numbers. Third quarter rental revenue was a record $3.463 billion - that’s a year-on-year increase of $239 million or 7.4%, supported again by growth from large projects and key verticals. Within rental revenue, OER increased by $153 million or 5.8%. Growth in our average fleet size contributed 3.8% to OER while fleet productivity added 3.5%, partially offset by assumed fleet inflation of 1.5%. Also within rental, ancillary and re-rent revenues were higher by $86 million or 15%, resulting primarily from strong growth in our specialty businesses. Turning to our used results, we sold a record amount of fleet in the third quarter, generating proceeds of $321 million in a strong demand environment. While we continued to see a normalization of used pricing, our adjusted margin and recovery rate both remained high by historical standards at 49.5% and 54% respectively. It’s also worth noting that our recovery rate was impacted by the age of fleet we sold in the quarter, which increased roughly four months year-on-year to 95 months on average. Moving to EBITDA, adjusted EBITDA was a third quarter record at just over $1.9 billion, translating to an increase of $54 million or 2.9%. Within this, rental contributed $132 million year-on-year. Outside of rental, used sales were a $43 million headwind to adjusted EBITDA, driven by the ongoing normalization of the used market. SG&A increased by $49 million year-on-year, primarily reflecting a larger business, including the addition of Yak and some discrete items in the quarter. Finally, the EBITDA contribution from other non-rental lines of businesses increased $5 million year-on-year. Looking at third quarter profitability, our adjusted EBITDA margin was 47.7%, implying about 140 basis points of compression. Excluding the impact of used, however, our margin was down about one percentage point, reflecting the impact of the investments we’ve talked about making this year, normal variability in costs, and the impact of roughly $15 million of discrete items in the quarter. Converting this to flow through, our incrementals would go from about 24% on an as-reported basis to 36% ex-used, and into the low 40s excluding the $15 million of discrete items I just mentioned. Finally, our adjusted earnings per share was a third quarter record of $11.80. Shifting to capex, gross rental capex was $1.3 billion, which was in line with expectations and within the range of historical seasonality. Moving to returns and free cash flow, our return on invested capital of 13.2% remained well above our weighted average cost of capital, while year-to-date free cash flow totaled over $1.2 billion. Our balance sheet remains very strong with net leverage of 1.8 times at the end of September and total liquidity of almost $2.9 billion. I’ll note this was after returning a record of over $1.4 billion to shareholders year to date, including $326 million via dividends and $1.1 billion through repurchases, and have reduced our share count by almost 1.7 million year to date. Now let’s shift to the updated guidance we shared last night, which reflects our continued confidence in delivering another year of strong results. As previously mentioned, we are maintaining the midpoints for all metrics and narrowing the ranges for total revenue, EBITDA, and gross and net capex, as we normally do at this point of the year. In terms of specifics, for total revenue we’ve narrowed our guidance to a range of $15.1 billion to $15.3 billion, implying total revenue full year growth of just over 6% at the midpoint. Within this, I’ll note that our used sale revenue guidance is unchanged at roughly $1.5 billion of proceeds on OEC sales that we now expect closer to $2.6 billion. On adjusted EBITDA, we’ve narrowed the range to $7.115 billion to $7.215 billion. Our range for gross capex was narrowed to $3.55 billion to $3.75 billion, and our net capex was narrowed to $2.05 billion to $2.25 billion. We’re still on pace to return a record $1.9 billion to shareholders this year, which translates to almost $30 per share or a current return of capital yield of about 3.6%. With that, let me turn the call over to the Operator for Q&A. Operator, please open the line."
},
{
"speaker": "Operator",
"content": "Thank you. [Operator instructions] We’ll take our first question from David Raso with Evercore ISI. Please go ahead, your line is open."
},
{
"speaker": "David Raso",
"content": "Hi, good morning. Thanks for the time. You made a comment, Matt, about good momentum into ’25, another year of growth. Can you give us at least how you’re thinking about that between specialty and gen rent growth, and also fleet productivity versus fleet growth? I’m not looking for exact numbers, but just how you think about the different contributors. Then I have a second question."
},
{
"speaker": "Matthew Flannery",
"content": "Sure David. When we think about how next year is playing out, and I’ll just talk about this qualitatively because we haven’t even finished our planning process, and that will inform what we actually think our growth will be. But we’re going to have a little bit of carryover in fleet, right, that we feel confident that we’ll put to work, and the on the demand perspective, there’s still a good pipeline of large projects. The wildcard as we get deep with our customers and our field leaders is what’s that local market going to do, and we talked about that a lot this year. Our assumption of interest rates starting to show some give and possibly more coming, we think at least the emotional part of that step has been heard from our customers, so people are starting to feel a little more confident. What kind of activity that actually turns into is the part that we don’t have any quantitative way of feeling that out, but we’re going to figure out from our customers and our field leaders and then we’ll add that growth. But when you think about the ending fleet having a little bit of growth to it, we’ll continue to strive to drive fleet productivity. I’m not going to put a number out there or forecast it, but our goal is to always drive revenue growth more than fleet growth, which is all fleet productivity measures, so we’ll continue to do that. We think specialty certainly has more headwind. I mean, we’ve been, I don’t know since when, but we’ve been eight, probably eight years-plus of specialty growing over 20% each year, and we continue to think that they have that kind of opportunity. The tailwinds that we talk about in the mega projects, infrastructure and the like really plays to our one stop shop full value offering. That also helps specialty drive more growth. That’s the way we think about it, what kind of growth and what kind of growth capex we’ll put in, and we’ll talk about that in January after we’re done with our planning process."
},
{
"speaker": "David Raso",
"content": "Also, you mentioned the strength of the balance sheet, the cash flow. As you’re aware, the sizeable acquisition in the mobile modular space recently broke apart, so I’ll just give you the platform here if you want to comment at all on the attractiveness of that space - obviously you became a player with Gen Finance. If you can just touch on that, and of course any other M&A landscape comments would be appreciated. Thank you."
},
{
"speaker": "Matthew Flannery",
"content": "Sure David. On the first part, we’re very pleased with the acquisition we did with General Finance. We talked about when we bought that, doubling the size of that business in five years. We’re probably ahead of schedule on that, but certainly on track. We feel really good about that. For that space, we like the idea of growing off of that platform a lot, and we’re accomplishing that. We don’t necessarily need to be the biggest provider in that space overall, we just need to be the biggest with our customers, and that’s the way we look at a lot of our adjacent product lines, so pleased there. As far as M&A, we continue to look at the pipeline, right? We’ve got a competency of integration and cross-selling that’s unique and something that really plays well with our customers and within our organization. But the bar’s high, so it’s not always easy to get the right dance partner. We can get the strategic fit, we can get cultural fit, and the last part’s financial, and our bar is high there. I think one of the reasons we’re good integrators is because we’re smart buyers, so we continue to work the pipeline and when something is imminent, we’ll let you all know."
},
{
"speaker": "David Raso",
"content": "All right, thank you."
},
{
"speaker": "Matthew Flannery",
"content": "Thanks David."
},
{
"speaker": "Operator",
"content": "We’ll take our next question from Michael Feniger with Bank of America. Please go ahead, your line is open."
},
{
"speaker": "Michael Feniger",
"content": "Yes guys, thanks for taking my question. I just was curious, Matt, when we think of 2025, just the puts and takes, like the last few years rate has been a good guy as we’ve been in a backdrop of high inflation. You guys were clearly able to pass that along, the industry was able to. As we approach 2025, Matt, if equipment pricing is softening, can you guys still drive rate in that environment, even if we’re in a more deflationary environment? Just love to get your view on that."
},
{
"speaker": "Matthew Flannery",
"content": "Yes, absolutely we can continue to drive rate - that’s about what’s your value to the customer and you’ve got to try to offset inflation. Even if equipment pricing stayed flat to down this year for the next batch we buy, we still have to absorb the inflation that we’ve been paying for the last couple of years on the fleet, which was significant. But additionally, there’s been inflation throughout the business, and we’re going to continue to give our employees raises, we continue to have cost inflation that we’ve been absorbing throughout the last couple of years, so the need to continue to drive rate is certainly there and, probably more importantly, the discipline in the industry is there, so everybody is in the same boat, where we have inflation that we’ve got to absorb. I think the industry is creating good value and giving a good output for the customer, which is the most important part of allowing yourself to get price increases."
},
{
"speaker": "Michael Feniger",
"content": "Fair enough, and Matt, if I could just follow up with my last question, how are you feeling with your fleet age, your fleet mix if we are in an environment where there’s a little bit more megas versus local, a little bit more specialty versus gen rent? Just curious if you could comment on whether you feel your fleet’s in position to still be able to have a growth year next year with where the age is today. Thank you."
},
{
"speaker": "Matthew Flannery",
"content": "Yes, our fleet is a little over 50 months, I believe right now. It’s the lowest it’s been pre-COVID, and that’s even absorbing some longer lived assets that we’ve bought in the last five to seven years with General Finance and Tanks, so we feel really good about where it is. There is plenty of headroom if we ever had to lean on that, but that’s not our expectation. We’re in real good position. Like I said, we’re back to pre-COVID fleet age. Thanks Mike."
},
{
"speaker": "Operator",
"content": "We’ll take our next question from Tim Thein with Raymond James. Please go ahead."
},
{
"speaker": "Tim Thein",
"content": "Thank you, good morning. Maybe just Matt, on the topic of fleet productivity, I’m curious - I think the expectation coming into the year was to maybe hold serve on time-ut. I’m just curious as we’re nine-plus months into the year, how you’re trending relative to that initial objective."
},
{
"speaker": "Matthew Flannery",
"content": "Yes, as we’ve said, we’d be really pleased if we were able to repeat the kind of time utilization that we achieved in 2023, and I’m pleased to say that’s what the team’s doing, so when we talk about the components of fleet productivity qualitatively, rate’s still a good guy and let’s call time neutral, which is a good achievement. When we’re talking about, just to put it in perspective, I said this previously, these are time utilizations back to better than 2019 levels, back to pre-COVID levels, so we’re pleased with that. Then the last part is mix, which that’s the variant part. That’s the part that is an output of tens of thousands of transactions a month, and just to remind everybody, within that mix is any inflation that we’ve paid for the fleet that’s over and above the 1.5% pay, and we’ve talked to you earlier this year that that looks more to be like 2.5 to 3 this year, so when we think about that fleet productivity, even ex-Yak at 1.9, absorbing that extra inflation, we’re really pleased with the execution of the team."
},
{
"speaker": "Tim Thein",
"content": "Got it, okay. And safe to assume, obviously given how you layer in fleet, that that inflation even in mildly--if it were to play out where one year is equipment purchases layered in with seven, eight years, so that would still remain--that fleet inflation dynamic, that we should still think about that as a headwind in ’25, correct?"
},
{
"speaker": "Matthew Flannery",
"content": "Oh, yes. That tail is going to last a little bit, a couple more years."
},
{
"speaker": "Tim Thein",
"content": "Yes, understood. Okay. Then just going back to thoughts around capital in ’25, you just brought in close to 30% more fleet in the third quarter year-over-year, and with fleet productivity, just call it 2% ex-Yak, and obviously you’ll typically de-fleet a bit in the fourth quarter, is the--if these trends kind of persist, would you maybe--would next year maybe lean a little bit lighter in terms of how you layer in that capex, in terms of the first half? I know it’s early days, but just thinking about kind of the timing of how you may think about landing fleet in ’25, any thoughts on that."
},
{
"speaker": "Matthew Flannery",
"content": "Yes, without having done the work, I would just make the assumption of a similar cadence at this point, but we’ll talk about that a little more in January after we finish the budgeting process. I don’t think we’re going to be that far off the cadence that we typically run. We’re back to a more normalized cadence as the supply chain’s just about fully repaired - I mean, there’s just a handful of items that maybe have longer lead times than we’d like, but the supply chain, our partners have done a good job getting their business back in line and their suppliers back in line, so we’re in pretty good shape and I think we’ll return to more normalized cadence, similar to what you saw this year."
},
{
"speaker": "Tim Thein",
"content": "Okay, thank you."
},
{
"speaker": "Matthew Flannery",
"content": "Thanks Tim."
},
{
"speaker": "Operator",
"content": "We’ll take our next question from Jerry Revich with Goldman Sachs. Please go ahead."
},
{
"speaker": "Unknown Analyst",
"content": "[Audio loss] on for Jerry. You’ve talked about pockets of soft demand in some of the markets, particularly the local markets. How much more [indiscernible] to optimize productivity?"
},
{
"speaker": "Matthew Flannery",
"content": "You broke up a little bit. Can you repeat that question, please?"
},
{
"speaker": "Unknown Analyst",
"content": "Yes, so just on the--regarding the pockets of soft demand in some of the local markets, just curious how much more fleet you are moving geographically today versus last year to optimize productivity. Thanks."
},
{
"speaker": "Matthew Flannery",
"content": "Yes, we have a very dense network, right, and we’re covered just about all of U.S. and Canada, so we’re not--we’re not having any exorbitant costs or any extra efforts to have to move things more than maybe a state to state, at the most. We’re not doing coast-to-coast movements or anything like that. We were asked that question in Q2, and fortunately with our business model of fungible assets, we’re able to move stuff within districts, so really nothing to call out there."
},
{
"speaker": "Unknown Analyst",
"content": "Thanks, and then obviously really strong growth on the specialty side. Can you rank order [audio loss]."
},
{
"speaker": "Matthew Flannery",
"content": "I didn’t catch it all again, Clay. I think you were asking us to rank order our specialty growth?"
},
{
"speaker": "Unknown Analyst",
"content": "Yes, just some color on what’s the stronger areas within specialty. Sorry about that."
},
{
"speaker": "Matthew Flannery",
"content": "Sure. I mean, we don’t get too granular here, but certainly we’ve talked about power being a very strong region for us, and that has continued to be the case. Frankly, there’s growth across all segments of specialty. They each have different variances - some are less mature and we’re building out, so you’re kind of building off smaller numbers so you can have stronger growth rates as a result, but they all performed quite well in the quarter and have year-to-date. That’s really what you’ve seen in those numbers."
},
{
"speaker": "Unknown Analyst",
"content": "Thanks."
},
{
"speaker": "Matthew Flannery",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "We’ll take our next question from Robert Wertheimer with Melius Research. Please go ahead, your line is open."
},
{
"speaker": "Robert Wertheimer",
"content": "Thanks, good morning everybody. My question is going to be on costs, and I know it’s not the highest growth revenue quarter - I think we talked about that last quarter, where little-ish costs show up, and I don’t imagine you’re managing your strategy for a quarterly SG&A number anyway. The question is really around the IT investments that you’ve made. Are you doing anything different there? Do you have a sense of--you know, is there a payback, are you thinking about a payback in the next year? What’s interesting about that spend there, and what are you trying to do? Thank you."
},
{
"speaker": "Ted Grace",
"content": "Yes, good question, Rob. As we’ve talked about all year, we are making, call it additional investments in various aspects of technology. We do each and every year, this year there’s probably a couple new programs we’ve talked about. Some of it would relate to, call it AI-related stuff, some of it would relate to the advanced telematics packages that we’re rolling out, all of which we think make the company more efficient and improve the customer experience. I’m not sure we’ve dimensionalized them, and one of the reasons we’ve called them out is just to bring up the fact that in the current environment, where you’re growing kind of in the single digits, not in the double digits as we had in prior years, it does have a relative impact on flow through, so as we’ve talked about kind of margin performance in ’24, flow through performance in ’24, that along with the cold starts are really the two underlying things that kind of bridge people to where we are and expect to be this year, versus maybe where they would have thought we would be in an otherwise different environment. But the investments, they’re across a broad range of things, certainly on the fleet side - sourcing, purchasing, there’s a lot of things we’re doing there that we think are exciting, that we’re very confident have very attractive ROI. You certainly get into proof of concepts and then pilots, and then you’ve proven out and you get ready to roll it out, and then you’ve got change management, so there’s a lot of considerations that take time to implement an example like that. Certainly we’ve got other examples across the business in aspects of HR, for example, but there’s a whole host of them that we think are really exciting - inventory management, R&M. I think we’ve talked about a few different examples. They are all in varying stages and certainly some will prove to be very attractive returns, and some will prove to be not as attractive, and those are ones we probably won’t move forward with. But at the same time, we’ve talked about augmenting our current capabilities internally with third parties, and it’s quite a process. I think you’re probably well aware of this, Rob, but as you start embracing some of this technology, you’ve got to kind of go through your data, you’ve got to clean it up, you’ve got to reorganize it, restructure it so that you can lever it in these new models, and that’s certainly part of the foundational work that we’ve been focused on in the last year, that then puts us in a position to really get even more value out of the data. Matt, I don’t know if you’d add anything?"
},
{
"speaker": "Matthew Flannery",
"content": "No, and I think Rob said it right in his question - we’re not managing for a specific flow-through number. We’re not going to put long term investments aside because maybe the growth is a little bit slower. I think that’s--that’s the way your question was phrased, and that’s the right way to think about it."
},
{
"speaker": "Robert Wertheimer",
"content": "That’s fantastic, thank you."
},
{
"speaker": "Matthew Flannery",
"content": "Thanks Rob."
},
{
"speaker": "Operator",
"content": "We’ll take our next question from Jamie Cook with Truist Securities. Please go ahead."
},
{
"speaker": "Jamie Cook",
"content": "Hey, good morning. I guess just piggybacking on Rob’s questions, I’m just trying to think through the path for potentially improved profit pull through or incremental margins next year. Ted, it sounds like it’s highly reliant just on you guys getting back to double digit growth in order to achieve that. I’m wondering if with improved visibility because of mega, more mix towards specialty, maybe some of these technology investments paying off, is there a path--I mean, not to get to your targeted 50% incremental margin, but at least a path towards improved incremental margins 2025 over 2024. Thank you."
},
{
"speaker": "Ted Grace",
"content": "Yes, I’ll certainly touch on that, Jamie. I don’t want to get ahead of ourselves. We’ll obviously give that guidance in January, but it’s dependent on a lot of things. Certainly growth is one we’ve talked about this year, and then call it the investments we’re making and/or other elements of cost. As you think about ’25, certainly there could be additional tech investments conceivably - I don’t want to forecast that at this point. The cold starts have been a drag - you know, we’ve talked about the impact that has as you start a branch and it’s fully burdened from a cost perspective, and yet it doesn’t really have revenue and it scales in over probably two years. You think about this year, we’re at 57 cold starts, so we’ve already exceeded the total we did in 2023. As we go through our 2025 plan, we’ll figure out what the game plan will be there. Certainly used is one of those other elements that you’ve got to be mindful when you think about flow-through, but when we kind of synthesize the whole thing back to the core margins and profitability, we’ve been really pleased with how 2024 has played out."
},
{
"speaker": "Jamie Cook",
"content": "Thank you."
},
{
"speaker": "Matthew Flannery",
"content": "Thanks Jamie."
},
{
"speaker": "Operator",
"content": "We’ll take our next question from Ken Newman with Keybanc Capital Markets. Please go ahead, your line is open."
},
{
"speaker": "Ken Newman",
"content": "Hey, good morning guys. Matt, I wanted to touch back on the local accounts. Correct me if I’m wrong, but you do sound slightly more optimistic about the demand there in terms of stabilization. Is the expectation there that demand is stable from 3Q to 4Q, or just any color there on the local accounts specifically?"
},
{
"speaker": "Matthew Flannery",
"content": "Yes, I would say the optimistic view would be supported by our customer confidence index, number one, so they remain positive. As I have said about the interest rates, there’s an emotional portion of that. The fact that that’s finally pivoted has got people thinking about what are we going to fund, what kind of projects are going to come back. The real question is when does that emotion, sentiment, and then future cuts turn into shovel-ready work? We don’t know that. The great news is we don’t need to know that. We have a business model where we can react quickly, so we’ll talk, like I said earlier, to our customers and our field team to put this plan together, and a big part of our internal investigation will be what does the local market look like for us next year. As we build that plan, we may be right to the upside, we may be--we might be wrong to the downside, but the supply chain is back intact and our flexible business model, I feel very confident will let us react to whatever the reality is. The truth is there’s no quantitative way to measure how fast these cuts will turn into revenue, but we are optimistic because of what we’re hearing from our customers."
},
{
"speaker": "Ken Newman",
"content": "Right, that makes sense. Just for my follow-up, Ted, obviously you’ve got a couple of moving pieces here in terms of the margin improvement, whether that’s [indiscernible] or specialty. You did touch on a little bit from disaster recovery and hurricanes - I know it’s still early days, but I’m curious if you can help us quantify what’s embedded into the implied 4Q margin at the midpoint at this point from hurricanes specifically."
},
{
"speaker": "Ted Grace",
"content": "There’s really nothing. I mean, there’s been no changes to the guidance, so we’ll see what the net impact of these two events is; but certainly as it relates to our guidance, there is no change."
},
{
"speaker": "Matthew Flannery",
"content": "Yes, I mean, the impact of those storms, although devastating to the folks there and we certainly are going to help out in any way we can, both our employees and the communities and customers that we work and live in, but at the scale of our business, we’re talking small numbers here in the big scheme of things, and probably more a ’25 event if there is some significant rebuild. But even within that, we’re talking small numbers in the big scale of things."
},
{
"speaker": "Ken Newman",
"content": "Got it, thanks."
},
{
"speaker": "Operator",
"content": "We’ll take our next question from Kyle Menges with Citi Group. Please go ahead, your line is open."
},
{
"speaker": "Kyle Menges",
"content": "Thanks guys. It would be great if we could hear a little bit more color on just what you’re seeing in some of the industrial end markets, maybe if--I know you called out manufacturing, it sounds like that’s been strong, but anything else that’s perhaps been weak this year? I know we’ve heard from some other companies that industrial MRO hasn’t exactly been that strong this year, so maybe that starts to improve into next year as you get some improvement in PMIs. Just anything noteworthy on the industrial side of things to call out, that could maybe improve a little bit next year?"
},
{
"speaker": "Matthew Flannery",
"content": "On our side, the one thing we’ve called out year to date, and it was again true in third quarter, was some of the headwinds we’ve got in petrochem, and it’s really across the board. Upstream has kind of mirrored what’s happened with the U.S. land rig count. We’ll see what happens with investment, upstream investment in North America next year, but that has continued to be a headwind. Midstream has kind of followed on - not a surprise there. If you’re not completing wells, there’s no need to tie them back. Then when you think about refining and chemical processing, those also year to date have been down a bit, so that to us is more likely timing. Certainly if you look at things like gasoline demand, diesel demand, jet fuel demand, very strong. It’s our sense that a lot of refineries are postponing work to the degree they can, to take advantage of the margins they’re earning, so that to us is more of a timing issue, and certainly on the chemical processing side, it would seem to be similar to refining. Other than that, industrial manufacturing has continued to be very strong for us."
},
{
"speaker": "Kyle Menges",
"content": "That’s helpful, thanks. Then certainly the revenue contribution from ancillary and re-rents has been a nice tailwind for this year, and sounds like it’s been driven by specialty, so just how should we be thinking about that into next year? Should we assume continued growth in ancillary and re-rents, just given expecting specialty growth as well next year?"
},
{
"speaker": "Matthew Flannery",
"content": "Yes, I mean, time will tell. If you look at that, I think it was up 15% in the quarter, so it certainly outpaced rental revenue. Part of that is Yak, the contribution they had, so as we anniversary Yak, you won’t have that component as a tailwind within ancillary. But otherwise, certainly the growth we’ve had in specialty is also contributing to it, whether it’s set up, break down, fueling, those sorts of things we do for customers. The thing to just remember is we will anniversary the impact Yak has on it, but it should certainly correlate to some of that specialty growth."
},
{
"speaker": "Kyle Menges",
"content": "That’s helpful. Thanks guys."
},
{
"speaker": "Matthew Flannery",
"content": "Thanks Kyle."
},
{
"speaker": "Operator",
"content": "We’ll take our next question from Angel Castillo from Morgan Stanley. Please go ahead."
},
{
"speaker": "Angel Castillo",
"content": "Good morning guys and thanks for taking my question. Just wanted to go back to your comment about some of the discrete investments that you’re making, particularly on the sourcing side that you mentioned. Just curious if you could unpack that a little bit more as to what exactly you’re doing on the sourcing. In particular, I was hoping you could provide some color as well as it pertains to the equipment type that you need, perhaps between small and local markets versus what is needed in the mega projects, and any differences there and how that impacts your fleet management, your sourcing and capex."
},
{
"speaker": "Ted Grace",
"content": "Sure, I’ll take the first part of that, and I think Matt will take the second part. On the sourcing side, there are two ways we think about sourcing. One is the way we manage fleet across our own network, and so certainly we’re leveraging technology, new aspects of technology and data analytics to more efficiently move fleet, to improve the customer experience, to make sure that that equipment availability is there; but also to reduce costs, and there are a couple of different ways that we think we can do that. Ultimately you come back to predictive analytics and the idea of trying to forecast where fleet is and where it needs to go across multiple iterations, so you’re thinking multiple steps. We think that’s an area where there’s a lot of opportunity for us to leverage technology. Certainly it can help with more efficient purchasing. Internally the way we think about planning, not so much as it relates to the acquisition of fleet but the way we think about managing fleet internally, I think we’ve always done a very good job there and this, we think, could make us a little better. I think that was the first part. The second part was on fleet by project size?"
},
{
"speaker": "Matthew Flannery",
"content": "Project size - yes. We don’t expect to have any kind of large change or swing in any category. One of the things that’s key to our business model, and you guys hear me talk about it plenty, is the fungibility assets. We don’t get into niche items that are just for one specific vertical. That’s the exception, not the rule here, and we think that’s important because with our broad coverage and our broad customer needs, it’s important that we can move assets from one vertical to the other vertical in case one slows down, like we talked about oil and gas, and one picks up, like we talked about infrastructure. If we got through specialized, we think--we think it’d be a lot harder to have the resiliency that we have by different end markets."
},
{
"speaker": "Angel Castillo",
"content": "That’s helpful, thank you. Then maybe just if you could talk about the trends that you’re seeing, kind of in new equipment prices and supply. You talked about inflation a little bit earlier in the call, but maybe to the extent that trends you’re seeing there, and then if you could comment on just the discipline in rental rates that you’re seeing from independents across particularly your local markets."
},
{
"speaker": "Matthew Flannery",
"content": "Yes, so first on the supply side, as I said earlier, we’re real pleased with our vendors, how hard they’ve worked to get their supply chain, which was severely disrupted, in line. As far as pricing, as I’ve said before, we won’t talk about our partnerships and the pricing negotiated on a public forum, but I think our vendors do realize the prices increases they had to push on over the past couple of years, and I think they value the steadiness of our demand and of our commitment to them, so we feel good about our position there. To the second part as far as--what was the second part of the question, Angel?"
},
{
"speaker": "Ted Grace",
"content": "Discipline--"
},
{
"speaker": "Matthew Flannery",
"content": "Oh, yes. So as far as the price [indiscernible], you see it in any data you look at, you see it--you hear it from our public peers. I mean, the industry has grown up, and we’ve been talking about this for a while. I’m just really pleased that people realize you can’t just keep absorbing inflation and absorbing these costs. You’re just going to--you’re going to hurt your business, so, and I think the value that rental brings overall, certainly we feel like we lead the way, but I think the industry overall gives better output, better value to the market. We’re a much more reliable channel, a much more flexible and responsive channel, so I think that’s part of the reasons why people are able to keep that discipline."
},
{
"speaker": "Angel Castillo",
"content": "Very helpful, thank you."
},
{
"speaker": "Operator",
"content": "We’ll take our next question from Neil Tyler from Redburn Atlantic. Please go ahead, your line is open."
},
{
"speaker": "Neil Tyler",
"content": "Yes, thanks. Good morning Matt, Ted. I wanted to come back to the cold starts and the pace of openings there. If we think about that in the context of what you said compared to ’23, what drives your planning outlook for how many and where to land those starts, and how should we think about the cold starts, particularly when I think about specialty and specialty branches within that number, and how should we think about where we are in, say, a five-year view on that journey? Are you trying to put a lot of branches in place in order to capture future growth, or do you think there’s a sort of more measured cadence over the next few years? If you could just sort of talk a little bit around that, that would be very helpful, thank you."
},
{
"speaker": "Matthew Flannery",
"content": "Sure Neil. We don’t have multi-year goals that we put out. In the beginning of each year, we’ll go through the planning process, we’ll see who wants to fund what cold starts and who wants to fund organic growth in many different ways, and then we’ll go through it and we’ll communicate that in January. But just when you think about it, we still have white space, some products that are more mature, maybe not as much in geographic expansion as opposed to penetration, but in others we have a lot of new products lines that we’ve added over the last couple of years, whether that’s our Reliable onsite business, our acquisition of Yak, and still quite frankly the General Finance team, where in mobile storage we still have white space to fill in. That’s most of what it is - it’s new products and/or deeper geographic penetration, and we communicate that each year. We think there’s plenty of headroom in specialty overall as a team, and quite frankly one of our most mature in power still is showing tremendous growth, and they’re just doing it by penetration versus cold starts. We continue to see a lot of opportunity with our specialty business. We think we’ve built a unique value proposition for large projects, large plans and large customers throughout the U.S. and Canada. I won’t give you a forecast of future cold starts other than to say there’s lots of headroom for us there."
},
{
"speaker": "Neil Tyler",
"content": "Okay, great. Thanks, that’s helpful. I was really just trying to think about the margin impact that’s taken place this year and whether that’s something we need to think about as an ongoing, but I guess to some extent it is. Can I follow up with perhaps picking up on your comment about power and the penetration there? Could you perhaps help us understand what’s driving that additional penetration, some of the market trends that you’re picking up on?"
},
{
"speaker": "Matthew Flannery",
"content": "I think power overall is a growth space, right, as an end market vertical, and that’s not just for our business but also for the industry as a whole and our gen rent products as well. But within our power business, which is power HVAC, we’ve got a lot of additional products that we’ve added in. We’ve got a lot of penetration that’s through deeper product offerings to existing customers, and allowing us to get into new verticals because of some of the products that we’ve added. That’s really--you know, the team is very innovative, very creative and very growth minded, and I think they’ve done a great job deepening existing products and broadening with new products, and a lot of that in the HVAC part of the business. That’s about--without going any further on that, I don’t want to get into competitive opportunities, but we’re really pleased with the headroom there."
},
{
"speaker": "Neil Tyler",
"content": "That’s helpful, thank you. Thank you very much."
},
{
"speaker": "Matthew Flannery",
"content": "Thanks Neil."
},
{
"speaker": "Operator",
"content": "We’ll take our next question from Stephen Volkmann with Jefferies. Please go ahead, your line is open."
},
{
"speaker": "Matthew Flannery",
"content": "Steve, you there?"
},
{
"speaker": "Operator",
"content": "Steve, you may need to check the mute function on your phone."
},
{
"speaker": "Matthew Flannery",
"content": "Can we move on? I’m guessing Steve’s--"
},
{
"speaker": "Operator",
"content": "Yes, we will take our next question then from Scott Schneeberger with Oppenheimer. Please go ahead, your line is open."
},
{
"speaker": "Scott Schneeberger",
"content": "Thanks very much, good morning guys. I have two kind of end of the call questions, one for Matt and then one for Ted. I’ll ask them both upfront. Matt, on M&A, is there a--you know, you have this long term initiative to grow specialty within the portfolio and mix. As you come into the new year, you’re done digesting Yak, how are you thinking about gen rent versus specialty rent acquisitions? I know part of your answer will be whatever is ripe and looks the best at the time, best cultural, financial fit. But are you looking at that mix when you make these considerations? Is that heavy consideration? Then also, you made a comment on--I think it was on David’s first question at the beginning of the call about not needing to be number one in the specialty category. I just was curious if you could elaborate on what you meant. You said in Gen Finance as a good building platform, but just curious if you could elaborate on what you meant. Then Ted, for you real quick, new sales were up a lot in the quarter, I think the biggest quarter in maybe three, four years. Just curious if there’s anything there unique - mega projects, a big [indiscernible]. Is that a trend, or was that a unique event? Thanks guys, appreciate allowing the time."
},
{
"speaker": "Matthew Flannery",
"content": "Thanks Scott, I’m glad I wrote those down - you’d be testing my memory here. But as I go through the M&A prioritization, which is how I heard your first question, it’s wherever we’re going to need more value for the customer, whether that’s in a new product offering, which is mostly specialty, and we love--we would highly prioritize any kind of brand new offering to the business where we could take a reasonable good sized platform and then grow upon it through our very strong network, like we did with Yak, like we did with General Finance. I wouldn’t call it that it’s because it’s gen rent or specialty, just like anything additional. If we found a new gen rent product line that we didn’t carry, we would feel the same way. Then when I think about gen rent, it’s more like, where do we need more capacity, where do we need more density, where do we need more of an offering? When we have that opportunity, we certainly are very comfortable integrating our gen rent business, as we’ve done, as you can see in our history very thoroughly. There’s not as much white space geographically, but certainly a lot of opportunity to add more capacity and serve more of the marketplace. When I talked about not being number one, just for clarity, I want us to be number one with our customers. Let’s use an example. For ROS, our Reliable Onsite, we don’t need to have port-a-johns at every wedding or every soccer field, but when you go into a major project or you go into a plant, we’re going to make sure we’re there to support our customer a full one-stop shop value. We want to be number one with our customers and those products. I used General Finance as an example - we don’t need to have modular classrooms in every school, right? That’s not the business we’re after. What we do need to do is make sure if our customers want a modular building or a storage container on a site for their needs, we want to be the number one in that space. That’s what I mean when I talk about that - not every product line do we need to be the largest in the industry, we need to be largest in our industry, so that’s the way we look at that. Then Ted, I think new sales--?"
},
{
"speaker": "Ted Grace",
"content": "Yes, that’s an easy one, Scott. Yak had an impact there. I think Yak had new sales of something like $16 million, so while you see that number up 48% nominally, I think if you backed that out, we’re up about 15%, which is probably a little more in line with what you would have expected."
},
{
"speaker": "Scott Schneeberger",
"content": "Great. Thanks for the color, guys."
},
{
"speaker": "Matthew Flannery",
"content": "Thanks Scott."
},
{
"speaker": "Operator",
"content": "There are no further questions in queue at this time. I’ll return the call to Matt Flannery for any additional or closing remarks."
},
{
"speaker": "Matthew Flannery",
"content": "Great, thanks Operator, and thanks to everyone on the call. We appreciate your time, and I’m glad you could join us today. Our Q3 investor deck has the latest updates, so please take a look at that when you get a chance; and as always, Elizabeth is available to answer your questions. Until we speak again in January, stay safe, have a great holiday season, and we’ll talk to you soon. Operator, you can end the call."
},
{
"speaker": "Operator",
"content": "This does conclude today’s program. Thank you for your participation, and you may now disconnect."
}
] |
uri | 2,024 | 2 | [
{
"speaker": "Operator",
"content": "Good morning and welcome to the United Rentals Investor Conference call. Please be advised that this call is being recorded. Before we begin, please note that the company's press release, comments made on today's call, and responses to your questions contain forward-looking statements. The company's business and operations are subject to a variety of risks and uncertainties, many of which are beyond its control, and consequently, actual results may differ materially from those projected. A summary of these uncertainties is included in the Safe Harbor Statement contained in the Company's press release. For a more complete description of these and other possible risks, please refer to the Company's Annual Report on Form 10-K for the year ended December 31, 2023, as well as to subsequent filings with the SEC. You can access these filings on the Company's website at www.unitedrentals.com. Please note that United Rentals has no obligation and makes no commitment to update or publicly release any revisions to forward-looking statements in order to reflect new information or subsequent events, circumstances, or changes in expectations. You should also note that the Company's press release and today's call include references to non-GAAP terms such as free cash flow, adjusted EPS, EBITDA, and adjusted EBITDA. Please refer to the back of the Company's recent investor presentations to see the reconciliation from each non-GAAP financial measure to the most comparable GAAP financial measure. Speaking today for United Rentals is Matt Flannery, President and Chief Executive Officer, and Ted Grace, Chief Financial Officer. I will now turn the call over to Mr. Flannery. Mr. Flannery, you may begin."
},
{
"speaker": "Matthew Flannery",
"content": "Thank you Operator, and good morning everyone. Thanks for joining our call. As you saw yesterday afternoon, we built upon our strong start to 2024 with another solid quarter. We're pleased with the growth, profitability, returns, and free cash flow in the second quarter as the year continues to unfold in line with our expectations. Our reiterated guidance is further proof of this. Of course, the key to these results is our team's diligence in providing our full offering across general and specialty, coupled with a steadfast commitment to safety, operational excellence, and innovation. Without the hard work of our 27,000-plus employees, the results we'll be discussing this morning would not have been possible. On our first quarter call, we discussed that we've doubled down on being the best partner for our customers. This unwavering focus on the customer is critical and drives our strategy every day, whether in our go-to-market approach, our value proposition, or in our investment decisions. We've built a diversified business model that enables us to serve our customers with broadened relationships and generate shareholder value. I'm pleased with how far we've come as a company over the last decade and for the opportunities ahead. Today, I'll discuss our second quarter results, our expectations for 2024, and what gives me confidence that United Rentals will continue to win in the marketplace. And then Ted will discuss the financials in detail before we open up the call for Q&A. So let's start with the second quarter results. Our total revenue grew by 6% year-over-year to $3.8 billion, and within this, rental revenue grew 8% to $3.2 billion, both second quarter records. Fleet productivity increased by 4.6%, supported by continued industry discipline. Adjusted EBITDA increased to a second quarter record of almost $1.8 billion, translating to a margin of nearly 47%. And adjusted EPS grew by 8% to $10.70, another second quarter record. Now let's turn to customer activity. We saw growth in both our general and Specialty businesses. And within specialty, we continue to see growth across all product offerings. In fact, even excluding the benefit of Yak, Specialty rental grew 18% year-over-year. Additionally, we opened 27 Specialty cold starts, which puts us at 42 year-to-date, and we remain on track to open at least 50 this year. By vertical, we saw growth across both construction, led by non-res, and our industrial end markets, with particular strength in manufacturing. It'll come as no surprise that we saw multiple new projects in the quarter across data centers, utilities, healthcare, battery manufacturing, and infrastructure. And if you're a soccer fan, you'll be excited to know that Freedom Park in Miami kicked off as well. Additionally, the used market remains healthy, allowing us to sell a second quarter record amount of OEC. We believe that demand for used equipment will remain strong and still expect to generate around $1.5 billion of proceeds this year. Turning to CapEx, we spent $1.4 billion in the second quarter, in line with our expectations as we added fleet to meet the seasonal uptick in customer activity. For the full year, our CapEx guide remains unchanged. Subsequently, year-to-date, free cash flow was nearly $1.1 billion. We continue to see our strong cash generation as a key differentiator and remain confident in our ability to produce over $2 billion this year. And as you've heard me say before, our flexible business model, coupled with our industry-leading profitability, enables us to drive positive free cash flow throughout the cycle and support long-term value creation for our shareholders. Now, turning to capital allocation, we returned $484 million to shareholders in the quarter via share buybacks and our dividend. Our balance sheet is in excellent shape, and we continue to plan to return nearly $2 billion to shareholders this year. The theme you've heard consistently so far today is that 2024 is playing out as we originally expected. As you saw from our updated guidance, we narrowed the range of expectations for revenue and EBITDA with the midpoint unchanged, while keeping CapEx and free cash flow intact. But let's step back from the remainder this year and look at what gives us conviction in our business even further out. First, we remain diligent in leveraging our unique value proposition. As we work through the myriad of tell-ins we've discussed many times. In fact, we've been successful in each area. The outlook for large infrastructure projects, chip manufacturing, autos, and energy and power all remain positive. Data center construction has also been an area of focus, and we continue to win in this vertical as well. All of these type of projects play into our one-stop-shop offering, and our great examples of United Rentals having all business units counted for, as we help solve more of our customers' problems. As an example, last month I visited a large data center project we'd recently won. Beyond providing the core, generous, and space Specialty products that might immediately jump through your mind, whether that be dirt, aerial, power, or trench, we're also supporting their safety and security requirements. We're providing secured access to the site with our advanced turnstiles and access control system. In addition to educating workers with our United Academy safety training, our experience and ability to help them solve their logistics from soup to nuts, differentiate us in the marketplace, and allow us to further strengthen our customer relationship. Second, we continue to grow with new products. Our acquisition of Yak, which has now been part of the United Rentals family for over four months, is a perfect example of this. The integration is well underway and progressing on track, and this is a textbook example of how we can leverage our existing customer relationships to accelerate growth with a new product. And finally, we work with our customers to ensure we are their partner of choice. This is enabled by our 1UR culture and is augmented by the investment we continue to make in technology. Our size and scale allow us to invest aggressively in both customer-facing technology, such as telematics and total control, as well as internal technology that tries operating efficiencies across logistics, fleet management, and repair and maintenance. And when put to task and working together, these investments allow us to further entangle ourselves with our customers, thus enabling future growth. So to wrap things up, we're happy with how 2024 is playing out, and we're confident that our extensive competitive advantages, combined with our flexible and resilient business model, allow us to drive profitable growth, strong free cash flow, and compelling shareholder value. And with that, I'll hand the call over to Ted before we take your questions. Ted, over to you."
},
{
"speaker": "William Ted Grace",
"content": "Thanks, Matt. Good morning, everyone. As Matt highlighted, Q2 played out as expected with healthy demand and strong execution, driving record second quarter revenue, EBITDA, and EPS. Looking forward, our reaffirmed guidance at the midpoint for total revenue, EBITDA, CapEx, and free cash flow reflects our continued confidence in delivering another year of solid growth, strong profitability, healthy returns, and significant free cash flow. As importantly, we remain focused on prudently allocating capital to drive shareholder value. So with that, let's jump into the numbers. Second quarter rental revenue was a record $3.215 billion. That's a year-on-year increase of $234 million, or 7.8%, supported by growth in key verticals and large projects. Within rental revenue, OER increased by $143 million, or 5.8%. Growth in our average fleet size contributed 2.7% to OER, while fleet productivity added 4.6%, partially offset by soon fleet inflation of 1.5%. Also within rental, ancillary and re-rent revenues were hired by $91 million, or 17.5%. Turning to our used results, second quarter proceeds of $365 million were in line with expectations at a healthy adjusted margin of 51.8%. The strength and depth of the market were evident in the fact that we sold a second quarter record amount of OEC at a robust recovery rate of 59%, in line with first quarter levels. Moving to EBITDA, adjusted EBITDA was a second quarter record at $1.77 billion, translating to an increase of $74 million, or 4.4%. Within this, rental contributed $127 million year-on-year. Outside of rental, and similar to the first quarter, used sales were a $30 million headwind to adjusted EBITDA, driven by the ongoing normalization of the used market that we've discussed over the last several quarters. SG&A increased $23 million year-on-year, reflecting a larger business, but was consistent with year ago levels as a percentage of sales. And finally, the EBITDA contribution from other lines of non-rental business were flat year-on-year. Looking at second quarter profitability, our adjusted EBITDA margin was in line with expectations at 46.9%. The 80 basis points of year-on-year compression was almost entirely due to the use dynamics I just discussed. Excluding the impact to use, our second quarter margin was down just 10 basis points with an implied flow-through of 44%. And finally, our adjusted earnings per share increased 8% to a second quarter record of $10.70. Shifting to CapEx, gross rental CapEx was $1.4 billion, which is in line with our forecast and historical seasonality. Turning to returns and free cash flow, our return on invested capital of 13.5% remained well above our weighted average cost of capital while year-to-date free cash flow totaled $1.065 billion. Our balance sheet remains very strong with net leverage of 1.8 times at the end of June and total liquidity of almost $3.3 billion. I'll add that we continue to have no long-term note maturities until 2027 and a very distributed tower thereafter. And all this was after returning a record $969 million to shareholders year-to-date, including $219 million via dividends and $750 million through repurchases. I'll add this has reduced our share account by over 1.1 million shares since January. Now, let's shift to the updated guidance we shared last night, which reflects our confidence in delivering another year of solid results. As previously mentioned, we are maintaining the midpoints for all metrics while narrowing the ranges for both revenue and EBITDA as we normally do at this time of the year. In terms of specifics, for total revenue, we've narrowed our guidance to a range of $15.05 to $15.35 billion, implying total revenue full-year growth of just over 6% at midpoint. Within this, I'll note that our used sales guidance is unchanged at roughly $1.5 billion in proceeds on approximately $2.5 billion FOEC sold. On Adjusted EBITDA, we've narrowed the range to $7.09 to $7.24 billion. I'll note that our guidance for gross CapEx, net CapEx, and free cash flow are all unchanged. And, importantly, we are still committed to returning a record $1.9 billion to shareholders this year, which translates to almost $30 per share or a current return of capital yield of about 4%. So, with that, let me turn the call over to the operator for Q&A. Operator, please open the line."
},
{
"speaker": "Operator",
"content": "Thank you. [Operator Instructions] Our first question will come from David Raso with Evercore ISI. Please go ahead."
},
{
"speaker": "David Raso",
"content": "Thank you for the time. The question relates to the interplay between GenRent rental revenue growth versus Specialty. It caught my ear when you said thinking about growth further out, right, kind of beyond this year. So just thinking about Specialty has gone just in the last 5 years from 20% of total rental revenues to now over 30%, right? And GenRent this quarter, even year-to-date, right, it's pretty much flat widening. So I'm just trying to think about how much GenRent could fall and Specialty can offset it, right, the simple math of if GenRent is 70%, Specialty is 30%. GenRent can fall 5% as long as Specialty is growing 10%, we're still flat, right? So that's sort of the spirit of the question. So I guess directly, gen rental revenues, do we expect those to go negative in the second half of the year now that we're sort of flat lining in 2Q, in Specialties, the offset I know Specialty has some Yak in it, but even just kind of thinking of it organically, right? Because you have implied in the second half rental revenues probably still growing, call it, 7.5%, 8% in the context of the whole company growing 6% revenues in the back half. So can you speak to GenRent trends? Should we expect those to go negative and Specialty kind of carries the ship? Just curious how you're thinking about that. Thank you."
},
{
"speaker": "Matthew Flannery",
"content": "Sure, David. This is Matt. So, we certainly, it's not our goal and we're not going to predict quarters by segment, but it's certainly not our goal for GenRent to go negative. That being said, our GenRent business is much more impacted by the local market dynamics, right? As opposed to Specialty where we don't have that local market penetration for those products. And think about our Specialty business, and we're very pleased with the growth specialty, both organically and with Yak, with the M&A, that they are really tailored to broader needs. So, when we can sell our one-stop shop to a customer, think about that advantage that we have on big jobs and big customers, which is a much higher profile of specialty's overall revenue. So, I think that's really the dynamic that's playing through. And not unexpected for us, we put most of our growth CapEx into Specialty this year, and you can see our cold start. So, we know we have more room for penetration for specialty, and it's just supported even more so by the major project work and the tailwinds that we've talked about, really backfilling some of the challenges in certain local markets where that local activity is just not as high as it was, and certainly impacting GenRent more especially."
},
{
"speaker": "David Raso",
"content": "Well, that's what I'm trying to think through, right? Everybody's just trying to figure out, Matt, like how much does the sort of softness in the underbelly of the market from typical rate impact lag now starting to slow some general projects, and how large you are now in specialty. The visibility on specialty, I assume it's also pretty tethered as well to some of the mega projects, your confidence in your visibility and Specialty can kind of carry the show. And at the same time, the gross margins are a lot higher in specialty, right? Could we actually see a mix shift that helps your gross margin? So, it's sort of a, like you're lined up better to serve the mega project specialty, it's bigger, so that's how you can kind of offset GenRent being down. And does that actually translate into a better mix just given the gross margin profile?"
},
{
"speaker": "Matthew Flannery",
"content": "Theoretically, absolutely, right? And there's one of the reasons why we continue to focus on Specialty and why we started this journey almost 15 years ago now, right? When we first started our first trench business unit. So, you're thinking about it in the right way. The only thing I wanted to clarify is we're still need to respond to our customers and what the demand is and make sure we have the right fleet in all of our businesses, GenRent as well, for what demand's coming. So, we do feel this is a transient year. We'll worry about the future as we get to the tail end of this year, but if you remember when we gave our guidance in January, we expected this local market challenge to be there until there was a bit of a transition year that we were feeling that was going to be coming in the local market. And, we'll react to the demands that our customers have, and Specialty can certainly be a boon to not just margins, but more customer entanglement."
},
{
"speaker": "David Raso",
"content": "All right. I appreciate the conversation. Thank you."
},
{
"speaker": "Matthew Flannery",
"content": "Thanks, David."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question will come from Rob Wertheimer with Melius Research. Please go ahead."
},
{
"speaker": "Robert Wertheimer",
"content": "Hey, everybody. And thanks for the comment about on GenRent. I guess it sort of saw it was coming and it's coming. I had a couple questions around that as well. And one is just a big picture. What's your strategy around? Are you still gaining share? Are you looking to gain share in a market that's a little bit flattening? Is the smaller end of the market actually down? You guys are flat-ish, is the smaller end of the market down? So, just sort of thinking about historically outgrown flat markets, is that kind of what's going on now and is that the desire?"
},
{
"speaker": "Matthew Flannery",
"content": "Yes, we certainly don't believe that we're giving up any market share. But frankly, we don't set market share goals, but just by definition, you'd have to believe that we think there are certainly some markets that are down in the local market business. Fortunately, because we saw this in advance, we didn't burden those branches with extra fleet. And I actually think the industry is doing a good job managing through this, and I think you see that in the metrics that are playing through. So, we're really pleased with our level of support for the work that is there in every market, including some local markets that are growing. The fungibility of our assets allows us to flex that, which has really been good. So, we don't set market share goals, but we certainly don't think we're seeding any market share. And the most important thing is with the targeted customers that we focus on, we do feel we're gaining share."
},
{
"speaker": "Robert Wertheimer",
"content": "Perfect. And then if I could just follow up, I mean, the local market is part of GenRent, but I guess it includes some megas and everything else as well. So, is the curve of mega projects still within that segment? And the lull that you kind of talk about this year, does that get offset by the wave that's still flowing in from those megas or by normal interest rate dynamics, lower rates and more projects starting and so forth? I'll stop there."
},
{
"speaker": "Matthew Flannery",
"content": "Yes. So, when we think about local market growth, we're not including the mega projects in that, right? So, as we're talking about that dynamic, but as you can imagine, where there's a lot of activity going on, there's going to be feeder plants, there's going to be other work going on around there, which supports it. And then the opposite, if you're in an oil and gas market right now, there's probably not a lot of activity, extra activity going around the local market because we all know oil and gas is one of the examples of an area that continues to struggle. So, it ties, Rob, but the way we look at it, we look at our large projects and large customers in a different segmentation than we do the local market."
},
{
"speaker": "Robert Wertheimer",
"content": "Thanks."
},
{
"speaker": "Matthew Flannery",
"content": "Thanks."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question will come from Tim Thein with Raymond James. Please go ahead."
},
{
"speaker": "Timothy Thein",
"content": "Thank you. Good morning. Matt, maybe I'll start with the kind of thinking about the components of fleet productivity and specifically the expectation coming into the year that maybe you could hold time flat and I don't remember if that was on a pro forma or an as reported comp versus 2023. But just going back to the comments on GenRent and if GenRent revenues were up just under 1%, but the fleet grew in total, closer to 3%, obviously, that suggests some component of time, rate and/or inflation acting as a headwind. So maybe just your -- any change to the expectation for the full year, again, just given the -- a little bit of softness on the local market dynamics that we've discussed."
},
{
"speaker": "Matthew Flannery",
"content": "Yes. Sure, Tim. So your memory is correct, right? We did talk about trying to match last years’ time utilization with this year, which would make the time component of the fleet productivity neutral, and that's what we've been able to do. And that's kind of -- that expectation is embedded in our guidance as we look forward. So when you think about qualitatively, we won't give them quantitatively, but qualitatively, the other components are we said in January that rate would be a good guide. I would be positive, and we continue to see that, and we continue to see that through our peers, which is great news that shows that industry discipline. And then the variability being in mix, so that's an output of a lot of different things. So we don't forecast it, but I would call time neutral, meaning we were able to achieve last year's level of time utilization, which we are pleased about. Rate a good guy and the variability to where we end up with fleet productivity will be more in the mix component."
},
{
"speaker": "Timothy Thein",
"content": "Okay, got it. And then maybe just a comment on the M&A pipeline and just given the prospects of some potential change in tax policy on the horizon, I'm just curious, a domestically, what you've seen in terms of just discussions and how the M&A pipeline is shaping up here. And then, the international story has never been one of significance. But I've noticed two smaller deals, in the last, I know, a couple months. Has the thought process changed around international growth more broadly?"
},
{
"speaker": "Matthew Flannery",
"content": "Yes. So, I'll take the first part first. The pipeline remains robust, right? I mean, we've been and has been for a couple of years. There's plenty of activity, both for Specialty and GenRent businesses. And you guys know what our prioritization is. If we get to see a new product offering like we did with Yak, right, that's in our sweet spot. That's primary. We think we can really be a better owner of businesses like that and selling it through our network. And then Specialty overall, we continue to look for more growth, more penetration there, because we do have more opportunity for to build density there. And then, but even in our GenRent, right, if we need capacity in a certain market and there's a good deal to be had, we've shown in the past that that will strike there. So, that pipeline continues to be broad and robust. And thinking about the international, we did recently close a deal in Australia. We have an international toehold right now, right? We have we have a business in Europe that we added a small tool business to at the end of last year. That dynamic was just strictly a tuck into the existing business we had there, selling into the same niche industrial markets and customers that we were that we were selling into. And our team there earned that right to get some of the support for their growth. And that was great. Australia is a little bit of a different story. I was able to spend some time there earlier this year. And the team there is doing a great job. And we saw some opportunity to broaden our product offering there. And there may be the opportunity one day to run more of the United Rentals Play in Australia. We're not all the way there yet. But this is definitely a dump, a jump into supporting the growth of that business there with some M&A and with a target that we think is a really good fit for the organization."
},
{
"speaker": "Timothy Thein",
"content": "Got it. Thank you, Matt."
},
{
"speaker": "Matthew Flannery",
"content": "Thanks, Tim."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question will come from Jamie Cook with Truist Securities. Please go ahead."
},
{
"speaker": "Jamie Cook",
"content": "Hi. Good morning. I guess my first question, Ted, just sort of longer term, your incremental margins for 2024 below your targeted range, which we understand why with some of the spend and use headwinds. But what type of environment do we need to see for United Rentals to get back to its targeted incrementals? I mean, do we need the double digit top line? Or I'm wondering if we have single digit growth next year with sort of used headwinds easing to the point of Specialty becomes a larger versus the GenRent. That's a positive. And with some of these acquisitions getting integrated, I'm just wondering what we need to see there to get a more normalized. Can we get back to the targeted incremental? Thanks."
},
{
"speaker": "William Ted Grace",
"content": "Sure. Thanks for the question, Jamie. So there's obviously a lot that goes into incrementals. So without saying the obvious or stating the obvious, obviously, relative growth does matter, right, growing whether you want to say 5, 10 or 15 drives different levels of fixed cost absorption. But obviously, the composition of that growth matters a lot if you think about rate versus volume. And so it's hard to say what kind of growth you need to kind of drive lift in flow through. And there's obviously the consideration of costs on top of that. If you think about this year, we're looking at what we think is healthy growth, mid-single digits overall. You'd point to flat margins in a year where, frankly, we're making some important investments that we've talked about, both on the cold start side and technology. So that kind of illustrates the importance of how you think about costs. So we absolutely task ourselves to driving kind of strong cost discipline, margin lift in some environments and under some conditions depending on where you're making investments that can be easier or not as easy. So I don't know that we want to get pinned down on what kind of top line growth you need to see for all the reasons I just went through, but what I can say is we have and we'll always have an incredible focus on driving as efficient operations as possible to drive attractive profitability."
},
{
"speaker": "Jamie Cook",
"content": "Okay. Thank you very much."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question will come from Jerry Revich with Goldman Sachs. Please go ahead."
},
{
"speaker": "Jerry Revich",
"content": "Yes, hi. Good morning, everyone."
},
{
"speaker": "Matthew Flannery",
"content": "Hey, morning, Jeff."
},
{
"speaker": "Jerry Revich",
"content": "Hi. I'm wondering if you can talk about the 18% organic growth and specialty. Matt, how broad base is that? And what are the stronger parts of the portfolio that's above that average? If you're willing to comment, then, is it fair to assume that Specialty as a mix of the CapEx plan has moved up over the course of the year?"
},
{
"speaker": "Matthew Flannery",
"content": "Yes, sure, Jerry. We're pleased. And I said in my opening remarks, we saw growth across all the product offerings and specialty, right? You can imagine the couple that have been the largest growers, let's leave the Yak aside for now, right? But even in the or 18% standalone growth without the Yak influence, we've mobile storage where we talked about our commitment to doubling the size of that business within five years is growing strong. Power continues to be strong growth, but we're seeing it in our trench and fluid businesses as well. So it's across the board. And I think that's really important. And I think it also points to the cross-sell opportunities that we have on large projects and large customers. Like I said in the opening remarks, every business unit's accounted for on these big jobs. And we do a really good job making sure we're selling that full value prop. And I think that's helped drive a lot of this growth."
},
{
"speaker": "Jerry Revich",
"content": "Super. And on Yak, can you just talk about what the developments have been under your ownership? Obviously, you folks have the advanced pricing tools and logistics tools. Can you just talk about how that integration has gone and any surprise and opportunities as you've owned the business for a number of months now?"
},
{
"speaker": "Matthew Flannery",
"content": "Yes. So the first surprise, and not really surprise, but great pleased to acknowledge that this was a really strong team. We understand why they were a leader in the space of this product. And we believe what we really bring to the table is our network, right? Our ability to fund their growth, distribute their growth across our network and our customer base. So they were, they're a little bit capital constrained for their growth. And frankly, really good. Have a lot of technology built in to support the customer already in that business, in logistics. And we think bringing in some of our tools and our network can help grow that business. So, but I don't want to, this was not a broken business. Actually, they're quite good at what they do. They just need more support. And we're looking forward to double in this business over the next five years as well."
},
{
"speaker": "Jerry Revich",
"content": "Thanks, Matt."
},
{
"speaker": "Matthew Flannery",
"content": "Thanks, Jerry."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Michael Feniger with Bank of America. Please go ahead."
},
{
"speaker": "Michael Feniger",
"content": "Yeah. Hey, good morning, everyone. Thanks for taking my question. Just Matt, obviously, the last few weeks, there's been some incremental negative data points around nonres construction in the industrial economy. You guys have kept the midpoint of your guide. Some of your peers had to revise our outlook. Are you guys observing that incremental weakness? Or are you guys just being more nimble, kind of moving fleet from weak areas to stronger areas? Is that fleet movement higher than normal that you guys have seen in the past?"
},
{
"speaker": "Matthew Flannery",
"content": "No. We're seeing -- as we said, we're seeing the year play out as expected. So we're not really seeing any concerns, and I know there's been concerns and questions we've been getting about the mega project flow, large projects come and go. You heard me talk about the Miami Soccer state in my opening remarks. Remember, last year, we were talking about that was one of the “cancellations” or holds. So there's an ebb and flow to these projects that is normal for us. We've been doing major projects for a long time. So maybe we already had a little bit of that expectation built in. But we're very pleased with the pipeline, and we think the back half of the year is going to look very similar to what we had here in Q2. The other part of the fleet movement once again, we've been moving -- we've been supporting projects like this for a while. But this is an area where I think our density actually helps. The fact that we have a lot of fungible assets and a broadly distributed network means we've probably got most of the fleet we're going to need for any project somewhere within a reasonable distance of the area. So I do think that helps us on logistics, and it's a great part of the business model and why scale matters."
},
{
"speaker": "William Ted Grace",
"content": "And Mike, the one thing I might add is, obviously, there are data points that everybody is looking at. And I know people struggle to make heads or tails of them. When we think about what our customers are telling us, they continue to be positive, right? And to us, that's much more telling than a given data point that tends to have a lot of volatility. So when we talk to our customers and we talk to the field, that's really what underpins kind of our outlook."
},
{
"speaker": "Michael Feniger",
"content": "And maybe just to follow up with that, Ted, just when you speak to your customers, I'm curious, you know, as we're potentially going into a rate easing cycle, there's been some downturns where an easing cycle takes quite a few, takes time to really see that pipeline fill. I'm curious with this backdrop right now with some of these mega projects, with what you're seeing already with the customers, what do you think an easing cycle starts to look like in terms of really seeing that sensitivity to filling that pipeline up in the local markets or continuing that momentum on the mega project side? Thank you."
},
{
"speaker": "William Ted Grace",
"content": "I think, our thought is sentiment matters as much as anything. And so the anticipation of, a more constructive rate environment likely helps for activity in terms of trying to calculate a lag. I'm not sure anybody's got a model that does that effectively, but certainly if you look at how equity and credit markets have traded the last month or so, there's certainly the expectation that the Fed is going to start easing, right? If you think about how the market started to discount rate cuts in the U.S., you're looking at about 2.7 cuts between now and year end. That number was probably 1.6 even a month and a half ago. And if you look at next year, the expectation is you're going to get north of a point of cuts in Fed funds. And obviously in Canada, I'm sure everybody's seen, but Canada has now started to cut. They've cut half a point in the last two months. So, I think when you think about customers thinking about cost of capital and the direction of the economy, we're becoming more encouraged. And that to us is positive."
},
{
"speaker": "Matthew Flannery",
"content": "Yes. And I would add that remember these tailwinds that we've talked about that we always expected would backfill any softness in some of the verticals within non-res or multi-year tailwinds. So you could see this type of, regardless of how long it takes to, for the local business to start building up and showing more green shoots again. And we have a good pipeline of work in the tailwinds that we've talked about."
},
{
"speaker": "Michael Feniger",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question will come from Tami Zakaria with JPMorgan. Please go ahead."
},
{
"speaker": "Tami Zakaria",
"content": "Hi. Good morning, Tim. You are I great to be on the call and thanks for the time. So I just wanted to confirm, I know you discussed time utilization rate and mix to Tim's question earlier, but overall fleet productivity, do you still expect that to remain positive for the year? And related to that, should we expect the Yak to be adding about 160 basis points to productivity for the rest of the year? Or is there seasonality to think about?"
},
{
"speaker": "Matthew Flannery",
"content": "Yes, Tam, this is Matt. So we, to the latter part of your question, there could be some seasonality there. It could be a little more. We're going to, you're not going to have to do a lot of work on that. We're going to call that out separately each quarter until we lap Yak. So we'll let you know what it is with or without Yak. And as far as to your first question, we do expect fleet productivity to be positive in every quarter this year. That was something we committed to in January and I'm really pleased to see the team executing on that. And we still have that expectation and that's what's embedded in our guide."
},
{
"speaker": "Tami Zakaria",
"content": "Got it. One more question. Thank you for the answer. For used equipment margin weakness this quarter, can you speak to what you're seeing in the third quarter, quarter-to-date, have things stabilized or remains sort of under pressure? And how much headwind should we think about from this in the second half versus the $30 million you called out in 2Q?"
},
{
"speaker": "Matthew Flannery",
"content": "Yes. So I don't think we've characterized the margin weakness as a function of the market. This is just ongoing normalization coming out of the really extraordinary period, 2022 that started to normalize in 2023 and is continuing in 2024. So Tami, just as a reminder, historically, we've recovered about $0.50 to $0.55 on the dollar selling assets. in 2022, that got as high as $0.74. At the time, we said that, that was unsustainable and really a function of the perfect storm with much better-than-expected demand and obviously, supply chain challenges. We then said we thought that would start the process of normalizing in 2023. You saw that kind of mean revert a little bit. We got $0.66 on the dollar last year. And this year, we think we'll get something around $0.60. That's where we've kind of been in the last two quarters. So we don't think it's rate pressure per se. We think it's this ongoing normalization. Those margins also remain well above historical norms. So we feel very good about that. We don't comment intra-quarter, but certainly, you can see in our guidance in my prepared remarks, we talked about $1.5 billion of proceeds and about $2.5 billion of OEC, which would underpin that $0.60 on the dollar. So demand has been very strong there. And frankly, we'd say those recovery rates have held in very well and reflect the strength of that demand. And I think that's another sign of the health of our customer. We had a second quarter record amount of OEC we sold into the market."
},
{
"speaker": "Tami Zakaria",
"content": "Got it. That's very helpful. Thank you."
},
{
"speaker": "Matthew Flannery",
"content": "Thanks, Tami."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question will come from Kyle Menges with Citigroup. Please go ahead."
},
{
"speaker": "Kyle Menges",
"content": "Thank you. Following up on Tammy's question on the used market, just what's giving you confidence that the used market will remain strong for the remainder of this year? And then second part of the question that I noticed that the mix of Specialty as a percentage of the new and used sales picked up in this quarter. So, should we expect that to continue for the remainder of the year, maybe even into 2025? And should we assume that that's a positive mix impact to use than new sales margins?"
},
{
"speaker": "Matthew Flannery",
"content": "So, taking the first question, Kyle, I think a big part of business confidence is obviously that year-to-date resulting in line with our expectations, knowing kind of what customer activity is. And so, there's nothing that would suggest we're kind of deviating from our expectations. And you come back to customer confidence and their own expectations looking out as we ask them. So, certainly, if we saw a deviation there, we start to ask questions why we're not. And so, I think those things come together to support our views of the used market. In terms of the mix, there's just a natural ebb and flow. I don't know that we want to get into kind of trying to forecast one variable or another, but obviously, we've been very pleased with the results."
},
{
"speaker": "Kyle Menges",
"content": "Makes sense. Thanks. And then could you just talk a little bit about where your fleet age is at the end of the quarter? And if you'd still like to bring that down a little bit, like what's a comfortable target range for the fleet age?"
},
{
"speaker": "Matthew Flannery",
"content": "Sure. So I think we're a little over 51 months in the quarter. So that's -- from the peak during COVID, it's probably down 4 months. I'll remind people that when you look at that 51, there are a couple of structural changes there versus pre-COVID levels. One was the acquisition of General Finance, which added about 2 months and the other was the acquisition of Baker right ahead of the COVID period that added about 1 month, 1.5 months. So if you were to adjust for structural changes to product mix, that average age is probably something in the 47, 48 months, which is very comfortable. We've long talked about fleet age as really more of a risk management strategy. In a prospective downturn, we'd want to be able to age the fleet 12 months, right? It's just kind of a way to hedge ourselves and protect cash flow. So we are now at the point where we feel like we could very comfortably age the fleet 12 months in that kind of scenario, not the plan. But we're not trying to engineer for a given fleet age. It's really an output of decisions we make. So I don't know if that helps, Kyle, we can dig in deeper there, if you'd like."
},
{
"speaker": "Kyle Menges",
"content": "That's helpful. Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question will come from Angel Castillo with Morgan Stanley. Please go ahead."
},
{
"speaker": "Angel Castillo",
"content": "Thanks for taking my question. Matt, I just wanted to follow up with that and also on some comments you made earlier about just your fleet, I guess that you have an ability to move product around maybe away from some of the local markets. You left your CapEx unchanged. And as you think about having the fleet age at a place where you can essentially age it a little bit or in a good spot, plus the fact that you have the ability to move product from other areas, I guess can you talk about the decision to perhaps keep CapEx unchanged and versus perhaps kind of lowering that and utilizing what's maybe being impacted on the local markets?"
},
{
"speaker": "Matthew Flannery",
"content": "Yes. So, first let me clarify. We have no goal to age our fleet. What Ted was pointing to is we have that opportunity when thinking about is your fleet age at the right place. We always like to leave that dry powder. We have no expectation of needing to use that dry powder anytime soon. And the reason that we're continuing on with our CapEx is because the team's putting it to work. As we stated earlier, our fleet productivity is positive. The demand, as you can see from our guide, we expect to be as expected. So there's really not a reason why we would then try to age our fleet forcefully and cut CapEx because we believe in the future growth prospects of the business and the CapEx is warranted because that's what the customer's demand is. As you can imagine, a big portion of that is replacement CapEx. We talked about that. About 3 billion of the CapEx is inflation adjusted to replace a 2.5-week spec to sell. And then on top of that, you can imagine that within the growth CapEx, that's really feeding the cold starts and the growth of Specialty primarily, which continues to be a good story for us."
},
{
"speaker": "Angel Castillo",
"content": "Very helpful. And maybe just to kind of clarify, there was a discussion around the neutral utilization for the year. Could you just talk about that on the second half versus first half basis and also kind of putting it in context of kind of longer term, I believe you've kind of essentially normalized to where you think it will kind of remain, so just in the dynamic of where we were in the first half versus second half?"
},
{
"speaker": "Matthew Flannery",
"content": "Yes, what we said in January maintained. We expect time utilization, our goal is to match last year's time utilization, which got to a good strong rate and at a healthy level, and that will remain our goal. We don't really see -- we're not going to forecast it numerically by half, but we don't see any need to adjust our thoughts. And therefore, that's why we're able to reiterate our guidance."
},
{
"speaker": "Angel Castillo",
"content": "Understood. Thank you."
},
{
"speaker": "Matthew Flannery",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question will come from Steven Fisher with UBS. Please go ahead."
},
{
"speaker": "Steven Fisher",
"content": "Thanks, good morning. So your positioning on large projects is clearly providing a variety of benefits this year. I'm just curious how active is the bid pipeline for the next round of large projects? Wondering how much visibility you have on those projects for the next year or so at this point? And how do you think those next projects are going to be different from what we've seen so far in terms of maybe the verticals or the size or duration or anything like that? Thanks."
},
{
"speaker": "Matthew Flannery",
"content": "Yes, Steve. So I think one of the key things is to remind people is these large -- we have equipment on projects right now that started in 2022. So these are long-lived projects. The mega projects that are going on. So we expect this to be a multiyear tailwind. We're not really getting into bid pipelines or all that. We view some of that as competitive information. But I think you guys all see and hear what's coming out of the ground and what's expected. And we feel good that this is a multiyear tailwind. That's probably the way that I would characterize that. And I think we're well positioned with the history of our relationships with the customers that are doing this type of work and the broad product offering to take advantage of this. And once again, I see this as a multiyear tailwind."
},
{
"speaker": "Steven Fisher",
"content": "Okay. That's helpful. And then the 44% flow-through ex use, I think, compared to about 54% in Q1, just curious what drove the reduction in that flow-through in Q2 versus Q1? Was it the impact of going from 15 cold starts in Q1 to 27%? Or are there extra logistics costs to redirect fleet around and how should we think about the kind of the flow-through that you have implied an embedded in the second half of the year relative to the 44% in Q2?"
},
{
"speaker": "Matthew Flannery",
"content": "Sure. Steve, I'll take that one. So one, I'll just remind you, quarter-to-quarter, there's a lot of sensitivity to these calculations. And certainly, in this kind of growth environment, that's very true. You saw we delivered kind of in-line profitability this quarter and the first quarter. We reaffirmed guidance. So all this is playing out as expected. I think it's important to start there. If you look at what's implied in the back half, it's kind of not dissimilar to what we did in the second quarter, right? You're going to have flow through in that mid-40s ex used. We've talked about ex use having -- targeting flat margins for the year. That was the expectation that remains the expectations. In terms of sequentially, cold starts are part of it. We talked about those investments we're making. We talked about technology investments we're making. And so it is that kind of making progress on those two programs specifically that continues in the back half."
},
{
"speaker": "Steven Fisher",
"content": "Perfect. Thank you."
},
{
"speaker": "Matthew Flannery",
"content": "Thanks, Steve."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question will come from Neil Tyler with Redburn. Please go ahead."
},
{
"speaker": "Neil Tyler",
"content": "Hey thank you. Good morning. A couple left, please. Just I suppose touching on the previous question around the cadence of cold starts. Was it always the intention to front load those or has that altered slightly? And then the second question, just coming back to the used comments you made, Ted. Is there anything to be done or being done in terms of channel shift that you've been able to achieve or intend to achieve to maximize the return on that used fleet? Thank you."
},
{
"speaker": "Matthew Flannery",
"content": "Neil, I'll take a cold start question and Ted can talk to you sale some more. But a little bit accelerated, right? So whether they fell in Q3 or Q2 was probably more a function of where they're able to find the right real estate. So we were pleased we were able to co-locate a couple in existing real estate that helped accelerate that. So we had some real estate capacity that probably accelerated that a little bit, not tremendously so, but certainly a little bit more. And that's not something we really try to manage by quarter. We don't manage the business really by quarter. It's not the way we look at it. So we are pleased that the team is a little bit ahead of schedule and on cold starts and feel good about our target for the year."
},
{
"speaker": "William Ted Grace",
"content": "Yes. On the channel mix for used sales, there's probably a little less retail this year than last year. I think last year, we averaged about 70% thereabouts. This year, we'll probably be closer to two third. That's really just taking advantage of capacity in other channels as we ramp the amount of OEC we're selling. I think last year, we sold something in the order of $2.3 billion of OEC, this year will be call it in that $2.5 billion vicinity. So we'll take advantage of some other channels that we held back on in prior years. But ultimately, what you're seeing in 2024 is really getting back to that normal distribution of about two third coming through retail."
},
{
"speaker": "Neil Tyler",
"content": "Got it. That’s helpful. Thanks very much."
},
{
"speaker": "William Ted Grace",
"content": "Thanks, Neil."
},
{
"speaker": "Operator",
"content": "Our next question will come from Scott Schneeberger with Oppenheimer. Please go ahead."
},
{
"speaker": "Scott Schneeberger",
"content": "Thanks very much. Good morning guys. I guess, Matt, for you on -- we've talked about mega projects. That's obviously a nice tailwind for you. Interest rate sensitive kind of smaller project end of the market, a little bit more challenging. We haven't really discussed the Infrastructure Bill and the funds flowing from that. Have you -- are you seeing a pickup year-over-year from that to the degree you can sense that from your customers? And how is that influencing large and small projects? And how do you anticipate that improving in 2025 or kind of a status quo flow year-over-year? Thanks."
},
{
"speaker": "Matthew Flannery",
"content": "Yes. So our infrastructure business has been growing for a while, right? I think the first time we started talking about was the Neff acquisition in 2016. We talked about we needed to bolster our fleet to start to serve the infrastructure needs. So we are long on this. We do think that there's more work to be coming. Some of the funding is hard to track about when it's coming out. And I think it's almost more postmortem than predictable in my opinion. But we are seeing -- continuing to see green shoots in infrastructure opportunities. I drive around this weekend, I was pleased to see a lot of our gear around on road and bridge projects. So -- and I think we all see about the airport work that's been going on as you travel. So we do feel good about infrastructure. I'd still say we're in the early innings of this. I do think there's more opportunity ahead than funding that's been -- that's gone on up to date."
},
{
"speaker": "Scott Schneeberger",
"content": "Appreciate that. And then, Ted, real quick, this may be a real simple question. But contribution from ancillary and re-rent 2% year-over-year, nice in the second quarter, had a real easy comp from last year. It might be just as simple that might just be the answer. But is there anything special going on? Or is it more of the comp? Thanks."
},
{
"speaker": "William Ted Grace",
"content": "In terms of the growth from ancillary and re-rent?"
},
{
"speaker": "Scott Schneeberger",
"content": "Yes."
},
{
"speaker": "William Ted Grace",
"content": "The biggest thing is Yak, right? So when we bought Yak, we talked about they've got a slightly different kind of composition of revenue. They've got the OER piece, which is the more traditional rental revenue. And then a bigger portion of the revenue coming from ancillary and re-rent and ancillary more specifically. You heard that in my prepared remarks, being up 17.5%. That substantially reflects the impact of Yak."
},
{
"speaker": "Scott Schneeberger",
"content": "Got it. Okay, thanks."
},
{
"speaker": "William Ted Grace",
"content": "Thanks, Scott."
},
{
"speaker": "Operator",
"content": "Thank you. Our last question will come from Ken Newman with KeyBanc Capital Markets. Please go ahead."
},
{
"speaker": "Kenneth Newman",
"content": "Hey good morning guys. Thanks for squeezing me in. Maybe just real quickly, I mean, I know you don't give time, but we can back into dollar utilization. I think the maintain guide implies we're getting back to dollars up high in the back half that we haven't seen since 2014. And obviously, I know that mix from Specialty has been a positive driver here for the last, call it, decade now. But I am curious just on how much more headroom you think there is for dollar utilization expansion from here?"
},
{
"speaker": "Matthew Flannery",
"content": "To be honest with you, Ken, we don't really focus on dollar utilization, right? So it's the combination of rate and time, which we do manage very aggressively on a daily basis. So we don't really look at it that way, but we do think mix certainly is a component both ways, by the way. We have some of the assets that are high return, but not necessarily as high value. The Yak acquisition, the revenue we got from Yak would certainly help dollar as well. So similar to how it helps fleet productivity. So that's been a lift. But it's really not the way we manage the business as opposed to the individual components of it, but we certainly think there's opportunity to continue to drive returns, and that should help [Indiscernible]."
},
{
"speaker": "Kenneth Newman",
"content": "Got it. Maybe just to -- as my follow-up, I just want to clarify a question that was asked at the beginning of the Q&A session. The GenRent growth for the second half is kind of expected. To clarify, I mean I know you're not expecting that growth to be necessarily negative year-over-year. But is it -- is the expectation that the decoupling that we've seen between Specialty and GenRent is probably going to be similar that we see in the second half versus the first half?"
},
{
"speaker": "Matthew Flannery",
"content": "It has been for a while, right? So our Specialty has been growing faster than the overall business for a while. Part of that is added products and services. And the other part of it is the maturation of many of these businesses. So -- and our ability to continue to improve and cross-sell to our existing customer base. So I would say that's been the driver of it, and we would expect Specialty to continue to outpace the overall company growth. And even if you look out to our long-term goals, we state that. So we feel really good about our ability to serve customers broadly and cross-sell, and we'd expect that to continue to show these type of results."
},
{
"speaker": "Kenneth Newman",
"content": "Thank you."
},
{
"speaker": "Matthew Flannery",
"content": "Thanks, Ken."
},
{
"speaker": "Operator",
"content": "Thank you. At this time, I would like to turn the call back to Matt Flannery for any additional or closing remarks."
},
{
"speaker": "Matthew Flannery",
"content": "Great. Thank you, operator and to everyone on the call, we appreciate your time. I'm glad you could join us today. Our Q2 investor deck has the latest update. So please take a look at it. And as always, Elizabeth is available to answer any questions you have. So until we talk again in October, stay safe and take care."
},
{
"speaker": "Operator",
"content": "This does conclude today's call. We thank you for your participation. You may disconnect at any time."
}
] |
uri | 2,024 | 1 | [
{
"speaker": "Operator",
"content": "Good morning, and welcome to the United Rentals Investor Conference Call. Please be advised that this call is being recorded."
},
{
"speaker": "",
"content": "Before we begin, please note that the company's press release, comments made on today's call and responses to your questions contain forward-looking statements. The company's business and operations are subject to a variety of risks and uncertainties, many of which are beyond its control, and consequently, actual results may differ materially from those projected."
},
{
"speaker": "",
"content": "A summary of these uncertainties is included in the safe harbor statement contained in the company's press release. For a more complete description of these and other possible risks, please refer to the company's annual report on Form 10-K for the year ended December 31, 2023, as well as to subsequent filings with the SEC. You can access these filings on the company's website at www.unitedrentals.com."
},
{
"speaker": "",
"content": "Please note that United Rentals has no obligation and makes no commitment to update or publicly release any revisions to forward-looking statements in order to reflect new information or subsequent events, circumstances or changes in expectations. You should also note that the company's press release and today's call include references to non-GAAP terms such as free cash flow, adjusted EPS, EBITDA and adjusted EBITDA."
},
{
"speaker": "",
"content": "Please refer to the back of the company's recent investor presentations to see the reconciliation from each non-GAAP financial measure to the most comparable GAAP financial measure."
},
{
"speaker": "",
"content": "Speaking today for United Rentals is Matt Flannery, President and Chief Executive Officer; and Ted Grace, Chief Financial Officer. I will now turn the call over to Mr. Flannery. Mr. Flannery, you may begin."
},
{
"speaker": "Matthew Flannery",
"content": "Thank you, operator, and good morning, everyone. Thanks for joining our call. As you saw yesterday afternoon, 2024 is off to a strong start and playing out as expected, and I'm pleased with our results across growth, margins and fleet productivity, all executed through the lens of putting the customer-first and with an unwavering focus on safety."
},
{
"speaker": "",
"content": "Coming into the year, we knew the key to success would be doubling down on being the best partner for our customers, and that's just what we're doing. And we're meeting their needs and finding opportunities to deepen our relationships with them. For example, we broadened our product offering to include matting solutions and we continue to invest in technology to improve the customer experience. Additionally, we're executing on our plan to open more cold starts."
},
{
"speaker": "",
"content": "And just as critically, we're doing all of this while maintaining our focus on operational efficiency. The team continues to demonstrate its commitment to our strategy, and we remain confident this will be another year of profitable growth. Today, I'll start with a recap of our first quarter results and then discuss our recent acquisition of Yak, followed by what's driving our optimism for the year. And finally, I'll give a very recent example of our 1 UR culture at work, which, in my mind, is a true differentiator."
},
{
"speaker": "",
"content": "So let's start with some of the highlights from the first quarter. Our total revenue grew by 6% year-over-year to $3.5 billion, a first quarter record. And within this, rental revenue grew by 7%. Fleet productivity increased by a healthy 4% and adjusted EBITDA increased to a first quarter record of $1.6 billion, translating to a margin of 45.5%. And finally, adjusted EPS grew by 15% and $9.15, another first quarter record."
},
{
"speaker": "",
"content": "Now let's turn to customer activity. We continue to see growth across both our GenRen and Specialty businesses. And within Specialty, we delivered double-digit growth across all lines of business. By vertical, we saw growth across both construction led by non-res and our industrial end markets with particular strength in manufacturing, utilities and downstream. And we continue to see numerous new projects across many of the same areas we've discussed the last several quarters, including power generation, data centers, automotive and infrastructure."
},
{
"speaker": "",
"content": "Additionally, the used market remains strong, allowing us to sell a first quarter record amount of OEC. In turn, we spent $595 million in the quarter on rental CapEx, and this is consistent with our expectation. As a result, free cash flow was $860 million in the quarter. Our ability to generate strong free cash flow throughout a cycle, while simultaneously funding growth is a critical differentiator."
},
{
"speaker": "",
"content": "The combination of our profitability and capital efficiency, coupled with the flexibility we've engineered into our operations, enables us to consistently generate strong free cash flow and create long-term value."
},
{
"speaker": "",
"content": "Now turning to capital allocation. Our #1 goal is supporting growth while also maintaining a strong balance sheet. And after funding organic growth, including 15 cold starts, and completing the Yak acquisition, we also returned $485 million to shareholders in the quarter via share buybacks and our dividend, all while remaining comfortably within our targeted leverage range."
},
{
"speaker": "",
"content": "Speaking of Yak, I want to share some initial thoughts now that we started the integration process. This acquisition is a textbook example of our M&A strategy at work. Through Yak, we've added more capabilities for our one-stop shop platform, enabling us to be even more responsive to our customers, while also generating attractive returns for our shareholders. And for those of you not familiar, Yak provides temporary access roadways and surface protection to any site with uneven or soft surfaces, where you need to safely move and operate heavy equipment."
},
{
"speaker": "",
"content": "And similar to our purchase of General Finance in 2021, Yak is a leader in its market. Yak still has plenty of room for growth as we bring this capability into our network. Since we've closed the deal, we spend a lot of time with their team, and we're even more excited with the potential here."
},
{
"speaker": "",
"content": "Turning to our updated outlook. As we look to the rest of 2024, we remain optimistic about the opportunities for growth. And thus far, the year is playing out as expected. Our updated guidance reflects the addition of Yak with our underlying expectations unchanged. Customer confidence remains strong while our team in the field is focused on the opportunities ahead. And while these indicators are tangible examples of what gives us confidence in our ability to deliver on our guidance, it's a team's daily actions, which further bolster our belief that we will continue to deliver strong shareholder value while supporting our customers in our normal operations and times of emergency."
},
{
"speaker": "",
"content": "A good example of this was our response to the devastating news of the Key Bridge collapse in Baltimore back on March 26. In true United Rentals fashion, we were all hands on deck, helping with the immediate urging -- emergency response and ongoing work. This support included a broad range of assets, including mobile storage, power, light towers, portable sanitation and fencing, as well as both our aerial and dirt equipment. And what's more, through the acquisition of Yak, which had just been completed, we're also able to provide the mats needed at the site for the operations. This is a perfect example of our differentiated business model, where we provide unmatched support through our one-stop shop offering to our customers and ensure they can safely and efficiently focus on their own operations."
},
{
"speaker": "",
"content": "It's also a true testament to our culture and the people that work for United Rentals. So in summary, we're excited by both the immediate opportunities, particularly on large projects, and the longer-term outlook we see. We've built a resilient company with a well-proven strategy that positions us to continue to drive profitable growth, strong free cash flow and compelling shareholder value."
},
{
"speaker": "",
"content": "And with that, I'll hand the call over to Ted, and then we'll take your questions. Ted, over to you."
},
{
"speaker": "William Grace",
"content": "Thanks, Matt, and good morning, everyone. As Matt highlighted, the year is off to a strong start as healthy demand and strong execution supported first quarter records across revenue, EBITDA and EPS. Consistent with our strategy, we remain focused on allocating capital both rental CapEx and M&A investment to drive profitable growth while also returning excess cash to our shareholders. Combined, this supports the solid earnings growth, free cash flow and returns, you see embedded in our updated 2024 guidance."
},
{
"speaker": "",
"content": "So with that, let's jump into the numbers. First quarter rental revenue was a record $2.93 billion, that's a year-on-year increase of $189 million or 6.9%, supported by both the market tailwinds we've been discussing as well as our strong position in large projects and key verticals. Within rental revenue, OER increased by $138 million, or 6.1%. Within this, growth in our average fleet size contributed 3.6%, while fleet productivity added 4% and partially offset by assumed fleet inflation of 1.5%. Also within rental, ancillary and re-rent revenues were higher by $51 million or approximately 10.8%."
},
{
"speaker": "",
"content": "Turning to used results. Supported by the strong demand Matt highlighted, our first quarter results were consistent with expectations. Used revenue came in at $383 million at a healthy adjusted margin of 53.3%. As we've talked about for the past few quarters, our used margins reflect the ongoing normalization of the used market following the extraordinary conditions created by supply chain issues that peaked in 2022."
},
{
"speaker": "",
"content": "From an OEC recovery perspective, which we view as a key indicator of the health of the used market, our proceeds equated to better than $0.59 on the dollar versus $0.50 to $0.55 prior to COVID. So another quarter of very solid results there."
},
{
"speaker": "",
"content": "Moving to EBITDA, adjusted EBITDA was a first quarter record at $1.59 billion, reflecting an increase of $84 million or 5.6%. The year-on-year dollar change includes a $108 million increase from rental. Outside of rental, used sales and SG&A were headwinds to adjusted EBITDA of about $27 million and $4 million, respectively, while other non-rental lines of businesses were a $7 million tailwind. Notably, SG&A as a percent of sales declined 40 basis points, setting a new first quarter best at 11.2%."
},
{
"speaker": "",
"content": "Looking at first quarter profitability. Our reported adjusted EBITDA margin was a healthy 45.5%. Due to these dynamics, I just discussed, consolidated margins compressed 30 basis points year-on-year, implying flow-through of 42%, excluding use, however, our core EBITDA margins increased 70 basis points, equating the flow-through of 54% in the quarter. And finally, our adjusted earnings per share increased 15% to a first quarter record of $9.15."
},
{
"speaker": "",
"content": "Shifting to CapEx. Gross rental CapEx was $595 million, which was in line with both our expectations and historical seasonality from a percentage of full year perspective."
},
{
"speaker": "",
"content": "Turning to return on invested capital and free cash flow, ROIC increased 50 basis points year-on-year to 13.6%, which remains well above our weighted average cost of capital while free cash flow was off to a strong start at $869 million."
},
{
"speaker": "",
"content": "Moving to the balance sheet, our net leverage ratio at the end of the quarter was a very solid 1.7x while our total liquidity was just under $3.6 billion. And as a reminder, we continue to have no long-term note maturities until 2027 and a very manageable distribution maturities thereafter through 2034."
},
{
"speaker": "",
"content": "Within the quarter, I'd highlight that we issued $1.1 billion of 10-year senior unsecured notes to fund the Yak acquisition, and we're very pleased with the market reception. The notes priced at a coupon of [6.18%] representing both the lowest coupon and the tightest credit spread to treasuries in the high-yield market for all 10-year issuers since August of 2022."
},
{
"speaker": "",
"content": "Notably, and probably most importantly, the transaction also marked the lowest spread to treasuries that United Rentals has ever achieved for a bond of any tenor. While this was driven by a number of factors, we view it as further evidence that credit markets continue to reward the company for its track record of impressive growth, strong execution, smart capital allocation and prudent balance sheet management."
},
{
"speaker": "",
"content": "Looking forward, you saw last night that we raised our full year guidance to include the acquisition of Yak, which is expected to contribute approximately $300 million in total revenue and $140 million of adjusted EBITDA in 2024. In terms of the specifics on the updated outlook, we've raised our guidance for total revenue to a range of $14.95 billion to $15.45 billion, implying full year growth of just over 6% at midpoint."
},
{
"speaker": "",
"content": "Within total revenue, I'll note that our used sales guidance is unchanged at roughly $1.5 billion. We raised our adjusted EBITDA range by $140 million to $7.04 billion to $7.29 billion. On the fleet side, we've raised both our gross and net CapEx guidance by $100 million to $3.5 billion to $3.8 billion and $2 billion to $2.3 billion, respectively."
},
{
"speaker": "",
"content": "And finally, we've raised our free cash flow guidance by $50 million to a range of $2.05 billion to $2.25 billion after funding growth. This is enabling us to return over $1.9 billion to shareholders this year, which translates to about $29 per share or a current return of capital yield of roughly 4.5%."
},
{
"speaker": "",
"content": "So with that, let me turn the call over to the operator for Q&A. Operator, please open the line."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Our first question will come from Steven Fisher with UBS."
},
{
"speaker": "Steven Fisher",
"content": "I just wanted to start off on CapEx. I know you said it was in line with your expectations, but it seemed to be maybe at the low end of your target range for the quarter. Can you talk about some of the factors keeping it on the low end there? Was it sort of weather or project timing or any other factors? And I guess related to that, have you made any changes in your thinking about the level of growth CapEx embedded in your plan for the year, either kind of mix of GenRent or specialty rent any changes around that growth CapEx?"
},
{
"speaker": "Matthew Flannery",
"content": "Sure, Steve. So actually, no, we don't feel that way about the first quarter CapEx, certainly wasn't any kind of designed outcome to temper the CapEx, for lack for a better word. It was about from our original guidance. So let's not include the 100 that we just upped for the Yak deal. It was about 17% of our -- at the midpoint of our guidance."
},
{
"speaker": "",
"content": "So it's about -- we always say we're going to get back to normal cadence, probably about anywhere from 15% to 20% in Q1. You can expect us to do somewhere between 35% to 40% in Q2, somewhere in the 30s in Q3 and then whatever balance in Q4. I think what it really points to, as opposed in the last couple of years, with the supply chain about mostly repaired, we no longer need to front-load Q1 and we could bring in the capital back to a, let's call it, a pre-COVID cadence, and that's how we view that."
},
{
"speaker": "",
"content": "As far as for the rest of the year, we reaffirmed our guidance and actually upped it, considering the opportunity to invest more and grow Yak. So we don't feel at all like we're going to move down our CapEx. It's pretty much reaffirmed the guidance across the board just with the addition of the Yak revenue and the Yak CapEx needs."
},
{
"speaker": "Steven Fisher",
"content": "Okay. Terrific. And then maybe just one on a vertical. I know there's been a lot of focus this year about power generation, and you have included that in your positive commentary for a number of quarters now. I guess, I'm just curious, given that the theme around power generation has intensified. I'm curious if you could give us a sense if you have any direct color on the types of projects that you're seeing in this -- in your pipeline of power generation in 2024, relative to what you've been seeing in, say, 2023?"
},
{
"speaker": "Matthew Flannery",
"content": "Well, so first off, this is something that we've been building that's focused on this vertical as far back as 2016. So this is anything new for us. And it's now over 10% of our business. So this is a big segment and a big focus for us. But you can imagine, whether it's traditional power, right, T&D work generating, whether it's alternative power, right?"
},
{
"speaker": "",
"content": "We've been playing in this space for a while. And then when you tap on top of that, the need for all the data centers and all the opportunities here for growth, even before we start really accelerating the transmission work that's needed and building out the grid for all the needs as we continue to electrify specifically in the EV space. We think this has got growth well beyond 2024, and this is one of the tailwinds that we're focused on. Ted, I don't know if you have anything to add."
},
{
"speaker": "William Grace",
"content": "No, I think you've captured it all."
},
{
"speaker": "Operator",
"content": "Our next question will come from Jerry Revich with Goldman Sachs."
},
{
"speaker": "Clay Williams",
"content": "This is Clay on for Jerry. First question, can you update us on your M&A pipeline from here? What's the range of capital deployment towards M&A that you expect to deliver over the next 12, 18 months?"
},
{
"speaker": "Matthew Flannery",
"content": "Sure, Clay. So we don't actually set targets nor do we even set plans or budgets for M&A, right? That's just a belief of ours that I think that could force people to feel the need to do M&A, and we're actually very opportunistic here. But to be clear, we work the pipeline regularly. And we have a robust pipeline. We really have a lean towards things that you just saw us execute on, like, Yak, where we can add new products that we think we could be a better owner of by significantly growing them when we introduce them into our network."
},
{
"speaker": "",
"content": "So that would be the real gems in the pipeline. But we don't really have anything imminent that we would forecast other than we continue to work the pipeline. And when we find the right partner, that meets all of our 3 strategic criteria as well as getting to the financial output, we will act. So stay tuned. We're working on the pipeline, but we don't have a plan or a budgeted number that we feel we need to meet."
},
{
"speaker": "Clay Williams",
"content": "And as a follow-up, can you talk about the opportunities you see for Yak access given the shorter useful life and higher depreciation load of the product versus the base business, we were curious what the path is to get the business to URI levels of returns."
},
{
"speaker": "Matthew Flannery",
"content": "Sure. So as you can imagine, before we pay the deal, we did a lot of modeling and sensitivity modeling, and we feel really good about the opportunity. And one of the opportunities might actually be lengthening the life of the asset. It doesn't really take a lot for it to have a meaningful impact, but that's not even required for us to comfortably clear our hurdle rates on this deal. So we really like the returns on this business. ."
},
{
"speaker": "",
"content": "We think we can double the size of this business in the next 5 years. So this is very much like what we did in mobile storage with the general finance deal. When we took a leader in that space and integrated it into our network, we were able to grow it significantly. And we see this as very similar. And the margins are strong. The team is really strong. We've got a lot of experience on that team. So we feel good about it, including the returns."
},
{
"speaker": "William Grace",
"content": "Yes, the thing I might add there, Clay, is if you look at the deal holistically, we think it's very attractive returns on a cash-on-cash basis, as Matt mentioned, well above our hurdle rate and cost of capital. That would look similar to what we actually achieved with the general finance deal. If you actually zero into the unit economics of a mat I think some of the observations you made are right. But even those cash-on-cash returns at the unit that level, are very attractive. We'd be looking comfortably in the upper teens."
},
{
"speaker": "",
"content": "And we think there could be opportunities to either extend the life of the mat or do some other things that could improve them beyond that. So when we compare that to the rest of the fleet, it's been very nice from a portfolio perspective."
},
{
"speaker": "Operator",
"content": "Our next question will come from Stanley Elliott with Stifel."
},
{
"speaker": "Stanley Elliott",
"content": "Can you talk a little bit about the category class. You've done a nice job of expanding it over the years, moved kind of the one-stop shop. How much larger is this an opportunity for you all and maybe what would be the limiting factor, I don't know if it's real estate or workforce or anything like that?"
},
{
"speaker": "Matthew Flannery",
"content": "So if you're speaking about new categories, Stanley?"
},
{
"speaker": "William Grace",
"content": "Was that in context of Yak, Stanley, just to be sure we understand the question?"
},
{
"speaker": "Stanley Elliott",
"content": "Yes, more in context of Yak, but it would seem like that just the number of category class you've had over the past several years, be it mobile solutions or anything along those lines that, that just continues to be kind of a, I guess, a big white space for you?"
},
{
"speaker": "Matthew Flannery",
"content": "Yes, exactly. So we view anything that's temporary on a project or on a plant as a potential right of way for us, right? So anything that doesn't stay with the fixed plant is, by definition, an opportunity for us to serve the customer. And we've continued to expand upon that."
},
{
"speaker": "",
"content": "So we don't talk about publicly what those other products could be because for obvious competitive reasons, and we don't want to create expectations without having the right partner, but that's how we see it. Even expanding our product line in existing business, whether it be more power in HVAC or chillers or spot coolers in that business or some of the flooring additions that we've been to our GenRent business or the pickup trucks that we put into our business, we also expand the offering to whatever the customer needs. And that's really our focus on this towards this one-stop shop value prop that we offer is continuing to expand those problems that we can solve for our customers."
},
{
"speaker": "William Grace",
"content": "I guess things I might add that we've shared, Stanley. I mean, mobile storage, we talked about a goal of doubling that business in 5 years. We're well on our way. That's obviously a huge market. So even as assuming we're able to do that, there's still plenty of white space beyond that to grow the business, penetrate existing customers. And obviously, we've talked about the opportunity to expand the footprint of that business."
},
{
"speaker": "",
"content": "Mats would be similar. I think we set a goal for doubling that business. They overlapped in about half the country for us. So there's a lot of white space there. And again, a very strong market from a growth perspective, given the opportunity in the grid. ROS is another example of one that we've built aggressively organically. We've quickly gone from not that market to certainly one of the biggest players in the country, and there's a tremendous amount of runway ahead of us there. So in each of these verticals, I think we continue to think there's a lot of opportunity to leverage our model and really continue to fund those businesses to fuel growth."
},
{
"speaker": "Stanley Elliott",
"content": "Perfect. And then I guess just a follow-up or second question, rather. Could you talk about kind of anything you saw from a regional basis. And I'm curious, I know you don't like to talk about weather, Matt, but did that have any impact on kind of the progression as the quarter went through?"
},
{
"speaker": "Matthew Flannery",
"content": "Yes. Knock on wood, we haven't had to talk about weather in a while. I think maybe even since Harvey -- Hurricane Harvey. But we -- certainly, you all follow. There are some markets that were more impacted than others, but it's not something that we call out. This is the great part of the diversification of our business, both by product and geography. There's really nothing that we would call out as an impact, and that's why we're very pleased that we're able to reaffirm our guidance just with the addition of Yak over and above. So the year played out as expected, and I wouldn't call out any weather constraints, Stanley."
},
{
"speaker": "Stanley Elliott",
"content": "Perfect. Congratulations with the great start."
},
{
"speaker": "Matthew Flannery",
"content": "Thanks."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Our next question comes from Ken Newman with KeyBanc Capital Markets."
},
{
"speaker": "Kenneth Newman",
"content": "First question -- my first question is just on the fleet productivity this quarter. It was pretty impressive and strong just given the tougher pro forma comp from last year. I know that you guys don't quantify the individual movers in that metric anymore, but I was just curious if there's any way to help us understand if there was a big move in one of those drivers, whether it's mix or rates or utilization, just given the tough comp."
},
{
"speaker": "Matthew Flannery",
"content": "Sure. So it played out as expected for us, quite frankly. When we came out in January, I went out a little further than I usually would because we don't like to forecast these individual metrics and certainly not the overall component. But we said we'd have positive fleet productivity each quarter in the year. And we still expect that to play out that way."
},
{
"speaker": "",
"content": "When I think about, I'll tell you, I won't tell you quantitatively to your point, but qualitatively, we talked about if we could replicate the time utilization that we had in 2023 and do that in 2024, we feel good about that. So I would call time, as expected, neutral. And then we still believe that it's a constructive rate environment, and we're pleased to see that it played out that way. And that the discipline in the industry, I think you'll hear that from the rest of our public companies in the space as well, that rate will help overcome any inflationary issues that we have."
},
{
"speaker": "",
"content": "And then specifically in this quarter, we had a small little improvement in -- from the Yak acquisition, and we'll see that as we go forward. That will play out a little bit more as we go forward in the rest of the year, and we'll communicate that each quarter."
},
{
"speaker": "Kenneth Newman",
"content": "Got it. That's very helpful. My second question here is just on the GenRent equipment rental side. It does seem like you saw a decent step down or moderation in the first quarter just on the equipment rental side, was there anything specific there that drove that sequential step down? Or is this more just a function of the fleet kind of returning back to more normalized cadence and seasonality?"
},
{
"speaker": "Matthew Flannery",
"content": "Yes. I mean we did expect slower growth. As you could imagine, the GenRent business versus the specialty business, the growth -- the headroom for specialty was much greater. And probably more importantly, the specialty business has a great opportunity with large customers and large projects to cross-sell into some of those that weren't using these products. So we called out specifically the double-digit growth in every one of our specialty segment product lines, which was great."
},
{
"speaker": "",
"content": "And in the GenRent side, I would just say, as expected, that we talked about in January, just more disbursement than we've had historically. The good news is, we put the fleet in the places that we needed it, where the opportunity was the best and a lot of those are driven by some large projects as well. And we're going to make sure that we win with those customers. Those are choices that we make, and we got the fleet in the right places, and that's why we're able to drive good fleet productivity."
},
{
"speaker": "Operator",
"content": "And with no further questions in queue, I would like to turn the call back to Matt Flannery for any additional or closing remarks."
},
{
"speaker": "Matthew Flannery",
"content": "Thank you, operator. And to everyone on the call, we appreciate it. I'm glad you could join us today. And just to remind everybody, our Q1 investor deck is on our site with its latest updates. And as always, Elizabeth is available to answer your questions. So I look forward to talking to you all in July. Until then, please stay safe. Operator, you can now end the call."
},
{
"speaker": "Operator",
"content": "Thank you. This does conclude the United Rentals First Quarter 2024 Earnings Call. You may disconnect your line at this time, and have a wonderful day."
}
] |
usb | 2,024 | 4 | [
{
"speaker": "Operator",
"content": "Welcome to the U.S. Bancorp Fourth Quarter 2024 Earnings Conference Call. Following a review of the results, there will be a formal question-and-answer session. [Operator Instructions] This call will be recorded and available for replay beginning today at approximately 11 AM Central Time. I will now turn the conference over to George Andersen, Senior Vice President and Director of Investor Relations for U.S. Bancorp. Please go ahead."
},
{
"speaker": "George Andersen",
"content": "Thank you, Audra, and good morning, everyone. Today I'm joined by our Chairman and CEO, Andy Cecere; President, Gunjan Kedia; Vice Chair and CAO, Terry Dolan; and Senior Executive Vice President and CFO, John Stern. In a moment, Andy and John will be referencing a slide presentation together with their prepared remarks. A copy of the presentation, our press release, and all supplemental consolidated schedules can be found on our website at ir.usbank.com. Please note that any forward-looking statements made during today's call are subject to risk and uncertainty. Factors that could materially change our current forward-looking assumptions are described on Page 2 of today's earnings release presentation, our press release, and in reports on file with the SEC. Following our prepared remarks this morning, we will be happy to take any questions that you have. I will now turn the call over to Andy."
},
{
"speaker": "Andy Cecere",
"content": "Thanks, George. Good morning, everyone, and thank you for joining our call. I'll begin on Slide 3. In the fourth quarter, we reported $1.01 per diluted share or $1.07 after adjusting for notable items. John will discuss these one-time charges in his prepared remarks. Net revenue totaled $7 billion for the quarter and $27.5 billion for the year as we saw both sequential and year-over-year quarterly growth in net interest income and non-interest income driven by effective balance sheet management, earning asset repricing and mix, and our highly diversified fee business offerings. Overall, the quarter was highlighted by top line revenue growth and continued expense discipline, which resulted in 190 basis points of positive operating leverage on an adjusted basis year-over-year. Turning to Slide 4, we had slight balance sheet growth this quarter with average earning assets increasing 1.2%, driven by higher on-balance sheet liquidity. This quarter, we had modest loan loss reserve release, largely reflective of improved credit quality and a more favorable portfolio mix. On the bottom right of the slide, you can see that our CET1 capital ratio increased 10 basis points from the prior quarter to 10.6%. Our tangible book value per share total $24.63 at December 31, an increase of 10.4%, compared to the end of last year. During the quarter, we effectively balanced continued capital accretion with an initial $100 million of share repurchases. Slide 5 provides key performance metrics. On an adjusted basis, we delivered an 18.3% return on tangible common equity and an improved efficiency ratio of 59.9% in the fourth quarter. Turning to Slide 6, fee income represented over 40% of total net revenue in the fourth quarter. Results this quarter were driven by double-digit, year-over-year fee growth in commercial products, trust and investment management, and investment product revenues. Slide 7 highlights a few of our key selected initiatives on interconnectedness across the franchise. Let me now turn over the call to John, who will provide more detail on the quarter as well as forward-looking guidance."
},
{
"speaker": "John Stern",
"content": "Thanks, Andy. If you turn to Slide 8, I'll start with a more detailed earnings summary followed by a discussion of fourth quarter earnings trends. In the fourth quarter, we reported earnings per diluted common share of $1.01, which included $109 million of notable expense items or $82 million net of tax. Notable items for the quarter included $60 million related to operational efficiency initiatives and $49 million from lease impairments associated with strategic real estate restructuring actions. After adjusting for these notable items, we delivered diluted earnings per common share of $1.07 this quarter. Slide 9 provides a balance sheet summary. Total average deposits increased 0.7% on a linked quarter basis to $512 billion as we continue to prioritize relationship-based deposits and maintained our pricing discipline. While total non-interest bearing deposits increased slightly this quarter, this was largely driven by institutional deposit seasonality at the end of the quarter. Importantly, after accounting for this seasonality, our percentage of non-interest bearing deposits to total deposits now looks to have stabilized in line with our earlier expectations. Average loans totaled $376 billion, a modest increase of 0.4% on a linked quarter basis, driven by commercial lending initiatives, slower paydowns, and new originations in residential mortgages, as well as higher seasonal credit card spend. At December 31, the ending balance on our investment portfolio increased slightly to $171 billion from opportunistic repurchases of securities. This quarter, we saw a slight decline in the average yield across both our investment portfolio and loan book as the impact of variable rates more than offset the benefits of fixed asset repricing. Turning to Slide 10, net interest income on a fully taxable equivalent basis totaled $4.18 billion, which was stable to the third quarter. For the year, total net interest income on a fully taxable equivalent basis was slightly better than our earlier guidance of $16.4 billion. Slide 11 highlights trends in non-interest income. Linked quarter, we saw non-interest income growth in the trust and investment management and other revenue that was partially offset by lower mortgage banking and seasonally lower payments revenue. Importantly, excluding security losses, full year noninterest income increased 3.9% compared to 2023, consistent with our 2024 guidance as we benefited from continued growth across our diversified and differentiated business mix. Turning to Slide 12, non-interest expense for the quarter totaled $4.2 billion as adjusted. For the year, total non-interest expense was $16.79 billion as adjusted, which was just below or better than our full-year guidance of $16.8 billion. We remain focused on prudent expense management and continued to benefit from operational efficiencies across the company. Slide 13 highlights our credit quality performance. Asset quality metrics this quarter were in line with expectations and reflected ongoing macroeconomic stability. Our ratio of non-performing assets to loans and other real estate was 0.48% at December 31st, compared with 0.49% at September 30th and 0.40% a year ago. The fourth quarter net charge off ratio of 0.60% was flat to the third quarter as expected and our allowance for credit losses totaled $7.9 billion, or 2.09% of period-end loans at December 31st. Turning to Slide 14, our CET1 capital ratio of 10.6% as of December 31st increased 10 basis points net of distributions, which included an initial $100 million of share buybacks this quarter. Moving forward, we expect the level and pace of buybacks to remain modest in the near term as we balance continued capital accretion with distributions. I will now provide first quarter and full year 2025 forward-looking guidance on Slide 15. Starting with the first quarter 2025 guidance, net interest income is expected to be relatively stable to the fourth quarter of 2024, excluding the impact of fewer days. As a reminder, the first quarter has two fewer days than the fourth quarter. Total non-interest expense is expected to be relatively stable to the fourth quarter level of approximately $4.2 billion as adjusted. We expect to deliver positive operating leverage in the first quarter of 200 basis points or more on a year-over-year basis. I'll now provide full-year 2025 guidance. Total revenue growth on an adjusted basis is estimated to be in the range of 3% to 5% compared to the full year 2024. We expect to achieve positive operating leverage excluding the impact of security gains or losses of greater than 200 basis points for the full year. I'll now hand it back over to Andy for closing remarks."
},
{
"speaker": "Andy Cecere",
"content": "Thanks, John. 2024 was a pivotal year for the company in many ways and it marked a very important inflection point in our story. Going into the year, there was much uncertainty with respect to the broader macroeconomic environment, persistent inflation, significant rate volatility, political and regulatory headwinds to name a few, but we effectively managed through the changes and most importantly executed on our strategic objectives. Fourth quarter results showcase our commitment to execution which was highlighted by our delivery of 190 basis points of positive operating leverage. As credit quality continued to stabilize and we prudently manage our capital position, it was effective balance sheet management, our financial discipline, and expanding interconnectedness across the franchise that enabled us to fully deliver the strong results we did this quarter and fully expect that momentum to continue into 2025. Finally, I'd like to extend our thoughts to those impacted by the devastating and ongoing wildfires in Los Angeles. We are closely monitoring the situation and have teams across the Bank involved in our collective response efforts to help best support our employees, customers, and their communities. Let me close by thanking our employees for their continued dedication to our clients, communities, and shareholders in what was a meaningful year for the company. We will now open up the call for Q&A."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] And we'll go first to Scott Siefers at Piper Sandler."
},
{
"speaker": "Scott Siefers",
"content": "Good morning, guys. Thank you for taking the time."
},
{
"speaker": "Andy Cecere",
"content": "Good morning, Scott."
},
{
"speaker": "Scott Siefers",
"content": "Hey. John, I was hoping maybe you could delve in a little more to discuss the drivers of the 3% to 5% expected full year ‘25 revenue growth. In other words, how much comes from NII, how much ends up coming from fees. And maybe -- and then I guess a little clarification, when you're talking about the 1Q NII guide, I think you're saying flat excluding the day count difference. I just want to be certain we're thinking it would be down on a reported basis marginally just due to fewer days."
},
{
"speaker": "John Stern",
"content": "Right. Thanks, Scott, and good morning. So let me take your last question first. Yes, excluding days, about $40 million would be lower on a reported basis. So stable, excluding those two days of that $40 million. That's how we're representing that. On the drivers on the 3% to 5% revenue growth, let me start with the fees and then I'll go over to -- into net interest income. We had really solid and healthy growth on the fee side of things. And we have a lot of momentum building. And that's despite some headwinds that we saw, particularly on our prepaid, on the card side of things, as well as freight. So some areas in the payment space that saw some headwinds. We also saw headwinds with the ATM exit of our cash servicing business. So those things will abate or have abated here in 2024. And so we see obviously momentum in the core. At Investor Day, we talked about our expectation for the medium term for rate -- expectations for 2026 and 2027 to be at mid-single-digits for fee growth. And that's a reasonable range for us to really think about as we think about 2025. And it really comes down to core areas of growth within our trust area. We're seeing strong market share, fund formation. The macro is really strong there. Payments, we have good momentum in a number of areas, strategic initiatives that are underway. Treasury management and capital markets continue to have strong growth in certain areas. A couple of areas that we're watching is mortgage. Mortgage is -- with these higher rates, it's hard to see volumes really persist or be a lot stronger than it was in the prior year and gain on sales pretty stable as well. And then our other revenue will continue to be in that $125 million to $150 million range on an average basis per quarter. So put another way, we expect fees to grow. We have strong momentum and we think that mid-single-digit is a reasonable place for us to begin. As we think about net interest income, again, well positioned. The balance sheet's in a great spot. We saw inflection in our 20 -- throughout 2024, and we really think about three key drivers for net interest income, it's going to come from better asset mix which we've seen more of a shift into higher returning assets that that shift will continue, we've seen deposit normalization, that's the non-interest bearing rotation is starting to slow down and really stabilize at this level. And importantly, fixed asset repricing on our back book is going to be a meaningful driver this year, particularly with the curve steepening. We've seen -- since we were last on this call, the curve, and I always look at, SOFR versus five-year treasury, that was meaningfully inverted back in September, now we're positive, actually. And so we think the back book is going to give us some nice trajectory. Just as an example, we have about $3 billion of investment portfolio that reprices per quarter $3 billion that runs off that can get replaced at 150 basis points to 200 basis points of spread. And then on the other fixed rate assets that we have which includes residential mortgage, commercial loans and auto loans and things like that, we have $5 billion to $7 billion on average that reprice again at that 150 basis points to 200 basis points mark and that's assuming kind of today's rates. So either way, we're very confident in our growth, both on fees and in interest income, and you put it all together and that's really where we come up with our 3% to 5% total revenue growth."
},
{
"speaker": "Scott Siefers",
"content": "Perfect. All right, good. Appreciate all the details, John. Thank you."
},
{
"speaker": "John Stern",
"content": "You bet."
},
{
"speaker": "Operator",
"content": "We'll move next to John McDonald at Truist Securities."
},
{
"speaker": "John McDonald",
"content": "Hi, good morning."
},
{
"speaker": "Andy Cecere",
"content": "Good morning."
},
{
"speaker": "John McDonald",
"content": "Hey, guys. I wanted to ask two strategic questions. Maybe the first one is for Gunjan. Just on payments, you reorganized the business yesterday or this week you announced a new head to the consumer side. Maybe just kind of give us the plan for payments and what you hope the new organization and setup will do for the growth and opportunities there."
},
{
"speaker": "Gunjan Kedia",
"content": "Good morning, John. Let me just remind you of some of the facts that we shared last time. A payment franchise is a very strategic asset for us, and our sense is that we can do more to interconnect that product set with our consumer franchise and our institutional franchise. So the oak structure and splitting it into the two pieces that are more aligned with the two parts of the franchise is an expectation to accelerate execution. So, it's not really a strategic focus. We are very pleased to welcome two very high quality leaders. Mark Runkel, we announced earlier in the year. He stepped into his role on the institutional side. And Courtney Kelso joins us from AmEx next month. So that was sort of the intention, and the goal is to truly accelerate our execution around our vision for interconnectedness."
},
{
"speaker": "John McDonald",
"content": "Okay. Thanks, Gunjan. And, Andy, maybe broader, just kind of where have you planted seeds for offense across the company? I think in the retail bank, you're looking in the union franchise and maybe through your partners, Edward Jones and State Farm. But maybe just across the footprint, where are you excited about where US Bank has kind of invested for growth and you might be moving to the front foot?"
},
{
"speaker": "Andy Cecere",
"content": "Thanks, John, and good morning. I think it's across all of our business lines, and it's that concept that we talked about in an Investor Day, which is about interconnectedness. But if you think about the momentum that John articulated and Gunjan talked about, our payments business, our trust and investment management business, our commercial products business, our retail business, the growth and deposit activity, our commercial business with the growth and targeted loan activity, profitable loans. So we really have a lot of momentum going in that. John, coupled that with sort of the headwind that was the yield curve that John talked about, I think, drives to positive momentum on net interest income. The fee category we talked about, which I all think have positive momentum, and all of that is coupled with a relatively flat expense for the last five quarters, which drives to this positive operating leverage that we talked about. So, across all the categories of revenue, it's positive, expense is well managed and that's going to deliver the positive operating leverage."
},
{
"speaker": "John McDonald",
"content": "Okay. Thank you."
},
{
"speaker": "Operator",
"content": "We'll go next to Betsy Graseck at Morgan Stanley."
},
{
"speaker": "Betsy Graseck",
"content": "Hi, good morning."
},
{
"speaker": "John Stern",
"content": "Good morning, Betsy."
},
{
"speaker": "Andy Cecere",
"content": "Hi, Betsy."
},
{
"speaker": "Betsy Graseck",
"content": "I noticed that mine sounds very ticky-tacky, but I just want to make sure I understand what forward curve your NII guide is based on? And I think you mentioned today, but I -- and the reason I ask is, as we all know, the forward curve has changed a lot between like beginning of December and today. So, that's the first question."
},
{
"speaker": "John Stern",
"content": "Sure. So, in terms of our curve, we do have two rate cut assumptions embedded. I think one's in May and one's in September. So that's kind of how we think about the short end of the curve and the long end of the curve is at this level. So, right now, the 10-year treasury is at [4.65%] (ph). That's probably a good place. That's kind of where we're at kind of throughout the year. Of course, we know that it's volatile. It's been volatile. And that's why, I say the curve does matter when we kind of look at these sorts of things. But, those are our projections."
},
{
"speaker": "Betsy Graseck",
"content": "Okay, great. And can you help us understand how your projections would move in the event that you've got fewer rate cuts or the long end went up more?"
},
{
"speaker": "John Stern",
"content": "Yep. Exactly. So, again, we continue to be neutral from an interest rate risk standpoint. So, as I mentioned, we expect two cuts. But if those cuts don't manifest or the Fed even hikes or there's more cuts which, we know the cycles, right, things will shift. We want to be as neutral as possible to those particular movements from the Fed on the short end of the curve. Where there is can be some change is really on the shape of the curve. So a steeper curve, the better off we are. If it's more inverted, then that would put a little bit more pressure on the net interest income. So at a high level, those are kind of the puts and takes."
},
{
"speaker": "Betsy Graseck",
"content": "And as we roll through the year, can you just give us a sense as to that fixed asset repricing? Is it coming through kind of quarterly cadence the same or is there any acceleration or deceleration during the year that we should be thinking about?"
},
{
"speaker": "John Stern",
"content": "It's pretty consistent. So I mentioned the $5 billion to $7 billion per quarter. I mean, it's going to range in that corridor, each quarter, but it doesn't accelerate. It doesn't tail off. It's pretty consistent throughout the course of the year. Same on the investment portfolio, pretty consistent."
},
{
"speaker": "Betsy Graseck",
"content": "Okay. Thank you so much."
},
{
"speaker": "John Stern",
"content": "You bet."
},
{
"speaker": "Operator",
"content": "We'll move to our next question from Ebrahim Poonawala with Bank of America."
},
{
"speaker": "Ebrahim Poonawala",
"content": "Good morning."
},
{
"speaker": "John Stern",
"content": "Morning."
},
{
"speaker": "Ebrahim Poonawala",
"content": "Sorry if I missed this in your prepared remarks. When we think about the NII guidance for the year -- or your revenue outlook, what's underpinning that from a loan growth perspective, like, one, so yeah, what's the assumption of loan and deposit growth? And are we seeing any green shoots of a pickup and lending demand?"
},
{
"speaker": "John Stern",
"content": "Sure. Thanks, Ebrahim. So, we did not comment yet on loans, but I would just say in terms for purposes of our forecast, now we're thinking about ’25, we have pretty modest loan and deposit growth for the full year. Now, in terms of sentiment and things of that variety, clearly there's a lot of positivity. Our client base is excited. I think there's a lot of momentum clearly in our pipelines that we can see has not yet translated into elevated loan growth at this point. But perhaps the changes we're thinking, hopefully is in the back half of the year, we can see that pick up in loan growth. But in terms of our forecasts and our projections, we anticipate modest for the year."
},
{
"speaker": "Ebrahim Poonawala",
"content": "Got it. And I guess maybe just talk about, I think you addressed a little bit around the payments business. As we think about the fee revenue sort of categories across payments, if you can sort of drill into expectations around that year-over-year in context of your overall revenue guide, and obviously, you brought in a new head of payments yesterday. Remind us of the market positioning. Are we winning share, losing market share, and what the ambition is there going forward? Thank you."
},
{
"speaker": "John Stern",
"content": "Sure. So, as I mentioned in payments earlier, we have momentum on the core side. We had had some headwinds there. So if I just kind of go through the different categories, on the card side of things, we had strong sales on the credit card side, just over nearly 6%, really. And total revenue was hurt and prepaid this quarter by about 4 percentage points given the exiting some of our prepaid revenue. That's going to impact us again in the first quarter, but then we'll fully lap that in the second quarter. But continuing in the card side, we anticipate growth there and we have a lot of momentum in different products. We have our Smartly card that is coming online. We have a lot of excitement around that, our Union acquisition increasing that penetration. So we continue to expect that mid-single-digit growth in terms of, on a retail card side of things. On the merchant side of things, we've had, again, strong sales. Our tech-led formation and growth there has been really strong. We've been making investments. We expect travel to improve, same store sales to improve. Clearly, our growth rate in ‘24 was below our expectations. And, as we see a lot more, high volume, lower margin type clients continuing their pace. We are looking at the growth rate as better than, of course, 2024, but it may not be at our aspiration of high single digits for 2025. And then on the CPS side of things, strong quarterly growth that we had, they had their best year. We've been making a lot of investments there. The pipelines are strong. Freight, we have lapped. So, a lot of positive things there. And again, the Union penetration is going to be really paying off for us as well. And so, we see high single-digits there as well."
},
{
"speaker": "Ebrahim Poonawala",
"content": "All right. Thank you."
},
{
"speaker": "Operator",
"content": "We'll go next to Erika Najarian at UBS."
},
{
"speaker": "Erika Najarian",
"content": "Yes, good morning. You did announce that $5 billion share repurchase authorization during Investor Day, and I think the market got quite excited about that. In terms of the pacing of the buybacks, you did $100 million this quarter. I guess, I heard you guys loud and clear during the prepared remarks, but what are the puts and takes that you're considering in terms of thinking about that pacing? I know that you're looking for modest -- a modest pace to begin with, but if loan growth is a little soft and that it seems like you have conservative guidance embedded in your revenue guide for balance sheet growth, what are the puts and takes in terms of the more modest start to buybacks?"
},
{
"speaker": "John Stern",
"content": "Sure. At a high level, Erika, it's really the balance between growing our capital to get to where we need to be from a Category II perspective. We talked about 10% being an approximate level of where we want to be on a Cat II basis. And obviously we don't expect to be a Cat II bank until 2027 or there about. So, that's really the one side of it. The other side is, as you said, long growth. If it's weaker, then there's an opportunity for deployment. But we're going to be -- we just started. We're stepping into this, and we talked about the next quarter and the pace thereafter is just going to be dictated on those factors that I just mentioned."
},
{
"speaker": "Erika Najarian",
"content": "And just as a follow-up here, and maybe this is for Andy, the way you laid out your projection on Slide 15 in terms of the revenue guide and then positive operating leverage, if net interest income or payments swing one way or the other, either to the better or maybe softer, it's a message here that there's -- you're now to a point where there's enough flex where regardless of the revenue environment, that 200 plus basis point is going to be sort of the baseline for what you can deliver in 2025?"
},
{
"speaker": "Andy Cecere",
"content": "Short answer, Erika, is yes. It's 200 basis points plus on positive operating leverage. We do have flex on expense. I'm going to ask John to highlight some of the areas. But we've been managing to a flat expense base for a number of quarters. This is our fifth quarter of the flat expenses. We're still investing in the company. We're managing across many different areas. And we are very confident in that positive operating leverage, regardless of what the revenue environment is. And, John, why don't you talk about some of the levers?"
},
{
"speaker": "John Stern",
"content": "Yeah, clearly we've done a lot of work on the expense. We're very proud of the efforts that the teams have made thus far, but we have continued to see different levers that we're looking at and we'll kind of, throughout the year, kind of talk more about. But obviously we had a notable item on the real estate side of things. There's -- continue to be optimization there. Procurement and third-party spend actions, we see opportunities as well as organizational simplicity and bringing fragmented groups together and centralizing certain aspects. And then just automation of processes. We have a lot of the investments that we've been talking about over in Investor Day help us manage that expense by automating certain processes. And then that inflection point that we talked about in terms of investment in our digital capabilities. So the stabilization of that digital investment, we've increased that amount all along that J-curve, if you will, and now we're at a flat place and we're bending that cost curve on the digital side, which we're really excited about. So those are kind of the main pieces. There's others. We have a lot of different initiatives, but those are the different levers that we look at."
},
{
"speaker": "Erika Najarian",
"content": "Great. Thank you."
},
{
"speaker": "Andy Cecere",
"content": "Thanks, Erika."
},
{
"speaker": "Operator",
"content": "We'll take our next question from John Pancari at Evercore ISI."
},
{
"speaker": "John Pancari",
"content": "Good morning."
},
{
"speaker": "Andy Cecere",
"content": "Morning, John."
},
{
"speaker": "John Stern",
"content": "Good morning."
},
{
"speaker": "John Pancari",
"content": "Just -- appreciate the color -- the breakout of the revenue growth outlook by fees and then your commentary around net interest income, just behind that net interest income commentary and some of the drivers you mentioned around fixed asset repricing and deposit normalization, can you give us maybe your thoughts around the net interest margin trajectory as we look through the year and perhaps maybe even help us with how the -- where the margin could end up as an exit rate coming out of 2025, just to help give us a better color around the -- what it means for the medium term trends. Thanks."
},
{
"speaker": "John Stern",
"content": "Sure. Thanks, John. And we anticipate, given the drivers, we do anticipate net interest margin to follow net interest income and increase. We -- certainly, from a management standpoint, we don't manage to net interest margin. As an example, this quarter, it fell 3 basis points entirely due to liquidity, right? So there's always going to be transitional puts and takes to it. But directionally, it should follow, we talked about it at Investor Day about how, not that there's anything magical about 3%, but I mean, there's certainly a lot of momentum in all those categories and drivers that I just mentioned really to kind of get us into that level over time. I think the big things that can move it are really loan growth as that goes up and down, deposit management, and then the shape of the curve, which impacts our fixed asset or our back book repricing. So those are gonna be the components, but certainly expect directionally the net interest margin to improve as we march through time."
},
{
"speaker": "John Pancari",
"content": "Got it. All right, John, thank you for that. And then separately back to capital. On the M&A front, I know post the Investor Day, you've been clear that large -- whole bank M&A would only be more of a consideration longer term as you look at your franchise versus a near term opportunity. I guess, Andy, has that, or Gunjan, has that changed at all or just given the election results and how comprehensively we expect a regulatory supervisory role change across the different regulators and then, does it, I guess another question would be what would change your view in terms of possibly putting M&A options more in the near-term view? Thanks."
},
{
"speaker": "Andy Cecere",
"content": "So, John, our perspective is the same, which is it’s just not a priority for us right now. The combination of the purchase accounting marks, the regulatory approval process, which may improve but isn't clear yet, and the current bank valuations all factor into this. So, while it may return -- large bank M&A may return over the longer term, we're very focused on our organic growth opportunities because we have a lot of them. And that's where we're putting our efforts and priorities right now. And Gunjan, maybe you can highlight a couple of them because I think that emphasis is because of the opportunities that we have in front of us."
},
{
"speaker": "Gunjan Kedia",
"content": "Very true. Good morning, John. I'll add that while the regulatory environment is very attractive for our organic growth opportunities, too, we saw a very significant acceleration of our trust and investment fees and our capital markets fees because investor confidence and consumer confidence is very high. So, the ability to drive a real inflection in organic growth with positive operating leverage is very much our focus. And it's across many, many parts of our business. On the product side, we have a balance sheet that would support a much bigger capital markets business. So we are very focused on that. We're introducing new capabilities there at quite a good pace. And the interconnectivity across our product sets is really deepening the franchise as well. So it's a very good strategy to drive growth with positive operating leverage, and that is our focus right now."
},
{
"speaker": "John Pancari",
"content": "Okay, great. Thank you, Gunjan."
},
{
"speaker": "Andy Cecere",
"content": "Thanks, John."
},
{
"speaker": "Operator",
"content": "We'll go next to Mike Mayo at Wells Fargo Securities."
},
{
"speaker": "Andy Cecere",
"content": "Good morning, Mike."
},
{
"speaker": "Mike Mayo",
"content": "You're finally turning the corner on positive operating leverage. You said at least 200 basis points. I think after so long not having positive operating leverage, I think people are wondering, it's kind of a show me story. I think you might understand that. Under what scenario do you think you could have more than the 200 basis points guide? Some other banks are actually guiding higher today and you have a lot of tailwinds in the industry. So, how high could that go? Because the stock is down, people are questioning this. What would be your reaction?"
},
{
"speaker": "Andy Cecere",
"content": "Mike, what we wanted to do is to provide a guide that we have confidence in and that we're conservatively giving you numbers. I'm very confident in our ability to manage expense in this environment. And I'm very confident in the inflection point on the revenue components. So that's why we put a 200 basis point plus on that guide. So we'll hit 200 at least. But at the extent that the market helps us on the revenue side with the yield curve and the things that John talked about, I’d expect it to be above that. But we want to give you a guide and an expectation that we're very comfortable with and that we take into account the different puts and takes that are a little bit out of our control like yield curve."
},
{
"speaker": "Mike Mayo",
"content": "And then a more specific question. The merchant acquiring yield looked like it contracted 70 basis points year-over-year in the fourth quarter, and the revenues didn't accelerate with the volumes. Was that expected? Was that a surprise? Is there competitive pressure? What's causing that 70 basis point contraction in the merchant acquiring yield? Thanks."
},
{
"speaker": "John Stern",
"content": "Sure. So, Mike, I think I mentioned, although it was pretty quick when I mentioned the -- that our client base, while we had strong growth in terms of same store sales and tech lead initiatives, which are -- the tech lead has strong margins and it continues to be about a third and has been growing a third of our total business on the merchant side, the growth on the other side of our client base has been in higher volume, lower margin, and that has persisted kind of throughout the year, and that's kind of creating that disconnect that you just mentioned. And [Technical Difficulty] talked about the expectations that we have here in 2025 is kind of followed because of that."
},
{
"speaker": "Gunjan Kedia",
"content": "I can add some color here, John, if I may. We were disappointed in the merchant results for this quarter as well, but the business is really showing two very different characteristics. There's the part that we are very proud of, which is the tech led part, about a third of the business now. The value proposition to the customer and the client across our franchise is very strong there. And we see very nice growth rates there. talech and Salucro were two acquisitions we did around the retail space and the healthcare space. So that part you see revenue and sales volumes show good patterns. On the other side, we have a very vast group of partners, and we just saw growth in a few very large volume, low margin businesses. And some of that might persist on that side of the business, but that was the quarter here."
},
{
"speaker": "Mike Mayo",
"content": "All right. Thank you."
},
{
"speaker": "Andy Cecere",
"content": "Thanks, Mike."
},
{
"speaker": "Operator",
"content": "We'll take our next question from Matt O'Connor at Deutsche Bank."
},
{
"speaker": "Matt O’Connor",
"content": "Good morning. I was wondering if you could talk about the trends in commercial products revenue. It was up nicely year-over-year, but was a little bit lower versus kind of the run rate between the other quarters this year. Just remind us, I think there's a decent contributor of capital markets in that and remind us like what the drivers of the underlying businesses are."
},
{
"speaker": "John Stern",
"content": "Sure. So this is the commercial products, Matt, is what I heard you say. So, yeah, we had strong growth in commercial products. It's been a good story for us. We've highlighted it, of course, at various investor conferences, obviously at Investor Day and then in a fourth quarter conference as well. So we've talked quite a bit about it. But the growth really came in a lot of different areas here this quarter. It was in client-related derivative activity, which were either interest rate swaps or foreign exchange. Loan syndication was up as well, bond underwriting. And we're seeing the new products also kick in. So we've talked about some of our other ABS desks, syndication desks and commodities and things like that. And so that's -- about 20% of our growth this year was really on the new product side. And the verticals, interconnectedness we have with the private credit side of things really help us focus in on that growth. And we expect, and we've talked about our expectations with that and nothing has really changed. We have high expectations for this business."
},
{
"speaker": "Matt O’Connor",
"content": "Okay. And then separately on the deposits, the average deposits grew and I noticed some seasonality on the period end, but they were down a little bit this quarter for the third quarter in a row. So maybe I just answered the question that there's too much seasonality to really focus on period end, but maybe just address that. And I think you did say you expect modest deposit growth. So anything to add to the narrative though that the period end was lower?"
},
{
"speaker": "John Stern",
"content": "Sure, yeah. So, for us, as we've talked about, the average balance is a better indicator than ending. The ending can really fluctuate. We do get -- we can get some pretty meaningful movements at the end of quarters, particularly in the third quarter was very strong from a deposit growth standpoint. So even though we had a pretty big surge of deposits at the end of the fourth quarter, it was compared to a really high third quarter. So that's just kind of one example. In the first quarter, part of the reason we talk about a stable net interest income for the first quarter is, in the first quarter, deposits seasonally decline, particularly in our institutional and wholesale side of things in DDA as an example, just because if you think about our operational accounts that we have there, there's a lot of either deployment of investments from our institutional clients or just overall investment from our corporate related clients. And so that's kind of a driver of Q1 from a deposit standpoint. But overall, you should think about deposits being a modest growth, consistent with the industry, those sorts of things is kind of how I would -- how I characterize it."
},
{
"speaker": "Matt O’Connor",
"content": "Okay, thank you."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] We'll go next to David Long at Raymond James."
},
{
"speaker": "David Long",
"content": "Good morning, everyone."
},
{
"speaker": "John Stern",
"content": "Good morning."
},
{
"speaker": "David Long",
"content": "I just wanted to stick with the deposit theme here. And when I look at your average deposit cost for the quarter, it came down in line with what I'm seeing with some of your peers. And just curious what you're seeing in the competition for deposits and pricing, and how do you think that plays out throughout 2025?"
},
{
"speaker": "John Stern",
"content": "Sure. Thanks, David. So, from a deposit standpoint, and this is again embedded in our growth projections and things like that of modest growth and deposits, I do expect it to be kind of equal in terms of either whether it's on the consumer side or on the institutional side. If I kind of break those two pieces apart, on the consumer side, it seems like things have been -- it's kind of either, it comes and goes in terms of competitive nature, I would say more lately with the rate cuts that have occurred, that's loosened things up and so we're seeing a little bit better in terms of pricing competitively. It may not show up immediately this quarter, but over time we would expect the retail competitiveness to moderate. On the institutional side, that also kind of comes and goes, but I would call it pretty standard at this point. I think the one negative or headwind right now is QT. That's been drying up liquidity and that can create some competitive natures on the institutional side, but all in all, we expect to be obviously very competitive out there. We have a lot of new great products that are helping us grow deposits, and we feel very strongly about that. And those are kind of the main puts and takes."
},
{
"speaker": "David Long",
"content": "Excellent. Thanks, John. Appreciate it."
},
{
"speaker": "Operator",
"content": "We'll go next to Vivek Juneja at JPMorgan."
},
{
"speaker": "Vivek Juneja",
"content": "Hi. Thanks for taking my question, Andy. So, a strategic question. Payments, there's been some discussion about that already. And it's a question we've talked on previous calls. I heard Gunjan's response, the tech-led is doing well, but the rest continues to drag. And that probably cut news into next year. Given the business, given the pricing pressures, have you considered about whether you should get rid of this business and deploy the capital to other areas where you’re doing a much -- where you're in a much stronger position, getting better returns? Why wouldn't you think of that?"
},
{
"speaker": "Andy Cecere",
"content": "I'll start, Vivek, and ask Gunjan to add on, but I think in this environment, this interconnectedness of banking and payments is as important as it's ever been. And the concept of moving money together with storing money and lending money is all intertwined. And to the extent we can offer these things together with a terrific technology platform that we have and also have the ability to grow that in a very capital-efficient, fee-focused way is why we want to retain the business. And the interconnectedness of that is as critical as it's been in the last 20 years. So, we're very focused on this business because of that opportunity, and Gunjan, why don't you add on?"
},
{
"speaker": "Gunjan Kedia",
"content": "Vivek, good morning. It's a thoughtful question. And I'll add to what Andy's saying here. First, just we are talking about deltas to expectations, but the business has very high returns. It's a very attractive business. It is an area where a lot of competitive set has been building market share, and we are seeing more discipline come into this industry, just focus on profitability, focus on a return on investments rather than just market share gains. And if you look long term, it is the one product where we have frequent, deep, and embedded interactions with our clients. And it anchors the client value proposition and the client retention in a way that is very hard to do from some of the banking and some of the more sort of routine products. So, we have deep conviction that money movement needs to be on the center of a financial relationship with the client surrounded by banking capabilities. I also would just remind you of the size of just the various parts of our payments business. It's 25% of our total revenue. Two-thirds of that is our core credit card, card issuing business. Very healthy, very steady market shares there. Our corporate payment and card issuing business is also looking at very healthy pipelines. All of this gives us great capacity to stay with the Elavon business and build it out both for the small business and for the corporate areas. So, to answer your question, it's a good question and strategically you want this capability in the mix with your clients."
},
{
"speaker": "Vivek Juneja",
"content": "Okay. Thank you."
},
{
"speaker": "Andy Cecere",
"content": "Thanks, Vivek."
},
{
"speaker": "Operator",
"content": "We'll move next to Bill Carcache at Wolfe Research."
},
{
"speaker": "Andy Cecere",
"content": "Good morning, Bill."
},
{
"speaker": "Bill Carcache",
"content": "Good morning. Thanks for taking my question. Your tech-led merchant processing service revenue growth seems solid at the time. There's still a perception that you're at a disadvantage to some of your fintech competitors. Can you take us inside of that 9% growth and discuss the breakdown between new additions versus customer attrition?"
},
{
"speaker": "Gunjan Kedia",
"content": "Good morning, Bill. Let me just start here. So, the competition on the tech-led comes in two ways. One is the user experience on the front-end. What we do with our partners here in the tech-led space is provide the reliability, the operations. It's not easy to be the backend partner of a unique value proposition in the front. So, it's fraud monitoring, it's transaction monitoring, it's reliability of systems, it's all of the networks that go into it. This is a very good partnership as much as it is competition with other areas. It's a matter of where you're playing role. And we do expect that to be a really strong contributor to the growth rate of this business. And as time goes by, it will take over more and more of the total franchise. To your question around sort of the new business versus not, it's a very dynamic space. I mean, we have a vast number of partnerships, and their success in the front end can shift that mix a little bit. So, it's really the portfolio that we manage to."
},
{
"speaker": "Bill Carcache",
"content": "Got it. Separately, following up on your NIM commentary, I may have missed this, but where did deposit funding costs end the quarter and where would you expect the average cost to grow from here given your rate expectations?"
},
{
"speaker": "John Stern",
"content": "Sure. So from a deposit cost standpoint, maybe I'll speak to it in beta terms because I think it's just easier to utilize that because we're -- obviously you're going to see a little bit of impact next quarter, but the Fed moves that we saw in the fourth quarter will impact the first quarter. So our cumulative beta for the – throughout the -- through the fourth quarter was 38%. We anticipate our beta to be at kind of the mid to high 40s as we look at our first quarter results. And so you'll see that decline on the deposit rate as we move forward."
},
{
"speaker": "Bill Carcache",
"content": "Got it. If I could squeeze in one last one, can you discuss how much cash flow and fair value hedge notional is active? I guess how that exposure changes as we progress through the year and any color on pay versus receive rates for both?"
},
{
"speaker": "John Stern",
"content": "Sure. So, this quarter is actually a really good example of our hedging program at work and why it's working as intended. We have pay-fix swaps and we have receive-fix swaps. The pay-fix swaps are intended to help protect capital when interest rates rise. They did rise. We saw 80 basis point upward movement. Our AOCI number did increase, but not nearly the magnitude that perhaps others and things of that [indiscernible] helps us manage that Cat II capital lull that I spoke to. Obviously with the pay-fix swaps, that's going to create a little bit of a drag on NII. However, offsetting that was our receive-fix swaps that were attached to either commercial loans or debt. And those receive-fix swaps increased our rate relative to where they would have been otherwise. And so you can think of those as largely offsetting. So, from an income standpoint, the hedges are relatively neutral."
},
{
"speaker": "Bill Carcache",
"content": "Thank you for taking my questions."
},
{
"speaker": "John Stern",
"content": "You bet."
},
{
"speaker": "Operator",
"content": "We'll take our final question from Saul Martinez at HSBC."
},
{
"speaker": "Saul Martinez",
"content": "Hey, good morning, guys. Vivek -- I think Vivek asked my question, but I'll maybe ask it another way. I guess I'm struggling to see how you differentiate yourself in the merchant acquired businesses. With the exception of maybe Chase, most banks have lost share over the years. There's enormous amount of innovation in that space, a lot of capital in that space. You see the shift in power to software providers and legacy merchant acquirers have lost share over the years. I guess, like what I was going to ask you is whether you can make an argument that it's worth more to somebody else than to you? And I guess the answer to that question from your answer to Vivek’s question is that it does provide value to the entire franchise, to the entire business. Is that the answer? And I guess the adjunct to that question is, how do you measure success in the acquiring businesses? Are you looking at just volume growth, revenue growth, are there other measures? How do you measure whether this business, you're succeeding in your strategy here and this business is adding value to the entire franchise?"
},
{
"speaker": "Andy Cecere",
"content": "So, Saul, I'm going to start and then ask Gunjan to add on. This is Andy. I'm going to start by reiterating what I said before, which is this interconnectedness of banking and money movement and payments. And we've made investments in categories and verticals that are very focused on capabilities to provide information and help those businesses run their platform and their business like healthcare and some of the other areas that we're focused on. So what's happened in payments and money movement has become more embedded in the banking component. And I think that's our advantage versus as pure play merchant provider is interlocking those components to help them run their business. And we've focused in certain verticals that are, I think, very important in terms of our overall growth opportunities. And in terms of what we're looking for, it's all those things. It's top line revenue growth, but importantly bottom-line profitable revenue growth. And the progress we've made in the tech and -- tech-led, the interconnected components that we've talked about in terms of those verticals we're focused on are all indications that we're headed in the right directions. We're not where we want to be yet, but we're heading in the right way. Gunjan, what would you add?"
},
{
"speaker": "Gunjan Kedia",
"content": "At the power of the distribution franchise, we have 15 million clients. And if you look at standalone players that bring a very high level of innovation, as you called it, to the table, their gap is the client franchise. And that's where the partnerships come with some of the innovation in the industry. Saul, it's a lot of infrastructure and investment to connect the transaction and the provision of the services beyond the user experience and the innovation in the front. And so we see very significant demand for a partnership with us, but the model has to transform in the direction that we are going where we need to be able to provide and connect and have a very easy onboarding experience, very easy, quick ability to bring merchants on and off. And that's all of the investments that we have been making. So, it's the distribution side, and it's all of the back-end product capabilities that may give us the competitive edge here."
},
{
"speaker": "Saul Martinez",
"content": "Okay. I mean, that's helpful. I guess just a quick follow-up in on deposits, John. I guess we're closer to the end of the rate cutting cycle, although seemingly every day there's shifts in what the forward curve is expecting. But remind us what the through-the-cycle deposit beta you're expecting. I heard mid-40s in Q1. I think like high 40s, low 50s is what you’ve -- is that the right, through-the-cycle beta?"
},
{
"speaker": "John Stern",
"content": "That's right, Saul. So, we think about 38 is spot through the cycle as of this quarter. We expect mid to high 40s in the first quarter. And assuming there's additional cuts, we would migrate kind of through the cycle to that 50%, north of that level is kind of where our expectations are. Thank you."
},
{
"speaker": "Saul Martinez",
"content": "Got it. Okay. Thank you."
},
{
"speaker": "Operator",
"content": "And there are no further questions at this time. Mr. Andersen, I'll turn the conference back over to you."
},
{
"speaker": "George Andersen",
"content": "Thanks, Audra. Thank you to everyone who joined our call this morning. Please contact the Investor Relations department if you have any follow-up questions. You may now disconnect the call."
},
{
"speaker": "Operator",
"content": "And this concludes today's conference call. Thank you for your participation. You may now disconnect."
}
] |
usb | 2,024 | 3 | [
{
"speaker": "Operator",
"content": "Hello, and welcome to the U.S. Bancorp Third Quarter 2024 Earnings Conference Call. Following a review of the results, there will be a formal question-and-answer session. [Operator Instructions]. This call will be recorded and be available for replay beginning today at approximately 10:00 A.M. Central Time. I will now turn the conference call over to George Andersen, Senior Vice President and Director of Investor Relations for U.S. Bancorp."
},
{
"speaker": "George Andersen",
"content": "Thank you, Ellie, and good morning, everyone. Today, I'm joined by our Chairman and CEO, Andy Cecere; CAO, Terry Dolan; President, Gunjan Kedia; and CFO, John Stern. Together with their prepared remarks, Andy and John will be referencing a slide presentation. A copy of the presentation, our earnings release and supplemental analyst schedules can be found on our website at usbank.com. Please note that any forward-looking statements made during today's call are subject to risks and uncertainty. Factors that could materially change our current forward-looking assumptions are described on Page 2 of today's presentation, our press release, and in reports on file with the SEC. Following our initial prepared remarks, Andy, Terry, Gunjan and John will take any questions that you have. I will now turn the call over to Andy."
},
{
"speaker": "Andy Cecere",
"content": "Thanks, George. Good morning, everyone, and thank you for joining our call. I'll begin on Slide 3. In the third quarter, we reported diluted earnings per share of $1.03, and generated total net revenue of $6.9 billion. The quarter was highlighted by strong growth in net interest income, good momentum across several fee business initiatives, and continued expense discipline, which supported modest, positive operating leverage on an adjusted basis compared with the third-quarter of last year. Our return on tangible common equity was 17.9% this quarter. Turning to Slide 4. Revenue growth on a linked-quarter basis was driven by improved spread income from more favorable loan mix, continued fixed asset repricing, proactive and disciplined liability management as well as strategic actions taken on our investment securities portfolio. John will provide more detail on these actions in his prepared remarks. On the upper right-hand side of the slide, you will see that non-performing assets, the net charge-off ratio, and late-stage delinquency metrics were all relatively stable compared with the second quarter levels. At September 30th, our common equity Tier 1 capital ratio was 10.5%, an increase of 20 basis points from last quarter, driven by continued earnings accretion. Our tangible book value per share increased to $24.71, a 6.7% improvement linked-quarter and an 18.5% higher than last year. Slide 5 provides key performance metrics. This quarter, our return on average assets increased to 1.03%, the efficiency ratio improved to 60.2%, and net interest margin expanded 7 basis points to 2.74%. Turning to Slide 6, we continue to see good momentum across many of our fee businesses. This quarter, we achieved year-over-year double-digit growth in both commercial and investment products revenue, driven by underlying capital markets activity and wallet share gains across our targeted industry verticals. Additionally, we also saw good year-over-year growth in trust and investment management, payment services, mortgage banking and treasury management fee revenues as we benefited from a combination of improved underlying market conditions, deepening client relationships, an expanded product set and expanded distribution channels. Let me now turn the call over to John who'll provide more detail on the quarter as well as forward-looking guidance."
},
{
"speaker": "John Stern",
"content": "Thanks, Andy. If you turn to Slide 7, I'll start with a balance sheet summary, followed by a discussion of third quarter earnings trends. This quarter, total average deposits decreased 1.0% on a linked quarter basis to $509 billion as we continued to prioritize relationship-based deposits and maintained our pricing discipline. Average loans totaled $374 billion, a modest decrease of 0.2% on a linked quarter basis. Industry loan growth remains muted, and the decline we saw this quarter was driven by slightly lower commercial balances, given continued headwinds from capital markets-related paydowns and continued relatively low utilization rates. Within retail, higher credit card loan balances and improved revolver rates drove more favorable loan mix and margins. As Andy mentioned, this quarter, we opportunistically restructured a portion of our investment portfolio to enhance our net interest income growth trajectory and to further strengthen our capital and liquidity profiles. At September 30th, the ending balance on our investment portfolio declined slightly to $167 billion with an average yield for the quarter of 3.20%. Slide 8 highlights our credit quality performance. Asset quality metrics continued to develop in-line with our expectations and reflected ongoing macroeconomic stability. This quarter, we saw a slight reduction in our exposure to commercial real estate office portfolio, which remained appropriately reserved at 10.8%. Late-stage delinquencies and non-performing asset metrics were relatively flat on a linked quarter basis, and the ratio of non-performing assets to loans and other real estate was unchanged at 0.49% linked quarter versus 0.35% year-over-year. Our net charge-off ratio of 0.60% increased 2 basis points from a second quarter level of 0.58%, in line with our expectations. At September 30th, our allowance for credit losses totaled $7.9 billion or 2.1% of period-end loans. We expect our fourth quarter net charge-off ratio to remain relatively stable compared with the third quarter level. In the near-term, we expect changes to the loan loss reserve to be driven primarily by loan balance growth and mix. Slide 9 provides a more detailed earnings summary. In the third quarter, we reported $1.03 per diluted share, which included $119 million of net losses or $189 million after tax on-sales and securities rebalancing actions within our investment portfolio. These actions were largely offset by tax favorability in the quarter, primarily due to settlements in various tax jurisdictions. Turning to Slide 10, net interest income on a taxable equivalent basis totaled approximately $4.17 billion, an increase of 2.8% linked quarter. Our net interest margin increased 7 basis points to 2.74%. Both net interest income and net interest margin growth this quarter benefited from a combination of earning asset repricing and mix, further supported by higher card revolve rates, investment portfolio actions, and disciplined deposit pricing. Slide 11 highlights trends in non-interest income. Non-interest income totaled $2.7 billion, and as mentioned, included the $119 million of net security losses related to rebalancing activity within our investment portfolio. Importantly, year-over-year, we saw a good growth across our core business offerings, including trust and investment management, commercial products, mortgage banking and investment products. As a reminder, last quarter's mortgage banking fees included an approximately $30 million gain on-sale of mortgage servicing rights. Service charges decreased 6.2% linked quarter, partly reflecting the impact of exiting our ATM cash provisioning business. The exit is now fully reflected in our run-rate for the third quarter of 2024. Turning to Slide 12, non-interest expense for the quarter totaled $4.2 billion, which was relatively flat to the prior quarter and 1.0% lower than a year-ago as-adjusted. The linked quarter increase of $16 million or 0.4% was driven by higher compensation and employee benefit expense, primarily due to higher performance-based incentives. On a year-over-year basis, the $42 million decrease as-adjusted was driven by prudent expense management initiatives and the identification of operational efficiencies across the company. Turning to Slide 13, our common equity Tier 1 ratio of 10.5% as of September 30th increased 20 basis points from the second quarter. Looking ahead, we intend to balance our continued capital accretion of 20 basis points to 25 basis points per quarter with capital distributions, starting with a modest share repurchase in the near-term. I will now provide forward-looking guidance on Slide 14. We expect net interest income for the fourth quarter on an FTE basis to be relatively stable to this quarter's $4.17 billion. This guidance is reflective of our current expectation for more modest loan growth and continued QT impacts on deposits. Full-year 2024 net interest income on an FTE basis is expected to come in at the higher-end of our $16.1 billion to $16.4 billion range. For the full-year, we still expect mid-single-digit growth in total non-interest income as adjusted, but likely at the lower end of the range. We expect full-year non-interest expense as adjusted to be $16.8 billion. I'll now hand it back to Andy for closing remarks."
},
{
"speaker": "Andy Cecere",
"content": "Thanks, John. Third quarter results showcase the resiliency of our unique and differentiated business model, which featured solid top line revenue growth, supported by healthy linked quarter margin expansion as well as continued year-over-year income momentum and steady expense discipline. This quarter, we reported modest operating leverage, excluding net securities losses in prior year notable items, and consistent with our message at Investor Day. We expect to deliver expanding positive operating leverage in the fourth quarter that will continue into 2025. As recent industry headwinds become tailwinds, and we realized the benefits of our now run-rate investment spend on industry-leading digital capabilities, integrated payment solutions, and continued technology modernization, it will be the combination of our scale, our interconnected business model, and our deep and talented management team that will allow us to capitalize on the many objectives and targets at this important inflection point in our story. As always, let me close by thanking our over 70,000 employees for their everyday commitment to our clients, communities and shareholders. We'll now open the call for Q&A."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Our first question comes from Scott Siefers from Piper Sandler. Your line is now open."
},
{
"speaker": "Scott Siefers",
"content": "Good morning, everyone. Thanks for taking the question."
},
{
"speaker": "Andy Cecere",
"content": "Hi, Scott. Good morning."
},
{
"speaker": "Scott Siefers",
"content": "Hey. John, I guess I wanted to start with NII. So, at least, relative to what I had anticipated, it looked like it came in better than you might have thought even as recently as a month or so ago at the Investor Day. I guess just in sort of simple terms, can you walk through what in your mind ended up coming in better than you might have anticipated?"
},
{
"speaker": "John Stern",
"content": "Sure, Scott, and good morning. So, a couple of factors I would say there. First, I think the remixing of our portfolio, we continue to see strength in our credit card and the revolver rate as we discussed in our opening comments. It's great to see that business has been growing at 8% year-over-year on the loan side of things. Our fixed asset repricing continues. And then the other factor I would just say is that on the -- what we didn't know was the Fed was going to cut 50 basis points and we had the ability to really price on our deposits. And so I think the combination of all those things really helped us power and see nice momentum here in the third quarter."
},
{
"speaker": "Scott Siefers",
"content": "Okay. All right. Perfect. And then if I could switch gears to fees for just a second. Just wanted to chat about the sort of the implied fourth quarter number. So even if we get to the lower-end of the full year fee guide, I guess that sort of implies that fourth quarter fees would get back up near sort of $2.8 billion, $2.9 billion level that might be more typical of one of your seasonally stronger quarters like typically, I think of you all doing best in the second quarter. Maybe if you could just sort of walk through the main puts and takes and where you would see sort of a reacceleration in momentum into the fourth quarter, please."
},
{
"speaker": "John Stern",
"content": "Sure. So I think we -- I think it's just in a number of different things. And as we discussed in our opening comments, the core business components are performing quite well. We had strong growth in Trust, 6%, commercial products was over double-digits at 12%. Mortgage had a nice year-over-year growth at 8%. And we -- if payments, while it came in at 3% or so, this quarter, we do have expectations of growth in those particular businesses in the fourth quarter. So, all that kind of leads into some momentum there from a fee standpoint side. We of course have some headwinds there that we've talked about like in our ATM, exiting our ATM business, some of the prepaid card metrics and some of the other things like that in the payments. But by -- all in all, that's what gets us and gives us confidence in our mid-single-digit growth on the fee side of things."
},
{
"speaker": "Scott Siefers",
"content": "Perfect. Okay, good. Thank you very much."
},
{
"speaker": "John Stern",
"content": "Thanks, Scott."
},
{
"speaker": "Operator",
"content": "Your next question comes from John Pancari from Evercore ISI. Your line is now open."
},
{
"speaker": "John Pancari",
"content": "Good morning."
},
{
"speaker": "John Stern",
"content": "Good morning."
},
{
"speaker": "John Pancari",
"content": "I know you cited the partial securities repositioning in the quarter, I wanted to see if you could give us a little bit more color on what you restructured in the quarter and the sizing of that in the yield? And then do you expect further actions on that front? And would further actions already be factored into your NII expectations? Thanks."
},
{
"speaker": "John Stern",
"content": "Sure. Thanks, John. So, in terms of the securities repositioning, we did take action on what $119 million of losses, there was -- in total, there was about $10 billion in total of notional that was transacted. But importantly for you all, I mean, it's -- we consider that more or less a two-year payback is kind of how we're thinking about it. I would call the impact to the quarter maybe around $10 million or so. So there's probably a little bit more pickup in the fourth quarter related to it. And as I think about in the future, we don't have any other of these sorts of things contemplated in our guidance or anything like that. It's just -- this was an opportunity that came up with as we saw interest rates fall quite a bit, we were able to take advantage of that and we feel good about the transaction. We're constantly looking at these things, but we don't have anything contemplated at this particular point in time."
},
{
"speaker": "John Pancari",
"content": "Okay. All right. Thank you. And then separately, on the expense side, you put up some pretty good positive operating leverage this quarter, and you implied that fourth quarter you'll see that as well. And I believe at the Investor Day, you expressed confidence in continued positive operating leverage. As you look at 2025, can you maybe help us get a sense of the magnitude of that operating leverage that you think is reasonable as you enter 2025 and longer-term, I believe The Street is looking at about 150 basis points to 200 basis points operating leverage next year. Wanted to get your thoughts on that as we look at your return profile in the coming years?"
},
{
"speaker": "Andy Cecere",
"content": "Yeah. Thanks, John. This is Andy. So as you saw, we reported positive operating leverage of approximately 30 basis points in Q3 here. The guidance that John provided would indicate that our expectation for positive operating leverage in the fourth quarter of '24 will be north of 1%, and we would expect it to continue to expand from there into 2025. So, building upon that 1-plus-percent into '25, exactly where we'll get, we'll give more guidance as we get the forward-looking guidance as we think about '25 across the categories."
},
{
"speaker": "John Pancari",
"content": "Great. Very helpful, Andy. Thank you."
},
{
"speaker": "Andy Cecere",
"content": "You bet."
},
{
"speaker": "Operator",
"content": "Your next question comes from Betsy Graseck from Morgan Stanley. Your line is now open."
},
{
"speaker": "Betsy Graseck",
"content": "Hey, good morning."
},
{
"speaker": "Andy Cecere",
"content": "Hey, Betsy."
},
{
"speaker": "Betsy Graseck",
"content": "Yeah. Just to -- one follow-up on that is, in the guidance for 4Q, you indicated expenses [at total of] (ph) $16.8 billion. And I know in the past, you had been saying $16.8 billion or less. So, is there anything we should take-away from that very ever so slight guidance change?"
},
{
"speaker": "John Stern",
"content": "Hey, Betsy, it's John. So, I think it's just reflective of we're in the third -- we're complete with the third quarter, we're at the fourth quarter right now. We have a very good line-of-sight in terms of where our expense base will be. And so we were just being more precise with that particular number. In addition, we saw good growth in our net interest income, and so it's kind of -- the expense was coupled in part with the net interest income. You'll recall, when we shifted our discussion points on that, and since we're at the higher-end of our range, we feel like $16.8 billion is the appropriate expense side of things this quarter."
},
{
"speaker": "Betsy Graseck",
"content": "Got it. Okay. Now that's helpful. And then, on the rate discussion earlier, you got the surprise 50, which you were able to pass-through onto the depositor side. So, as we're thinking about the next several quarters here, does NIM expand further as rates continue to cut-down -- come down, or is there a catch-up on the asset side that we should be skewing to?"
},
{
"speaker": "John Stern",
"content": "Yeah. I think broadly speaking, rate cuts are a positive thing for us in the sense that we're able -- we have a deposit base that's conducive really to cuts. We have the ability, as you know, we have 50% of our deposit base is institutional and 50% is retail. We're able to cut institutional rates fairly quickly. And so the beta for this particular juncture was around that, I'll call it, 30% area for this particular cut, and we expect that to continue to migrate closer to or up to -- just north of 50% as we kind of get through the cycle and that sort of thing. And so that's going to be helpful. And I think the other thing is, over time, as the cuts happen, then that implies a more upward sloping curve, which should help us in our trajectory going forward as well. So, those are the two pieces that I would point to."
},
{
"speaker": "Betsy Graseck",
"content": "Right. And the 30% and 50% that's on total IB deposits or total deposits, what's your denominator?"
},
{
"speaker": "John Stern",
"content": "Total IB, total interest-bearing deposits. Yeah."
},
{
"speaker": "Betsy Graseck",
"content": "Yeah. Super. Thanks so much."
},
{
"speaker": "John Stern",
"content": "You bet, Betsy."
},
{
"speaker": "Operator",
"content": "Your next question comes from Erika Najarian from UBS. Your line is now open."
},
{
"speaker": "Erika Najarian",
"content": "Hi, good morning. Just a few follow-up questions. First, on John's previous question."
},
{
"speaker": "Operator",
"content": "Sorry, Erika, can you just -- we're having a hard time hearing you."
},
{
"speaker": "Erika Najarian",
"content": "Can you hear me better now?"
},
{
"speaker": "Andy Cecere",
"content": "Yeah, that's better. Thank you."
},
{
"speaker": "Erika Najarian",
"content": "Okay. Sorry about that. Just wanted to follow-up on John's question. You mentioned $10 billion of notional was sold. Could you -- so that we can understand the impact for fourth quarter, could you tell us what the average yield was of what was sold and what you invested in? And just a follow-up to Betsy's line of questioning, you said that you saw a 30% beta and the terminal would be north of 50%. As we think about the fourth quarter, is it a sort of a smooth glide path to that 50%, do you expect it to significantly accelerate from that 30% initial beta?"
},
{
"speaker": "John Stern",
"content": "Sure. So, maybe I'll just take those in pieces. The first one on the securities book, I think it was just an opportunity there to remix in a couple of different things. And it was really there to improve our liquidity profile as well as some lower-yielding securities that have seasoned to reposition those. So, it's just a number of different securities. So it's hard to just summarize it in one thing. But I would just say on the beta side of things, 30% or so terminal beta, I think that just is a gradual increase as we look forward. And the reason for that is on the institutional side, you're going to get that benefit on each cut. On the retail side, you're going to get that benefit, it's kind of as I mentioned in the past, kind of an arc to the retail pricing sort of thing. And so as CDs reprice and as the money market rates come down on retail, that's going to be kind of that glide path into the 50% terminal that I spoke to earlier."
},
{
"speaker": "Andy Cecere",
"content": "And John, all of that, all that you said, which is spot-on is all baked into your flat or stable net interest income projection for Q -- quarter four."
},
{
"speaker": "John Stern",
"content": "That's exactly right. Yeah."
},
{
"speaker": "Erika Najarian",
"content": "Got it. And my second question is for you, Andy, and this is sort of a broader question. You hosted a very comprehensive Investor Day, and I think the investor reception at least as it followed through to the stock was probably less than desired. And as I think about the feedback from investors, I'm wondering if you could sort of re-address this on this call. You seem determined and you have showed us positive operating leverage. Maybe some quick notes on '25. The comments on the Southeast expansion was also hit on as a potential negative. And the third would be, you are now in a place where you're building capital loan growth hasn't yet come back, what would allow you to be a little bit more aggressive more quickly on the -- on acting on that $5 billion authority?"
},
{
"speaker": "Andy Cecere",
"content": "So, I'll take them in pieces, Erika. So first of all, I thought the team did a terrific job articulating the strategy at Investor Day and part of that strategy was the inflection point discussion we talked about, which is controlled expenses, delivering on operating leverage and stronger revenue growth given the inter connectiveness of the businesses, and we're hitting on all those. And I think part of what the analyst community and investor community wants is examples and execution. And this quarter started that execution. And as I said on operating leverage, we expect that to expand into the fourth quarter and into '25. So we're going to deliver on that. Secondly, with regard to the M&A environment, the -- given this environment, large bank M&A is just not a priority for us. That's not something we're focused on. What we are focused on is organic growth and the components that Gunjan talked about, and I'm going to ask her to just highlight some of those key aspects of that right now."
},
{
"speaker": "Gunjan Kedia",
"content": "Good morning, Erika. As we shared in during the Investor Day, we do have very meaningful organic growth opportunities in our portfolio. And as Andy said, our attention is very much on executing against those priorities, deepening our client relationships, enhancing our product interconnectivity and broadening our reach. We are very focused on delivering meaningful positive operating leverage and the execution that goes with it. We have optimized our distribution via investments in our digital capabilities and our Southeast expansion is very much focused on our partnerships and our digital capabilities. Thank you."
},
{
"speaker": "Andy Cecere",
"content": "Thanks, Gunjan. And then finally, and your last question is with regard to capital, Erika, as you know, we -- as we talked about and as John articulated in his comments, we would expect to go to some level of modest buybacks here shortly. And then, we would expect to build upon that once we have more clarity on Basel III and some of the capital rules and then loan growth as you talked about is a key factor as well. But given all that, we would still expect to be up at our capital targets even under the CAT II when we cross that threshold, which again as a reminder, we talked about is not expected till 2027."
},
{
"speaker": "Erika Najarian",
"content": "I guess just to follow-up on that, the Basel III shouldn't impact you that much, right, other than -- and everybody had already put in the impact of AOCI actually more immediately than whatever phase-in Basel III end game has. I guess I'm wondering, as a regional bank, are you -- do you think it's just a -- you're just a prudent constituent in terms of not wanting to be aggressive ahead of a new set of revisions? Or are there -- are you also considering that the ratings agency is just sort of wondering what the -- and I completely understand that you're about to buyback in the first quarter, but I think that it's probably an important component of long-only investors starting to increase their position in U.S. Bank."
},
{
"speaker": "Andy Cecere",
"content": "Yeah. All those constituencies you talked about are factors in our thinking. Loan growth, the final capital rules, the rating agencies, those are all factors. But we're very confident in our accretion ability as you saw this quarter, 20 basis points, we've articulated 20 to 25. We're very comfortable with our capital position and we're very comfortable with the ability to start to buy-back and distribute as well as accrete, the level of which we'll continue to determine and judge over-time, given all those factors you talked about."
},
{
"speaker": "Erika Najarian",
"content": "Thank you, Andy."
},
{
"speaker": "Andy Cecere",
"content": "You bet, Erika. See you."
},
{
"speaker": "Operator",
"content": "Your next question comes from Mike Mayo from Wells Fargo Securities. Your line is now open."
},
{
"speaker": "Andy Cecere",
"content": "Good morning, Mike."
},
{
"speaker": "Mike Mayo",
"content": "Hi. First -- hey, good morning. First, a cleanup question. So, are you interested in buying a bank in the Southeast because that's got a lot of play just following-up to the prior question."
},
{
"speaker": "Andy Cecere",
"content": "No."
},
{
"speaker": "Mike Mayo",
"content": "Not even a small bank?"
},
{
"speaker": "Andy Cecere",
"content": "Mike, the environment right now is just not conducive. There's too much uncertainty for M&A, and I don't want to focus all our efforts on that when we have so much opportunity on the organic growth front. So, in this role, what you do is prioritize against the opportunity set you have in front of you and our organic growth opportunities are far more important and much more tangible to us right now. And as you know, Mike, the M&A environment is just so uncertain right now that would not be a good place to focus our efforts."
},
{
"speaker": "Mike Mayo",
"content": "Okay. So my main question here goes back to the operating leverage, which is how much of this is expenses versus revenues? And on the expense side, your investments in the last three, five more years, it's all-in the run-rate as you said at Investor Day. And how much benefit do you get from being a scale player because some smaller banks say they can just buy a lot of these things off-the-shelf and compete with the likes of U.S. Bancorp. So that's the expense question. And then the revenue question is, Gunjan, I know you're leading the go-to-market strategy, kind of what stage of that go-to-market strategy, and are we seeing it in the results now or do we expect to see more of that in the results ahead? Thanks."
},
{
"speaker": "Andy Cecere",
"content": "So, Mike, I'll start and then Gunjan will add on. I think to answer your question, I would think about it on both components. I think it's going to be both increased revenue growth and managed expenses. So, as we talked about, we were flattish this time. We might have some modest increase as we go into next year, but we're not going to have expenses growing above revenue levels and I would expect growing revenue and those jaws widening from the expense revenue differential. The revenue will be driven by the activities that Gunjan is focused on, and I'll let her comment."
},
{
"speaker": "Gunjan Kedia",
"content": "Good morning, Mike. The go-to-market is in its third and final year of our transformation. So, we are beginning to see the results in some of the areas like the consumer deposit. We built-out a lot of capabilities to manage deposit pricing, we benefited from that in this downgrade cycle. We are seeing a lot of momentum with our multi-serve clients and deepening our relationships on the institutional side. We saw that with the capital markets growth over this quarter. So, the impact of a good scaled business model is delivering good positive operating leverage, including expense management. So this is what we would continue to focus on from an organic growth standpoint."
},
{
"speaker": "Mike Mayo",
"content": "All right. Thank you."
},
{
"speaker": "Andy Cecere",
"content": "Thanks, Mike."
},
{
"speaker": "Operator",
"content": "Your next question comes from Gerard Cassidy from RBC Capital Markets. Your line is now open."
},
{
"speaker": "Andy Cecere",
"content": "Good morning, Gerard."
},
{
"speaker": "Gerard Cassidy",
"content": "Hi, Andy. Hi, John. John, on the deposits -- on the deposit pricing, can you share with us, the loan to deposit ratios for the industry and yourselves are not as high as in previous cycles. Do you think that can give you added flexibility in lowering the costs aside from obviously, you talked about the institutional deposits that are essentially, I think, index-priced, so they come down quickly. But in the other deposit classes, do you think you're going to have some leverage to lower those rates because the loan-to-deposit ratio is not at 90% or something like that."
},
{
"speaker": "John Stern",
"content": "Sure, Gerard. So, I would say that we don't target necessarily loan to deposit ratios. What we look at is holistically just overall serving of our clients, making sure we have the right mix of deposits and loans. And loan growth is obviously going to be a driver or not of deposits and where they're at. This quarter, loans were flat to down just slightly. And so we took this opportunity to bring down some deposits that were at a higher cost side and you saw that in the results here. And so if that continues, I would continue to expect that. Conversely, if loan growth continues to take up, we're going to be making sure that we have the deposit base to suffice that. The other thing we always try to manage around that is our liquidity needs as well as interest-rate risk profile as well. So, it's kind of more of a holistic nature as it relates to that."
},
{
"speaker": "Gerard Cassidy",
"content": "Very good. And then for Andy or Gunjan, on the organic growth strategy, some of your peers, the bigger banks in particular have embarked upon a branch build-out across the country, even a few -- one super -- or two regional banks have done this as well. And can you share with us as part of your organic strategy, how do you guys view new branches into maybe newer territories combined with your ongoing digital reach-out that of course, you have?"
},
{
"speaker": "Gunjan Kedia",
"content": "Good morning, Gerard. Maybe I'll start here. So first, the branches are very critical to our business strategy. We see deep client relationships anchored around the branch. It really drives brand recognition. And we are very steady in investing in our branch network. Our strategy focus is to create density in the highest-growth areas within our current footprint rather than use branches to expand out of our footprint. And the reason for that is that we have built some very good strong digital capabilities that allow us to deliver our services nationally, and we are combining that with our very strong partnerships with other partners that have brand recognition and client reach in areas where we don't have. It's a powerful combination, it's a capital-light way of expanding into other markets. Second is our national businesses from the institutional side. There we are actually growing client centers in areas where we are not to expand our reach. So, you'll see us continue to invest in our branch network both inside digitally enabling them, but within our current footprint."
},
{
"speaker": "Gerard Cassidy",
"content": "Very good. Thank you."
},
{
"speaker": "Andy Cecere",
"content": "Thanks, Gerard."
},
{
"speaker": "Operator",
"content": "Your next question comes from Vivek Juneja from JPMorgan. Your line is now open."
},
{
"speaker": "Vivek Juneja",
"content": "Hi. Thanks for taking my questions. Just wanted to understand on payments and delve a little bit into that. You had talked last quarter about corporate payments will be lapping this quarter because your tough comps with your trucking-related fees last year, but we didn't really see the benefit of that lap in this quarter. So, anything there that has caused it to be delayed, nor have we seen really merchant payments pickup in terms of year-on-year fee growth? So, any color on what's going on, and why the delay and what gives you confidence that it will actually materialize in the coming quarters?"
},
{
"speaker": "John Stern",
"content": "Sure. So, Vivek, I would start by saying that I think there were still a little aftermath here on the freight side in the third quarter, but we expect that to completely lap here in the fourth quarter. And then we do see corporate spend being stronger. We saw some nice momentum at the end of the third quarter and into the fourth quarter, and that's what's really giving us the confidence that, that will grow from the level that you saw in this quarter's results from a corporate payments perspective."
},
{
"speaker": "Gunjan Kedia",
"content": "Maybe, John, I'll add. Good morning, Vivek. Just a little point on the long-term expectation for payments. Where payments is in the mix with the client relationship, it creates really sticky enduring relationships. We do see good core growth in many of the categories of payments. They are partially offset by some unique items, freight is one of them, which was very disrupted post-COVID and just is beginning to normalize and there are some others as well. So the long-term confidence question that you asked is we look at the client value, and we look at the core dynamics and you'll see that continue to improve over-time."
},
{
"speaker": "Vivek Juneja",
"content": "Thanks for that. I have another follow-up for John. John, I just -- one of your comment earlier in response to a question just piqued my interest. You said expenses were up because net interest income was up. Is there incentive comp tied to growing net interest income or is there something else that would drive expenses up when you get net interest income up? That's not really -- any color on that?"
},
{
"speaker": "John Stern",
"content": "Yeah. Vivek, no, there's no linkage. What I was getting at is we're in the -- in the fourth quarter, we have a very good line of sight on what our expense levels. So we're just being more precise really with it. I was comparing that to our net interest income that had -- has gone up higher and is in the higher-end of our range. I was just making a comparison. There's no linkage from a compensation perspective in that sense. So, we'll just be more precise is the short answer."
},
{
"speaker": "Vivek Juneja",
"content": "Okay. Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from Ebrahim Poonawala from Bank of America. Your line is now open."
},
{
"speaker": "Andy Cecere",
"content": "Good morning, Ebrahim."
},
{
"speaker": "Ebrahim Poonawala",
"content": "Good morning, Andy. I guess one question maybe first on fees, and I appreciate you're not talking about '25 right now. But just talk to us in terms of the linkage of the fee momentum accelerating from this mid-single digits into next year. And how much of that is dependent on loan growth picking up or how much of that can happen where even if loan growth or loan demand is fairly muted in the first half, we see better fee revenue momentum being a differentiator for USB?"
},
{
"speaker": "John Stern",
"content": "Sure. From a -- from Investor Day, we talked about mid-single-digits being in terms of our range from a financial metric performance. And I think you know what you saw this quarter is a good example of that, particularly look at commercial products, which has benefited, of course, from loan growth being done in more in the capital market space, we see that benefit in our businesses. But we've also grown and provide -- have new products, new capabilities in that space. Mortgage is continuing to see nice growth as that has gone. The service charges you know has -- will start to lap the ATM exiting business as we think about that starting in 2025. Corporate trust continues to be just a very strong growth rates and that is tied in-part to the markets, of course. And so as that continues to develop, we have good momentum there. And Gunjan just talked about the payments side of the house. And so I think all those things put together really gives us a lot of confidence in terms of that mid-single-digit growth that we think of it from a -- on the medium-term standpoint."
},
{
"speaker": "Gunjan Kedia",
"content": "Ebrahim, I would just add that we do have a very beautifully diversified fee mix. So right now, we are seeing a lot of growth in capital markets and to some extent, that's a -- that's impacting loan growth. But our capital markets businesses are very strong. Otherwise, too, wealth is seeing a very good year because the stock markets are very strong, our investment services businesses benefit from that. And then as the rate environment changes, we would expect mortgage to have, sort of, momentum. So really as we go into the next year, it isn't any one thing, but it's the diversified mix because they play off of each other depending on different macroeconomic environments."
},
{
"speaker": "Ebrahim Poonawala",
"content": "That's helpful. And I guess one follow-up, John. When I look at the 7 basis points NIM expansion, I think you mentioned $10 million lift from the bond book restructuring, that's probably 1 basis point. Should we expect the 7 basis point expansion as getting better as we move forward with a couple more rate cuts this year, the back-book repricing? Like, how should we think about the cadence of the NIM from your ex any kind of bond restructuring actions? And is it conceivable that we could be at a 3% NIM in the back-half of next year?"
},
{
"speaker": "John Stern",
"content": "Sure. So maybe just to go off of a couple of those points. From a net interest income standpoint, in the fourth quarter, we expect to have relative stability and that's just thinking about our earning assets are going to be relatively flat, we expect, and our asset repricing and liability pre-pricing are going to be largely offsetting. So, that's kind of how we think about the stability component in the fourth quarter. Beyond that, all the positive momentum that I've talked about in terms of continuing remixing in terms of our assets into higher return parts of the portfolio, our ability to reprice on deposits, as I mentioned on the institutional side and then ultimately on the retail side. And then, our deposit rotation, as you have observed is slowing down, and for all intents and purposes, complete. And so that's all conducive to growth and continued expansion. I can't put a timeframe on when exactly the 3% occurs, but that's a good level to think about, and it's -- obviously it's embedded within our medium-term guidance that we provided to you during Investor Day."
},
{
"speaker": "Ebrahim Poonawala",
"content": "And one last one, I guess maybe, Andy, I think you mentioned, and you mentioned this on the Investor Day on the 2027 crossing of becoming a CAT II bank. Is that in any which way a constraint as you think about pursuing loan growth? Like was -- do you -- Is there any reason to believe USB is disadvantaged on pursuing loan growth next year, because you're kind of, you have an eye on the $700 billion asset number? Just address just that if you don't mind."
},
{
"speaker": "Andy Cecere",
"content": "No, there's no constraint on our loan growth. The loan growth activity right now is more a function of demand and consistent with the market overall and the HA data that you're seeing, and we have no constraints on loan growth. And again, as a reminder, Ebrahim, the way it works is, you are at that $700 billion for four quarters on average, so when we think about '27, that's four quarters of impact, so we have no constraints on our assets or our balance sheet."
},
{
"speaker": "John Stern",
"content": "And we would expect that our growth will be in line with the industry."
},
{
"speaker": "Andy Cecere",
"content": "The industry, which is GDP, GDP-plus."
},
{
"speaker": "John Stern",
"content": "Yeah, exactly."
},
{
"speaker": "Ebrahim Poonawala",
"content": "Got it. All very clear. Thank you so much."
},
{
"speaker": "Andy Cecere",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Your next question comes from Matt O'Connor from Deutsche Bank. Your line is now open."
},
{
"speaker": "Andy Cecere",
"content": "Good morning, Matt."
},
{
"speaker": "Matt O’Connor",
"content": "Good morning. I think you guys announced that you were looking for a new payments head and were looking externally, and we're just wondering if you could update us on if there's any updates on that. And then I guess, what type of person are you looking for? And is it to kind of continue the strategy that you had or potentially re-evaluate some areas? I think there's the general view that maybe you could do more with payments, given what the revenue pool out there is overall, and that you kind of under-punched a little bit. So I don't know if you would agree with that, but what's the thought in terms of what you're looking for in the new leadership? Thank you."
},
{
"speaker": "Gunjan Kedia",
"content": "Matt, good morning, it's Gunjan, and, we are indeed excited to be out in the market looking for new leadership for payments. We have a lot of interest in our franchise. It's unique, it's different, it's very important for us, and we do have big aspirations for not just a standalone, sort of, payments franchise, but how much it embeds and integrates with the everyday lives of our customers. So with that, we are looking for someone who is talented from a payments perspective, but culturally embraces this concept of an interconnected set of solutions for our client base. And that's what we are looking for. And as just to reiterate what we shared, we have a long transition time, very grateful that Shailesh has given us enough time to plan a very smooth and careful transition."
},
{
"speaker": "Matt O’Connor",
"content": "And I guess just from a strategic point of view, and this isn't really trying to lead you one way or the other, but like, are you set on kind of the long-term strategic path that you have in payments or are you open to potentially fairly decent size changes one way or the other? Again, not really a leading question, but it seems like it might be an opportunity to take a fresh look and look for some opportunities that maybe you haven't before."
},
{
"speaker": "Gunjan Kedia",
"content": "Thank you, Matt. We have deep conviction around the strategy and the path that we are on today. When you meet clients and you see the impact of the payments product sets on the relationships we have, you sort of build that conviction. So the question that we are focused on is how do you execute perhaps differently? How do you accelerate the execution? How do you stay current with the digital capabilities? And all of the strategies that we shared with you on Investor Day are really focused on accelerating the how, rather than sort of rethinking our strategy where we do have a lot of conviction that payments becomes the center point of how people manage their day-to-day lives, and it needs to be embedded in every product, every relationship that we have."
},
{
"speaker": "Matt O’Connor",
"content": "Okay. That's helpful. Thank you."
},
{
"speaker": "Andy Cecere",
"content": "Thanks Matt."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Your next question comes from Mike Mayo from Wells Fargo Securities. Your line is now open."
},
{
"speaker": "Mike Mayo",
"content": "Hi, just a follow-up to my earlier question related to the benefits of scale and specifically AI. Do you look to be an AI leader or a close follower, or do you think you can get those tools off the shelf and you'll just wait and see in the context of the benefits of scale, again, after your years of investing?"
},
{
"speaker": "Andy Cecere",
"content": "Yeah, Mike. So as you know, we do have scale, we invest $2.5 billion a year in technology and technology initiatives. We did a great job with the digital capabilities, we highlighted those at Investor Day, and we're following that same model with the AI initiatives, which is the center of excellence and then the business lines surrounding them in terms of use cases. As we talked about, we have a number of use cases underway. I would say, traditional AI, we've been doing for a while, Generative AI is in the early innings, and what is important is we have a structure, expertise, leadership, and technology to deliver on it, but it is early innings."
},
{
"speaker": "Mike Mayo",
"content": "Okay. And just one cleanup from Investor Day as it relates to the digital strategy, I mean, going through State Farm, just one more time, you had spent the whole day with management in New York City and more information always better, but the idea of going out of market where you don't have too much branches and going through State Farm with the digital strategy, just -- are there other examples of banks or non-banks that have succeeded with that sort of approach? We've heard a lot of those stories over the last 20 years, and they haven't always played out. So eventually you have to build more branches than you expected or something. So again, that's just a little bit of cleanup from Investor Day. So, as relates to digital strategy."
},
{
"speaker": "Andy Cecere",
"content": "Yeah. I think for the strategy to work, I think you have to have a couple of key components. One is the digital capabilities to allow it to work with the other partner. The second is a partner who has the need from a banking product standpoint for their customer base, and then alignment in terms of how that gets done. And I think both with State Farm and certainly with Edward Jones, those pieces are in place, and we've seen good results on that. So opening up core banking products, checking accounts, savings accounts outside of our market through that partnership, we have strong conviction on, and we believe it will be successful because of those attributes. Gunjan, what would you add?"
},
{
"speaker": "Gunjan Kedia",
"content": "Andy, I would add -- Mike, that we have been in this partnership business for some time now. We have a very strong franchise called Elan, which is a white label credit card provider to other banks. So, it does take a unique skillset to make these partnerships work. And many of these partnerships are restricted in terms of the number of products we're providing. So to your point, there might come a time when you think about expanding. For example, Charlotte was a market where we organically expanded and we're building out branches there. But for the core product sets and having put in place both the digital and the operational capabilities to fulfill servicing needs for people outside, we've become very good at it. So, we are expanding it now with Edward Jones. And as Andy said, good early successes and good momentum as a starting point to get your name and your brand in areas that we are not in today."
},
{
"speaker": "Mike Mayo",
"content": "Thank you."
},
{
"speaker": "Andy Cecere",
"content": "Thanks, Mike."
},
{
"speaker": "Operator",
"content": "There are no further questions at this time. Mr. Andersen, I turn the call back over to you."
},
{
"speaker": "George Andersen",
"content": "Thank you, and thanks to everyone who joined our call this morning. Please contact the Investor Relations department if you have any follow-up questions. Ellie, you may now disconnect the call."
},
{
"speaker": "Operator",
"content": "Thank you. This concludes today's conference call. You may now disconnect."
}
] |
usb | 2,024 | 2 | [
{
"speaker": "Operator",
"content": "Welcome to the U.S. Bancorp Second Quarter 2024 Earnings Conference Call. Following a review of the results, there will be a formal question-and-answer session. [Operator Instructions] This call will be recorded and available for replay beginning today at approximately 10 A.M. Central Time. I will now turn the conference call over to George Andersen, Senior Vice President and Director of Investor Relations for U.S. Bancorp."
},
{
"speaker": "George Andersen",
"content": "Thank you, Krista, and good morning, everyone. Today, I'm joined by our Chairman and CEO, Andy Cecere; Vice Chair and CAO, Terry Dolan; and Senior Executive Vice President and CFO, John Stern. Together with their prepared remarks, Andy and John will be referencing a slide presentation. A copy of the presentation, our earnings release, and supplemental analyst schedules can be found on our website at usbank.com. Please note that any forward-looking statements made during today's call are subject to risks and uncertainty. Factors that could materially change our current forward-looking assumptions are described on Page 2 of today's presentation, our press release, and in reports on file with the SEC. Following our prepared remarks, Andy, Terry, and John will take any questions that you have. I will now turn the call over to Andy."
},
{
"speaker": "Andrew Cecere",
"content": "Thanks, George. Good morning, everyone, and thank you for joining our call. I'll begin on Slide 3. In the second quarter, we reported diluted earnings per share of $0.97, which included $0.01 per share of notable item related to the FDIC special assessment. Excluding this one-time charge, we delivered earnings per share of $0.98. This quarter was highlighted by an increase in net interest income, continued fee income growth, prudent expense management, credit quality stabilization, and strong capital accretion. Notably, our return on tangible common equity increased to 18.6% on an adjusted basis. Turning to Slide 4. Revenue growth for the quarter was supported by improved spread income and well -- as well as continued growth across many of our fee-based businesses. On both a linked-quarter and year-over-year basis, non-interest expense as adjusted was down benefiting from cost synergies with Union Bank, prudent expense management, and multiyear investments across the business that have resulted in greater efficiencies and enhanced operating effectiveness. As I mentioned earlier, credit quality results were in line with our expectations as we saw stabilization in delinquency rates and a modest increase in NPAs. Average total deposits increased 2.2% and we continue to see growth in consumer deposits despite industry and liquidity headwinds. As of June 30th, our tangible book value per share increased $23.15 -- to $23.15 or 2.8% better than last quarter and 10.1% higher than last year. Our CET1 capital ratio increased 30 basis points from the prior quarter and 120 basis points from last year to end the quarter at 10.3%. John will discuss some key takeaways from this year's stress test in his opening remarks. Slide 5 provides key performance metrics. Excluding notable items, our return on average assets increased to 0.98%, and return on average common equity improved to 12.6%. Our efficiency ratio also improved from the first quarter to 60.7% on an adjusted basis. Turning to Slide 6. Fee income represents just over 40% of total net revenue and benefited this quarter from high seasonal revenues across each of our payment businesses. Strong [core] (ph) growth in trust and investment management fees as well as improved treasury management revenue. Overall, diversified fee income businesses continue to operate at scale and provide earnings consistency through the cycle. And most importantly, we are encouraged by the progress we're making to deepen our most profitable client relationships, expand our product set, and enhance our distribution channels. These efforts are positioning us well for continued growth and strategic differentiation. Let me now turn the call over to John, who will provide more detail on the quarter as well as forward-looking guidance."
},
{
"speaker": "John Stern",
"content": "Thanks, Andy. If you turn to Slide 7, I'll start with a balance sheet summary followed by a discussion of second quarter earnings trends. Total average deposits increased $10.8 billion or 2.2% on a linked-quarter basis to $514 billion, driven by stable institutional deposit balances and continued consumer balance growth. Average noninterest-bearing deposits decreased $1.4 billion or 1.6% on a linked-quarter basis, as we continue to emphasize stickier relationship-based deposit generation. The pace of decline in noninterest-bearing balances continued to slow this quarter. As the chart on the upper-left shows, we are prudently managing our pricing as we remained focused on retaining and growing core operational relationships across the franchise. Average total loans were $375 billion, an increase of $3.6 billion or 1.0% linked-quarter. The increase was driven by higher credit card loans from high spend -- higher spend volumes and increased commercial loans from growth in corporate banking. Loan growth this quarter was partially offset by lower commercial real estate and total other retail loans. With elevated deposit levels, we opportunistically increased the size of our investment securities portfolio with short-dated high-quality securities to better optimize cash levels. As a result, the ending balance on our investment portfolio was $168 billion as of June 30. Actions taken on the investment portfolio this quarter, together with approximately $3 billion of securities runoff resulted in an average yield increase to 3.15%, a 19 basis point increase from the prior quarter. Going forward, we would expect the balance on the investment portfolio to remain relatively flat to the current level and for the reinvestment benefit from quarterly securities runoff to be approximately 6 basis points to 8 basis points on average based on current rates. Slide 8 highlights our credit quality performance. Asset quality metrics continue to develop in line with expectations and we remain appropriately reserved for potential adverse economic conditions. In the second quarter, delinquencies were flat sequentially. Non-performing assets increased approximately 3.7% linked quarter, reflecting a slower pace of change. The ratio of non-performing assets to loans and other real estate was 49 basis points at June 30th, compared with 48 basis points at March 31st and 29 basis points a year ago. Our second quarter net charge-off ratio of 58 basis points increased 5 basis points from the first quarter, in line with our expectations and we continue to expect our net charge-off ratio to approach 60 basis points in the second half of this year. Our allowance for credit losses as of June 30th totaled $7.9 billion or 2.1% of period-end loans. Slide 9 provides a more detailed earnings summary. In the second quarter, we reported $0.97 per diluted share, which included $0.01 per share or a $26 million charge for an increase in the FDIC special assessment following last year's bank failures. Turning to Slide 10, net interest income on a taxable equivalent basis totaled approximately $4.05 billion, an increase of 0.9% on a linked-quarter basis. The increase in net interest income this quarter was driven by a combination of deposit volume growth, pricing stabilization, and slower migration as well as fixed asset repricing, improved loan mix, and other actions taken on the investment portfolio to optimize cash balances. Elevated deposit levels and higher on-balance sheet liquidity drove a 3 basis point decline in net interest margin this quarter to 2.67%. Slide 11 highlights trends in noninterest income. Fee income increased $115 million or 4.3% on a linked-quarter basis, driven by seasonally higher payments revenue and stronger mortgage banking fees, which included an approximate $30 million gain on sale of mortgage servicing rights. This increase was partially offset by a slight decrease in commercial product revenue due to lower corporate bond fees and losses on investment securities sales of $36 million. Noninterest income through the first six months of the year increased 5.4% on a year-over-year basis as we continue to benefit from deepening client relationships across our fee businesses. Turning to Slide 12, noninterest expense as adjusted, decreased $6 million or 0.1% on a linked-quarter basis. The decrease was primarily driven by lower compensation and employee benefit expense which was partially offset by higher net occupancy and equipment as well as marketing and business development costs. Year-over-year noninterest expense as adjusted decreased $71 million or 1.7% as we prudently managed expenses, identified operational efficiencies across the business, and realized synergies from the Union Bank acquisition. Turning to Slide 13. Our common equity Tier-1 ratio of 10.3% as of June 30th was reflective of a 30 basis point increase from the first quarter and a 120 basis point improvement compared to last year. On June 26, the Federal Reserve released its 2024 stress test results. Consistent with the industry, the Fed's modeled results were largely reflective of an assumption taken to significantly lower fee income and increase provision expense in stress, which resulted in a 60 basis point increase to our preliminary stress capital buffer of 3.1%. We remain well-capitalized and prepared to manage any potential industry stress that might result from a severe macroeconomic downturn. I will now provide forward-looking guidance on Slide 14, which is consistent with our previous guidance. We expect net interest income for the third quarter on an FTE basis to be relatively stable to the second quarter. Full year 2024 net interest income on an FTE basis is expected to be in the range of $16.1 billion to $16.4 billion. For the full year, we expect to achieve mid-single-digit growth in noninterest income as adjusted. We continue to expect full year noninterest expense as adjusted of $16.8 billion or lower. Let me now turn it back to Andy for closing remarks."
},
{
"speaker": "Andrew Cecere",
"content": "Thanks, John. I'll finish up on Slide 15. Second quarter results highlighted the resiliency of a business model that features a highly diversified revenue mix, strong risk management discipline, and a robust earnings and capital generation profile. We remain focused on our core competencies and are aggressively building upon our key differentiators. The investments we're making across the businesses are showing through in the form of enhanced customer acquisition, improved client experiences, and deeper relationships that are further propelling our growth story. Expense management is a key priority for us and we remain focused on our target of positive operating leverage in the second half of this year and beyond. Looking ahead, we are well-positioned to continue to build upon our solid foundation and already established interconnectedness across the business with the scale, reach and product capabilities that allow us to deliver industry-leading returns well into the future. Let me close by thanking our employees for everything they do to make us the destination of choice for many clients, communities and shareholders we serve. We'll now open up the call for Q&A."
},
{
"speaker": "Operator",
"content": "Thank you. [Operator Instructions] Your first question comes from Scott Siefers with Piper Sandler. Please go ahead. Your line is open."
},
{
"speaker": "Scott Siefers",
"content": "Good morning, everyone. Thanks for taking the question."
},
{
"speaker": "Andrew Cecere",
"content": "Good morning, Scott."
},
{
"speaker": "Scott Siefers",
"content": "Hey. John, I was hoping you could please sort of discuss the puts and takes within the NII trajectory from here. It looks like we would hopefully get a bump in the fourth quarter after a stable third quarter if we sort of assume the midpoint of the full year range. I guess maybe just a thought or two on factors that would cause you to come in either towards the high-end or the low-end of the full year range, please."
},
{
"speaker": "John Stern",
"content": "Sure, Scott, and good morning. First of all, we're pleased to see our net interest income grow, and we like the actions that we've taken to position ourselves for the future. Deposit rotation and rate paid have stabilized. Loan mix has improved. Our fixed asset repricing -- earning asset repricing continues to march on, and we've been opportunistically working with the investment portfolio to deploy excess liquidity. So, if you think about some of these things going forward, the higher and lower end of the range, I'd say a couple different things. First of all, I would just say, as I mentioned, we expect stable third quarter net interest income. And then from there, we do expect growth. We would anticipate that the pluses and minuses is going to be depending upon deposit rotation and beta. We do expect some level of rotation out of deposits going forward, but it's going to be relatively modest. And as you can tell, it's slowed. In terms of rate paid, that's going to be dependent on the market. But as you can tell, that has slowed as well. And we feel good about our positioning for rate cuts as we move forward should they occur. Our earning assets, we know are going to be formulaic and continue to reprice, whether that's the investment portfolio or the mortgage book. We expect kind of in that 6 basis point to 8 basis point range on average, given current levels. And then, loan growth, we assume to be very modest in this -- in our forecast kind of going forward just kind of given the loan dynamics that we're seeing. And then, finally, I would just say, although it's not as going to be meaningful for 2024, it's just the actions of the Fed and what they do, whether they cut or not. So, those are kind of the puts and takes as we kind of think about the next couple of quarters."
},
{
"speaker": "Scott Siefers",
"content": "Okay. Perfect. Thank you, John. And then maybe if I could ask you to delve a little more deeply into one portion of that, just you noted modest loan growth here going forward. What are you all seeing in terms of commercial loan demand? I guess, I sort of asked within the backdrop of the modest outlook, but your average commercial loan growth this quarter looked a little more favorable than what we've seen from peers. So, just curious as to sort of the insight based on that."
},
{
"speaker": "Andrew Cecere",
"content": "Sure. So, I think on loan growth, we did see pockets of loan growth occur in the corporate loan book, but I think our overall thesis really hasn't changed over the last several quarters. The loan growth environment remains tepid. It remains -- there's caution in the clients, but there's a lot of interest rate movement, and I'm sure that will -- that could spark some things. But overall, it's still a very tepid market. We just happen to find good -- some pockets of growth on the corporate loan book this quarter."
},
{
"speaker": "Scott Siefers",
"content": "Perfect. Okay, good. Thank you very much."
},
{
"speaker": "John Stern",
"content": "You bet."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Ebrahim Poonawala with Bank of America. Please go ahead. Your line is open."
},
{
"speaker": "Ebrahim Poonawala",
"content": "Good morning."
},
{
"speaker": "Andrew Cecere",
"content": "Good morning."
},
{
"speaker": "Ebrahim Poonawala",
"content": "I guess maybe, John, just following up on the NII, by my math, like your fourth quarter could be as high as $4.3 billion. So, appreciate the puts and takes you provided earlier. As we think about the NII trajectory from here, in a rate cut scenario, just remind us, in terms of the positioning of the balance sheet, what four to six rate cuts would imply, and flex on the deposit side, given sort of your corporate institutional makeup?"
},
{
"speaker": "John Stern",
"content": "Sure. Thanks, Ebrahim. So, the way I think about potential rate cut shift and change in market there is that we are well positioned, given the mix of our deposit base. So, approximately 50% of our balances are retail-based and about 50% of our balances are institutional or corporate-type balances. And in a cut environment, those institutional corporate balances, the beta, if you will, of those are going to go down as quickly as they came up. So, we feel very good about the repositioning of that. On the retail side, I would just say that there will always be some arc to the retail, so there'll be probably some repricing that occurs at the [still current] (ph) higher levels, but over time those balances will come down. And so, overall, it gives us an advantage as the curve in theory should starting to steepen and you have a lower short-term rate and a higher longer-term rate that allows for continued earning asset favorability on the repricing side of things."
},
{
"speaker": "Ebrahim Poonawala",
"content": "Got it. And I guess just separately, when you think about the outlook for the back half on fee revenue growth, the mid single-digits, where do you think fee revenue growth is going to be driven? What categories are going to drive that growth? Where do you expect some more moderation relative to what we've seen in the first half of the year? Thank you."
},
{
"speaker": "John Stern",
"content": "Sure. I think on the fee side of things, we had a solid quarter, but we continue to expect momentum in the various categories. And it's going to be a combination of all the main ones. It's going to be payments, it's going to be our trust investment management fees, and it's going to be in the capital market space is probably the three areas that I would point you to. On the payment side of things, we continue to see strong core competencies and whether in merchant processing, you're talking about our tech-led areas, if you're talking about our corporate payments side of things, you're looking at us starting to lap some of the things in freight and fleet. And on credit, credit card, we continue to see strong spend level. So, those are all going to be positive things for us as we move forward. The trust in investment management fees as well as the capital markets continue to see very strong market backdrop. And we have been doing very well in terms of investment in those businesses and as well as just utilizing our client base and deepening relationships there in a number of different facets. And then, those are going to be kind of the tailwinds that we see that position us well for continuing our guidance here in terms of mid-single-digit growth for fees."
},
{
"speaker": "Ebrahim Poonawala",
"content": "Got it. Thank you."
},
{
"speaker": "John Stern",
"content": "You bet."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Betsy Graseck with Morgan Stanley. Please go ahead. Your line is open."
},
{
"speaker": "Betsy Graseck",
"content": "Hi, good morning."
},
{
"speaker": "John Stern",
"content": "Good morning."
},
{
"speaker": "Betsy Graseck",
"content": "I know we already talked a little bit about the loan growth piece, but going through the slide deck, you highlighted that there's utilization rate increase. So, I guess, I'm just wondering this, and it's important, right, because at least you're the first institution I've seen this quarter that's had a utilization increase. Do you think that's a function of the types of industries where you're seeing utilization increase, or is that more your new geographies where perhaps more focused attention on new clients is driving that? Would just like to understand that."
},
{
"speaker": "John Stern",
"content": "Sure. Thanks, Betsy. So, in terms of utilization, it did tick up. I would say it's pretty modest and I would say it's pretty much in line with where we've seen in the past. I wouldn't point to it as some new trend that we're going to see continued utilization investment or increase. I think it's really more of a function of the loan mix that we saw this quarter. Some of the loans that were brought on came at a high utilization level versus some of the things that rolled off. So, I just think it's more of a mix shift rather than a change in trend."
},
{
"speaker": "Betsy Graseck",
"content": "Okay, thanks. And then just on the credit outlook here, I got a sense that maybe there was a little bit more credit coming through towards the back half of the year. Is that right, or did I get that wrong?"
},
{
"speaker": "John Stern",
"content": "Well, I don't think -- well, first of all, our guidance really hasn't changed from a credit standpoint. It continues to be -- it's stabilizing. It's as expected. From a net charge-off perspective, we came in at 58 basis points. We would anticipate approaching 60 basis points here in the back half of the year is kind of how we're thinking about the charge-off. But things like delinquencies and non-performing, those metrics have come in -- have stabilized, and have come in very nicely, giving us confidence in our credit outlook."
},
{
"speaker": "Betsy Graseck",
"content": "Okay. And are you already reserved for these NCOs? Just wondering if there's a reserve release behind that as well."
},
{
"speaker": "John Stern",
"content": "Yeah, we feel very much appropriately reserved for the book that we have. We saw a little bit of increase in our reserve build this quarter just simply because of growth, particularly in cards and things of the like. So that's kind of what has been the driver on the reserve side."
},
{
"speaker": "Betsy Graseck",
"content": "Okay, super. Thanks so much."
},
{
"speaker": "John Stern",
"content": "You bet."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Erika Najarian with UBS. Please go ahead. Your line is open."
},
{
"speaker": "Erika Najarian",
"content": "Hi, good morning."
},
{
"speaker": "Andrew Cecere",
"content": "Good morning."
},
{
"speaker": "Erika Najarian",
"content": "My first question -- good morning. First question is for you, Andy. I think what was really striking about this quarter is that the balance sheet growth was impressive on both sides of the sheet and really outperforming peers. At the same time, I think we were all surprised by the stress test results, especially given we thought that the PPNR dynamics with MUFG fully baked in would be a little bit cleaner. And so, if I'm calculating this right, your adjusted CET1 would be 8% this quarter versus 7.6%. And I'm wondering, as we think about balancing those dynamics, how are you thinking about managing growth relative to this sort of changing, unpredictable element of the SCB plus, obviously, you have done a great job at managing risk-weighted assets last year, and obviously there's a burn-off rate to the AOCI. At the same time, rates are staying a little bit higher for longer, and there's a huge debate on what's going to happen to the belly of the curve, even if everyone subscribes to Fed cuts. So, I'm wondering how we should think about balance sheet management from here, especially in light of the good growth that you experienced this quarter."
},
{
"speaker": "Andrew Cecere",
"content": "Sure. Thanks, Erika. And let me start on the CCAR results. So, as you think about MUFG, the component that we were focused on there that did happen was the expense component that came down. So, that was as expected. The component that went up versus the Fed last year was the fee income component. And we don't have a lot of clarity or transparency into why that happened. It happened for a number of banks, and it happened in spite of the fact that our fee growth is actually even positive. So that was the part that was the driver of the increased SCB for us and for a number of other banks. Let me take a step back and let me talk about capital and the balance sheet overall. As we've talked about in the past, Erika, our priorities from a capital distribution standpoint haven't changed there. First is investing in the business, second is dividends, and third is buybacks. And so, as a part of this year's stress test, as we talked about, our planned capital distribution assumed an increase to the quarterly dividend of about 2% starting in the fourth quarter. And as you saw, and as you referenced, our CET1 ratio is 10.3% this quarter. So, we continue to have strong capital accretion each quarter. We expect to be well above our fully-loaded Cat II capital targets well before the cross -- we will cross that threshold. So, from a capital standpoint, we're comfortable with our levels and our ability to accrete 20 basis points to 25 basis points a quarter. So, the one open item, as you all know, is the final Basel III endgame rules. And while we prefer to have those clarified before revising our capital and distribution targets, we will assess whatever information we have available and update on our capital distribution, our targets, as well as our return targets at Investor Day on September 12."
},
{
"speaker": "Erika Najarian",
"content": "So, Andy, just as my follow up is, based on what you've just told us, it doesn't seem as if, as we think about the rest of 2024 and the CCAR years, '24 October 1st, 24th of September 30th of next year, it doesn't sound like we should expect this similar active balance sheet management in terms of growth, as we saw in '23."
},
{
"speaker": "Andrew Cecere",
"content": "So, as we've talked about, I think most of the capital accretion going forward, Erika, will be through normal earnings accretion. And as we talked about, we expect that to be 20 basis points to 25 basis points. We had a little bit of a benefit this quarter from additional RWA optimization, but going forward, I would think about that 20 basis points to 25 basis points a quarter."
},
{
"speaker": "Erika Najarian",
"content": "Okay. Perfect. Thank you."
},
{
"speaker": "Andrew Cecere",
"content": "You're welcome."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Ken Usdin with Jefferies. Please go ahead. Your line is open."
},
{
"speaker": "Ken Usdin",
"content": "Hey, guys. Good morning. I just wanted to ask you to dig in a little bit on the payments business. Obviously, the sequential math worked as normal, but the year-over-year growth looked like it slowed from 4% in the first quarter to 3% in the second. I know we have some easier comps coming up in the second half, but can you just kind of help us understand just the absolute trajectory within the three business areas? And how do you expect that kind of growth rate to go, aside from just comps? Thanks."
},
{
"speaker": "John Stern",
"content": "Sure. So, thanks, Ken. And I do agree, I think, we do expect momentum. Part of that is comps, but we're not, obviously, relying on that. If I kind of think about the different businesses here, maybe I'll just start with merchant processing. We have seen a very good core growth in our tech-led initiative. That's about a third of our sales now, and has been growing at a very strong rate. The margins on that business have -- we are seeing nice expansion there. And a lot of our non-travel categories are really seeing very good growth. So, those are kind of the tailwinds. We have seen some headwinds this quarter, particularly on travel volumes in Europe, but that is something that we hope that will reverse and things of that nature. But otherwise, we feel like we're positioned well on the merchant side of things. On the retail card side, credit card spend is strong and constructive. I would say, the Union Bank client acquisition, we're continuing to increase the penetration rate there, but we did see a little bit of a decrease as well, just because of risk mitigation around prepaid card, which may pressure this quarter, but may linger into a couple quarters as we move forward. But still, we think that the strong growth on the retail side of things is going to -- continue to be very helpful. And then, on the corporate side of things, we are starting to get into that inflection point of lapping freight and fleet and all those sorts of things, as well as our bank card is really performing quite well. And so, I think those are really some of the things, I think especially on corporate, we -- payments we -- by lapping that fleet kind of in the third quarter or so is going to allow for very strong rates as we think about the fourth quarter. So, at a high level, we just think that there's momentum on this side of things that will allow us to grow and grow nicely."
},
{
"speaker": "Ken Usdin",
"content": "Great. Thank you. One more follow-up on NII. You had a really good second quarter result, but the outlook for a third quarter is stable and that's with an extra day. And I'm just wondering, can you just work us through like what's the holdback in terms of NII, not just growing from here? Was there either some things that helped in the second that don't recur? It looked like your securities yields were a lot higher as one example, but I'm not sure if that would have been it. So, why don't we just see the growth straight up from that 40, 50 zone we just saw in the second quarter? Thanks."
},
{
"speaker": "John Stern",
"content": "Sure. Well, I think it just comes down to the question earlier that is really around the range of outcomes that -- what's going to drive it. And it's really going to be around the deposit behavior and things. Now we saw very good trends in terms of rotation out of DDA, that pace has certainly slowed. We continue to expect it to slow moving forward, but it doesn't mean it's over, right? And so, there is that component. On the rate-paid side of things, we're just monitoring just how the competitiveness of the deposit rates will go. And quite frankly, we don't expect a lot of deposit growth in the next quarter just simply because QT is still around and is still putting pressure on industry liquidity for us and for the market. And so, that's the primary driver is just kind of the watch of that. And on top of that, we just don't know if the Fed will cut or not. I know the market has priced that in, but that's another factor in this sort of thing. So, those would be the factors I would call out."
},
{
"speaker": "Andrew Cecere",
"content": "And John, in our projections, we've assumed two more rate cuts in September and December."
},
{
"speaker": "John Stern",
"content": "That's right. We've assumed September and December for rate cuts. That's right."
},
{
"speaker": "Ken Usdin",
"content": "Okay. Got it. Great. Thank you."
},
{
"speaker": "John Stern",
"content": "You're welcome."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Mike Mayo with Wells Fargo. Please go ahead. Your line is open."
},
{
"speaker": "Mike Mayo",
"content": "Hi. I just think my math is wrong here. If you can help me out with that? Even assuming the four items you just mentioned for NII not going higher in the third quarter, if you could just highlight your fixed asset reprice a little bit more? Here's my math, and it's clearly wrong, because, one, you said security should reprice up 6 basis points to 8 basis points per quarter, if I heard that correctly. So, if you take 7 basis points on $168 billion of security, that'd be like $100 million extra next quarter. If you take your mortgage book of $117 billion, and you take 7 basis points on that, I wasn't sure if you meant 7 basis points on that, but then you get up to almost $200 million more for NII on a base of $4 billion. That'd be 5% growth next quarter, 5% growth the quarter after that, et cetera, et cetera. And that's not your guidance. So, first, if you could just fix my math as far as the fixed asset repricing on the securities mortgages, what I'm doing wrong, and then confirm or not those four items that you mentioned offset all of that? Thank you."
},
{
"speaker": "John Stern",
"content": "Sure, Mike. Happy to. So, I think in terms of the math, in terms of mortgage, that's going to continue, given that's a very much a fixed rate book. On the investment portfolio, given current rates, we would expect 6 basis points to 8 basis point increase. However, if we assume in our projections, as we just mentioned, that there'll be a cut in September, and about half of our book is floating rate, or swap to floating and that sort of thing. And so, that will impact the investment portfolio that way. And the deposits, of course, on the other side of that will start to shift. Of course, the institutional side would start to move right away, but the retail side will have an arc to it. And so, it's the movement of the cut within the quarter, which is sort of a part of why we anticipate a relatively stable third quarter."
},
{
"speaker": "Mike Mayo",
"content": "And just for clarification, you did intend that the mortgage book should reprice upward by 7 basis points a quarter also same as the security?"
},
{
"speaker": "John Stern",
"content": "Yeah, that's right. Mortgage book is kind of that 6 basis point to 8 basis point range."
},
{
"speaker": "Mike Mayo",
"content": "And then, one more follow-up and I'll re-queue. Your noninterest-bearing deposits, you mentioned that as one of the risk factors. You said it's slowing. Can you remind us what it did between the second and first quarter? And what's your all-time low for that ratio?"
},
{
"speaker": "John Stern",
"content": "On the mix of DDA to total deposits, I think, 16.2% or so is where we came in this quarter, it was 16.9% a quarter ago, it was 18% or so the quarter before that. So, that pace is changing and slowing. And in terms of where it goes, it's going to be just how clients behave and all that sort of thing, but it is an all-time low for us, for sure as we look back at our data."
},
{
"speaker": "Andrew Cecere",
"content": "And Mike there is a -- on Slide 7, there's a chart upper left that shows the migration out that has slowed. It was 7.1% in the fourth quarter, down 6.4% in the first quarter, and then slowed to 1.6% down in the first -- in the second quarter of '24."
},
{
"speaker": "Mike Mayo",
"content": "Okay. Thank you."
},
{
"speaker": "Andrew Cecere",
"content": "Sure."
},
{
"speaker": "John Stern",
"content": "Sure."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Gerard Cassidy with RBC Capital Markets. Please go ahead. Your line is open."
},
{
"speaker": "Gerard Cassidy",
"content": "Hi, Andy. Hi, John."
},
{
"speaker": "Andrew Cecere",
"content": "Good morning, Gerard."
},
{
"speaker": "Gerard Cassidy",
"content": "John, you talked about the deposits and how you will approach them as the Fed starts to cut rates. I thought it was interesting in your supplement on the average balance sheet that one of your largest deposit category, if I'm seeing it correctly, money market savings, the yield was down from the prior quarter at 3.85% versus 3.92% in the March quarter. Can you share with us what kind of strategies you used or what took that down when many of the other rates like, time deposits obviously went up in the quarter?"
},
{
"speaker": "John Stern",
"content": "Sure, Gerard, no problem. So, if you look at that category, it's, as you mentioned, our largest category for deposits. So, it's a mix of wholesale as well as retail and small business and all that sort of thing. And I think what we have done is, in light of loan growth, obviously it grew a little bit, but it's not -- again, it's not growing tremendously. And so, we have the opportunity to look at our relationships across the bank and price things in an appropriate manner that makes sense for us to do. And so, we've taken some opportunities to exit some high-cost deposits and we've really utilized our distribution network, whether that's on the retail side, the branch network, our app capabilities, really taking advantage, and our partnerships really taking advantage of our national bank reach and really growing in deposits in areas that have a lower cost. And so that's kind of the positive rotation that you're seeing in that specific category."
},
{
"speaker": "Gerard Cassidy",
"content": "I got it. I don't want to put words in your mouth, but when the Fed starts to cut rates, from this line item, at least you guys could potentially benefit from lower rates and the balances continue to grow, which obviously would be beneficial. Andy, just a more bigger macro question. John touched it a little bit a moment ago about the utilization rate on the C&I loans. Can you share with us when you guys go out and talk to clients, what are they -- commercial clients, that is, what are they thinking about CapEx spending, which would enable them to draw down lines? And then second, are you seeing any increased competition from alternative lenders, whether it's private credit or other, that may be affecting the C&I loan growth?"
},
{
"speaker": "Andrew Cecere",
"content": "Yeah, Gerard. I think our clients are probably a little bit more focused on defense than offense right now. We just did a CEO survey and we talked to clients. They are focused on productivity, efficiency, expense management, and the investments that they're making to the extent that they're utilizing lending activity is to really amplify some of that efficiency opportunity that they're focused on. So, a little bit more on defense. But as John mentioned, the utilization rates were up modestly in pockets across the board. And I would expect that to continue as we go forward. So, nothing significantly different from what we saw in prior quarters. The competition is strong, so both bank and non-bank competition, that's driving pricing a little bit. We're continuing to seek full relationships with appropriate returns, and that'll drive the volumes as well."
},
{
"speaker": "Gerard Cassidy",
"content": "And just as a quick follow-up on the competition, are you guys seeing more aggressive underwriting for banks that want to grow that balance sheet? How are you seeing that from the underwriting standpoint?"
},
{
"speaker": "Andrew Cecere",
"content": "Yeah, I'm not sure that the underwriting is changing significantly as opposed to the pricing, Gerard. That's how I would focus on it."
},
{
"speaker": "Gerard Cassidy",
"content": "Okay. Thank you, Andy."
},
{
"speaker": "Andrew Cecere",
"content": "Sure."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Matt O'Connor with Deutsche Bank. Please go ahead. Your line is open."
},
{
"speaker": "Matt O'Connor",
"content": "Good morning. Wanted to circle back on payments. A lot of good details, kind of by segment, but was wondering if you could update kind of your thoughts on the growth you expect for full year this year. And then just still, it might be a little bit lower than what you were thinking before. And then just the medium-term outlook, if that's still the same?"
},
{
"speaker": "John Stern",
"content": "Yeah. I'll answer your second question first. The medium-term outlook has not changed in terms of growth rate trajectory for the payment businesses. So, we think of high single-digit growth in terms of the merchant and corporate payments system categories. And we think of mid-single-digit growth as we get into the credit card, debit card kind of area. As I mentioned, we had 4% or so and then 3% growth this quarter, the last two quarters on a year-over-year basis. We would expect momentum as we move forward and getting and approaching those sort of medium-term levels. And some of the puts and takes I had mentioned earlier are going to be kind of the drivers of that. And, of course, whether or not we're on the higher end or lower end is going to depend upon spend levels and where that ultimately comes through, but we feel confident in terms of where the market is going and how that is. So, we feel like we're well positioned in that space."
},
{
"speaker": "Matt O'Connor",
"content": "Okay. And then, what's the prepaid card risk mitigation that you referred to? Maybe I missed if you've mentioned that in the past, but can you just remind us what that is and how long it [might drive for] (ph)? Thanks."
},
{
"speaker": "John Stern",
"content": "Yeah. So, it's just more fraud and things of that variety that has picked up. And so, we just -- there's just some areas there that we want to mitigate against, and so that we've chosen to just step away from some of those sorts of things."
},
{
"speaker": "Matt O'Connor",
"content": "And then, how much of a drag is that and how long will it continue? That's my last one. Thanks."
},
{
"speaker": "John Stern",
"content": "Well, I think it's -- you saw the card growth rate was about 1% or so versus our sales area of about 4% -- 3% to 4%. So, I think there's going to be some of that pressure in the third quarter or so."
},
{
"speaker": "Matt O'Connor",
"content": "Okay."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Vivek Juneja with JPMorgan. Please go ahead. Your line is open."
},
{
"speaker": "Vivek Juneja",
"content": "Hi. Thanks."
},
{
"speaker": "Andrew Cecere",
"content": "Good morning."
},
{
"speaker": "Vivek Juneja",
"content": "A couple of just follow-ups. One on payments. So, trying to understand, I know you've said merchant, you expect to get to high single-digit. What's happening with the -- when I look at the volumes, merchant was only up 1.7% year-on-year, and that's the slowest volume growth we've seen in six quarters. So, why has -- despite all the tech-led initiatives, which are great, and the other areas that you're trying to spend, why is volume growth slowed so much? And then, what would cause that to turn around?"
},
{
"speaker": "John Stern",
"content": "Sure. So, I can talk to that, Vivek. So, on the merchant processing side, you mentioned that the sales component was about 2% or so. In terms of where we saw some volume decreases was really had to do with travel, particularly on the European side of things. Volumes were just lower for our clients in that particular area. So that's really the focal point. I think if you think about as we start to lap some of that sort of thing and same store sales come in and that sort of thing, that's where we expect the momentum in the second half of the year."
},
{
"speaker": "Vivek Juneja",
"content": "Okay. Shifting gears, you're talking about charge-offs going to 60 basis points in the second half. Delinquencies are down, so that should help. But your C&I losses are running high. Despite the losses, NPLs are running still up. Where -- first, a two-part question there. Where in C&I are you seeing these losses, which industry sectors? And your overall charge-off rate of 60 basis points, which categories do you expect would tick that up from where you are currently given the outlook for delinquencies coming down?"
},
{
"speaker": "John Stern",
"content": "Sure. So, on your two-parter, I'll take the C&I question first. First of all, the increase there in charge-off was really attributed to one unique or idiosyncratic loan that went through, and that was an NPA that we saw a couple quarters ago that worked its way through. We don't anticipate anything really in the C&I book outside of that. So that is something that -- is something that we're not concerned about. On the rest of the charge-offs, if I think about just at a big picture on credit card for, as an example, we did see a little bit of an increase in charge-offs this quarter, but given the delinquency, as you just mentioned, we would expect our charge-offs in the first or the third and fourth quarter to look more like the first quarter. And I think the balance of it will be more kind of in the commercial real estate office side of things. So that's kind of the puts and takes to the charge-off guide."
},
{
"speaker": "Vivek Juneja",
"content": "Okay. So, you had one large loan written off, but then what refilled that bucket, John, given that the NPL has actually ticked up, not down in C&I?"
},
{
"speaker": "John Stern",
"content": "Well, yeah, I mean, I think it's very -- it's just very modest. It's more idiosyncratic-type loans. It's not something that we're holistically concerned about at any reach."
},
{
"speaker": "Andrew Cecere",
"content": "Vivek, as you mentioned, and as John mentioned, the delinquency levels are stable. And so that drives stabilization on credit card. The idiosyncratic loan that John mentioned, it was the second quarter. As we think about the future, I think the lumpiness will come out of CRE office and that's the one that's going to go up and down a little bit. We talked about that. We've mentioned that in prior calls. Certainly manageable, but that will just cause a little bit up and down."
},
{
"speaker": "Vivek Juneja",
"content": "Okay. Thank you."
},
{
"speaker": "Andrew Cecere",
"content": "You bet."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of John Pancari with Evercore ISI. Please go ahead. Your line is open."
},
{
"speaker": "Andrew Cecere",
"content": "Hey, John."
},
{
"speaker": "John Pancari",
"content": "Good morning. Andy, I appreciate the color you gave on capital. And as you look at it, I know it sounds like you're still on the sidelines on buybacks as you walk through your priorities and the expectation for capital here, but I guess what changes that? Is it continued pull to par on the AOCI side? Is it Basel III clarity? Is it clarity on rates? What gets you to the point where you get confidence in buyback outlook, or how you're thinking about your internal CET1 target? If you could just walk us through the thought process there?"
},
{
"speaker": "Andrew Cecere",
"content": "Yeah. So let's start, John, by saying that I'm very confident in our capital levels and our ability to accrete capital. It's consistent with what we've talked about, that 20 basis points to 25 basis points, and we've made great improvements, as you saw from the number, 140 basis points over the last year. So, let me start there. Second, as we talked about before, we were seeking clarity on two components: number one is CCAR, which we now have; and number two is Basel III endgame, which we're getting closer to. And my expectation, John, is that we will -- one way or the other, we'll have more clarity or not -- if not the perfect answer. We will update on both our capital targets and distribution objectives as we think about it at Investor Day on September 12. So, I'll give you a full update at that point."
},
{
"speaker": "John Pancari",
"content": "Okay, thanks. Appreciate that. And then, separately on operating leverage. I know you reiterated your confidence in achieving positive operating leverage in the second half of this year. I mean, can you help us -- I know you're not giving formal 2025 expectations, but I'm trying to think about what that positive operating leverage you're generating in the back half of that expectation, what that could mean as we look into the quarters through 2025. I mean, it looks like consensus is ballparking around 300 basis points positive operating leverage. When you look at the full year '25 expectations, you were above 200 basis points in 2022, but in the years prior, you were well below that. What's a good way to think about it medium term in terms of where USB should be operating from that standpoint?"
},
{
"speaker": "Andrew Cecere",
"content": "Let me do it in components. So, first of all, as you saw this quarter, our expenses were relatively flat and we focused on the $16.8 billion or lower for the full year '24. So, we are past the point of investment in the curve on increasing expenses and now realizing the benefits from those expenses. So, I would expect us to be moderate from an expense growth standpoint going forward and managing that well. We talked about the momentum in fee growth, and I would expect that to continue given the unique businesses we have. I think the biggest difference is the headwind that was net interest income turned into a tailwind this quarter. And as we talked about stabilization in the third quarter, I think as we get into '25, that becomes more of a tailwind, and those things all drive positive operating leverage into '25."
},
{
"speaker": "John Pancari",
"content": "Okay, great. Thanks."
},
{
"speaker": "Andrew Cecere",
"content": "You bet."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Chris Kotowski with Oppenheimer. Please go ahead. Your line is open."
},
{
"speaker": "Chris Kotowski",
"content": "Yeah, good morning."
},
{
"speaker": "Andrew Cecere",
"content": "Hey, Chris."
},
{
"speaker": "Chris Kotowski",
"content": "Hi, it's a small item, but a curiosity to me. I mean, I noticed that your automobile loan portfolio is down by more than 30% year-over-year. And I'm just curious, how did that category suddenly become in like no-fly zone? Because you think it's short-duration assets? Do you think it would be attractive given the..."
},
{
"speaker": "John Stern",
"content": "Sure, Chris. So, in terms of the drop, obviously, we haven't been as active in the auto loan market just simply because the spreads and the returns on those sorts of loans have not been at our standard. And the competitors that we're facing aren't banks and they have a different return profile in this particular environment. That doesn't mean we've exited or anything like that. In fact, we've been very strong in terms of some of the leasing and some of the other areas and we continue to monitor that market very closely. And if the spreads and returns are appropriate, we will be very active in that space just as we have been in the past."
},
{
"speaker": "Chris Kotowski",
"content": "Okay. All right. Thank you."
},
{
"speaker": "John Stern",
"content": "You bet."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Saul Martinez with HSBC. Please go ahead. Your line is open."
},
{
"speaker": "Saul Martinez",
"content": "Hi. Hey, good morning, guys."
},
{
"speaker": "John Stern",
"content": "Good morning, Saul."
},
{
"speaker": "Saul Martinez",
"content": "Just a follow-up on the cards growth, 1.4% year-on-year, credit of 4.3%. I guess, John, is that entirely due to the exiting or the reducing of exposure to prepaid, or you've seen any weakness in debit as well? That would be somewhat unusual typically debit in an environment where there is an economic slowdown, tends to outperform. So, just any additional color there. And just wanted to reaffirm that this is sort of a transitory thing and you should lap this and I suspect in the fourth quarter. Is that -- did I get that right?"
},
{
"speaker": "John Stern",
"content": "Yeah. I think to answer your question very simply, I mean, the difference between the fee growth and versus the sales is really all prepaid on that side of things. We see strong trends in terms of credit card spend and all the union penetration, all those things that I mentioned. Those are the things and all the different partnerships that we have, those are all still very good. It's just that it's all on the prepaid side."
},
{
"speaker": "Saul Martinez",
"content": "Okay, got it. And then just a follow-up on deposit dynamics. You've talked a few times about a slowing of the rotation. And -- but if I look at period-end noninterest-bearing, it did fall close to 5% sequentially versus much different -- much worse than or much larger sequential decline than what you see on average. Just anything there that you want to call out what drove that? Is this -- and is it something that's somewhat transitory or not?"
},
{
"speaker": "Andrew Cecere",
"content": "Thanks for asking that question, because I want to point something out. We have a lot of volatility in the day-to-day NIB deposit levels principally due to our corporate trust business that has payments coming in and out on a daily basis, and depending upon where the quarter ends, the holidays, the end of the week, the end of the month, you could have volatility. So, we are very focused on the average balances and I would encourage you to do the same, because day-to-day, it could be very volatile and it does not indicate any trends."
},
{
"speaker": "Saul Martinez",
"content": "Got it. All right. Thanks very much."
},
{
"speaker": "Andrew Cecere",
"content": "Sure."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Mike Mayo with Wells Fargo. Please go ahead. Your line is open."
},
{
"speaker": "Mike Mayo",
"content": "Hi. During the last quarter, there's been a few management changes, people leaving, people getting repositioned. And I think as we get ready for the September 12th Investor Day, we might look at the presenters and say, \"Wow, these are a lot different than the presenters at your last Investor Day.\" So, I'm just trying to figure out what the tea leaves are saying and maybe you can just tell us directly, Andy, in terms of what is your time horizon for remaining CEO? And I only ask that given some of these recent changes. So -- and who are the contenders to be the next CEO of U.S. Bancorp? And would you consider looking outside of U.S. Bancorp for your successor? Just a little more color on all the moves that have taken place? Thanks."
},
{
"speaker": "Andrew Cecere",
"content": "Thanks, Mike. So, as it relates to Investor Day, you're going to see some new faces for sure, but you're going to see some familiar faces as well. So, we'll have a good mix of both people that you're very familiar with as far as -- and some new. One of the things that we made a change with was putting Gunjan in the President's role. And about a year and a half ago, we combined what was then called WSIB, which is the -- or we combined to the institutional wealth group together with the corporate and commercial Group. And the synergies and the activity and the customer focus that evolved from that was just terrific. So, Gunjan has that same objective to do that with the entire bank, with the payments organization, with the consumer and business banking organization. And pulling together the leadership under one -- the businesses under one leader with the customer in the center and really taking advantage of all the diverse set of businesses that we have to really grow the business, that's the objective. And she's done a terrific job with that already. She's already started very fast to do it with the entire bank, and I'm looking forward to sharing that story on September 12th."
},
{
"speaker": "Mike Mayo",
"content": "Okay. And the departures, anything related to that? Is that..."
},
{
"speaker": "Andrew Cecere",
"content": "Yeah, Mike, I would just say that's natural activity. We've had a very stable senior leadership group for years and years, and sometimes change happens, but there's no messaging in that."
},
{
"speaker": "Mike Mayo",
"content": "Okay. And so, the theme, not to front run your conference too much, is, it's One USB, so you've done more One USB with wealth and commercial and now you're looking to be One USB, deliver the whole firm to the client, that sort of simple statement that's easy to say, tough to execute?"
},
{
"speaker": "Andrew Cecere",
"content": "Exactly."
},
{
"speaker": "Mike Mayo",
"content": "Okay. All right. Thank you."
},
{
"speaker": "Andrew Cecere",
"content": "Thanks, Mike."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Ken Usdin with Jefferies. Please go ahead. Your line is open."
},
{
"speaker": "Ken Usdin",
"content": "Hey, thanks, guys. I just had a follow-up on the securities book. Just can you help us understand the meaningful increase that happened this quarter in the yields? And then, also, you mentioned 50% of the bond book is floating. Is that the total bond book? And then, can you help us understand how much of that book is swapped and what you do with that going forward in the -- given the rate outlook? Thanks."
},
{
"speaker": "John Stern",
"content": "Sure. So, on the securities book, in terms of the quarter, the 19 basis point increase, a majority of that was related to opportunistically taking some of the excess liquidity that we had and putting it into the securities book. And so, you can think of that as short-dated treasuries or treasury swap to floating, that sort of thing, which is the equivalent from a net interest -- or an interest-rate risk perspective versus cash is just a kind of a simple way to think about it. In terms of the book itself, I would say that I made that comment because about in terms of AFS risk and all that sort of thing, we have hedged approximately 40% or so of the risk component. And then that coupled with just natural floating rate securities that we have within the book that are already floating, that gets you to about 50% that are either floating or synthetically floating through swaps. So that's kind of the details of it. Now on the other side of that, we have put on hedges to -- put receive fixed swaps on our corporate book, so that if rates do fall, we're protected on that end as well. So, those are kind of the balances. All in, it gets us to where we want to be from an interest-rate risk standpoint, which is neutral to shocks, which is where we are today."
},
{
"speaker": "Ken Usdin",
"content": "Okay. So just -- so are you saying that gets you to around half of the total book, AFS and HTM?"
},
{
"speaker": "John Stern",
"content": "Yes, that's correct."
},
{
"speaker": "Ken Usdin",
"content": "Okay, cool. And sorry, just one last one. Under $16.8 billion for cost after the second quarter result, can you just remind us what that means for the trajectory from here? And thanks again for follow-ups."
},
{
"speaker": "John Stern",
"content": "Yeah. $16.8 billion or less, that's our fee -- or excuse me, that's our expense outlook. Where we have been over the last couple of quarters is very consistent with where we're at. As Andy talked about, we've hit the -- that point on the investment curve. We continue to feel like we're in a very good spot in terms of managing expense going forward."
},
{
"speaker": "Andrew Cecere",
"content": "Thanks, Ken."
},
{
"speaker": "Ken Usdin",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "And we have no further questions in our queue at this time. Mr. Andersen, I turn the call back over to you."
},
{
"speaker": "George Andersen",
"content": "Thanks, Krista. Thanks to everyone who joined our call this morning. Please contact the Investor Relations department if you have any follow-up questions. Krista, you can now disconnect the call."
},
{
"speaker": "Operator",
"content": "This concludes today's conference call. Thank you for your participation, and you may now disconnect."
}
] |
usb | 2,024 | 1 | [
{
"speaker": "Operator",
"content": "Welcome to the U.S. Bancorp First Quarter 2024 Earnings Conference Call. [Operator Instructions] This call will be recorded and available for replay beginning today at approximately 8:00 a.m. Central Time."
},
{
"speaker": "",
"content": "I will now turn the conference call over to George Andersen, Senior Vice President and Director of Investor Relations for U.S. Bancorp."
},
{
"speaker": "George Andersen",
"content": "Thank you, Rochelle, and good morning, everyone. Today, I'm joined by our Chairman, President and Chief Executive Officer; Andy Cecere; our Vice Chair and Chief Administration Officer, Terry Dolan; and Senior Executive Vice President and Chief Financial Officer, John Stern. Together with some initial prepared remarks, Andy and John will be referencing a slide presentation. A copy of the presentation, our earnings release and supplemental analyst schedules are on our website at usbank.com."
},
{
"speaker": "",
"content": "Please note that any forward-looking statements made during today's call are subject to risk and uncertainty. Factors that could materially change our current forward-looking assumptions are described on Page 2 of today's presentation, our press release, our Form 10-K and in subsequent reports on file with the SEC. Following our prepared remarks, Andy, Terry and John will take any questions that you have."
},
{
"speaker": "",
"content": "I will now turn the call over to Andy."
},
{
"speaker": "Andrew Cecere",
"content": "Thanks, George. Good morning, everyone, and thank you for joining our call. I'll begin on Slide 3. In the first quarter, we reported earnings per share of $0.78, which included $0.12 per share of notable items. Excluding notables, earnings per share totaled $0.90."
},
{
"speaker": "",
"content": "Our balance sheet remains strong. We are maintaining our through-the-cycle underwriting discipline and seeing the benefits of our multiyear investments in digital, technology and payments ecosystem in the form of strong fee growth across our business lines. Importantly, we continue to accrete capital this quarter. Our CET1 ratio ended the period at 10.0% and our return on tangible common equity ratio was 17.4% on an adjusted basis."
},
{
"speaker": "",
"content": "Slide 4 provides additional performance metrics on both a reported and adjusted basis."
},
{
"speaker": "",
"content": "On Slide 5, I'll provide some additional high-level observations for the quarter. Starting with the balance sheet. Credit quality metrics continue to develop in line with our expectations, and we achieved healthy growth in tangible book value per share on both a linked quarter and year-over-year basis."
},
{
"speaker": "",
"content": "Loan and deposit growth remains under pressure for the industry, and that dynamic impacted our net interest income this quarter. Our NII on a taxable equivalent basis of approximately $4 billion was within our guidance, albeit on the lower end of the range. We are seeing good opportunities for loan growth in targeted portfolios. And notably, we continue to see consumer deposit growth despite the impact of QT on industry deposit levels."
},
{
"speaker": "",
"content": "Over the past few weeks, the outlook for potential rate cuts in 2024 has meaningfully changed as long-term rates have backed up. Client behavior across the industry is adjusting in response to the potential higher-for-longer interest rate environment that has impacted our deposit mix and pressured deposit costs."
},
{
"speaker": "",
"content": "As a result, we now expect our NII for the full year to be lower than anticipated. However, we are taking a closer look at our expense base given these near-term NII headwinds and plan to take actions to mitigate the impact of lower-than-expected NII to our overall profitability. John will go on to more details on these topics, but importantly, we believe this is a near-term phenomenon."
},
{
"speaker": "",
"content": "Turning to Slide 6. We continue to feel good about the momentum across our differentiated fee businesses. Fee income represents about 40% of our total net revenue, which stands to position us well in a lower interest rate environment. Overall, we are encouraged by our current trends in our client growth and penetration rates, as evidenced by the continued strength we have seen across many of our fee revenue businesses this quarter."
},
{
"speaker": "",
"content": "Slide 7 provides an update on our differentiated payments ecosystem. Over the past few years, we have made good progress to both expand our business banking and payments relationships and grow related revenue associated with these relationships. You may recall, we discussed an opportunity to grow small business relationships by 15% to 20% and related revenue by 25% to 30% a few years ago. As you can see on this slide, we're making good progress and see even greater opportunity to further expand these relationships and related revenue in the medium term."
},
{
"speaker": "",
"content": "Let me now turn the call over to John, who will provide more detail on the quarter as well as provide forward-looking guidance."
},
{
"speaker": "John Stern",
"content": "Thanks, Andy. On Slide 8, we provide an earnings summary. This quarter, we reported diluted earnings per share of $0.78 or $0.90 per share after adjusting for notable items, including the last of merger and integration costs of $155 million following our acquisition of Union Bank and $110 million related to an anticipated increase in the FDIC special assessment."
},
{
"speaker": "",
"content": "Turning to Slide 9. Total average loans were $371 billion, down 0.5% linked quarter, as growth was impacted by slow industry loan demand in the current higher interest rate environment. Despite tightening monetary policy and ongoing pressure on industry-wide deposits, our total average deposits of $503 billion were stable linked quarter as we continue to see our efforts to grow consumer-related deposits materialize."
},
{
"speaker": "",
"content": "End-of-period deposit growth was a little higher than we would typically see in the first quarter. Trust and corporate deposit inflows are seasonally higher at the end of the first quarter. However, the impact of holiday timing at quarter end delayed planned outflows of institutional deposits, which resulted in temporarily higher cash levels. We expect deposit outflows to move in line with more typical seasonal patterns."
},
{
"speaker": "",
"content": "Importantly, we continue to proactively manage the balance sheet by prioritizing opportunities that exceeded our cost of capital and further optimized our funding mix. We continue to limit our reliance on short-term borrowings and remain disciplined on deposit rate paid as we focus on relationship-based deposits."
},
{
"speaker": "",
"content": "Turning to Slide 10. Net interest income on a taxable equivalent basis totaled approximately $4.0 billion, down 3.1% linked quarter. And net interest margin declined 8 basis points to 2.70%. Both net interest income and net interest margin declines were driven by continued unfavorable deposit mix shift and deposit pricing pressure as well as slower loan demand."
},
{
"speaker": "",
"content": "Slide 11 highlights trends in noninterest income. Noninterest income increased 7.7% or $193 million on a year-over-year basis, driven by higher payments revenue, continued strength in underlying capital markets activity and stronger mortgage banking fees. On a linked quarter basis, noninterest income, as adjusted, decreased 1.4% or $38 million, reflective of seasonal declines in payments volume; and previously discussed impacts related to the exiting of our ATM cash provisioning business, which pressured service charges; and lower tax credit syndication fees, which impacted other revenue."
},
{
"speaker": "",
"content": "Turning to Slide 12. Reported noninterest expense for the quarter totaled $4.5 billion, which included approximately $265 million of notable items. Noninterest expense, as adjusted, decreased $10 million or 0.2% on a linked-quarter basis and $117 million or 2.7% year-over-year, driven by both cost synergies with Union Bank and our continued focus on operational efficiency."
},
{
"speaker": "",
"content": "Slide 13 highlights our credit quality performance. Asset quality metrics continue to develop in line with our expectations. Linked quarter, nonperforming assets increased 20%, reflecting continued stress in our commercial real estate office portfolio and one idiosyncratic commercial loan. The ratio of nonperforming assets to loans and other real estate was 0.48% at March 31 compared with 0.40% at December 31 and 0.30% a year ago. Our first quarter charge-off ratio of 0.53% increased 4 basis points from a fourth quarter level of 0.49% and was higher when compared to a first quarter 2023 level of 0.3% as adjusted. Our allowance for credit losses as of March 31 totaled $7.9 billion or 2.1% of period-end loans."
},
{
"speaker": "",
"content": "Turning to Slide 14. Our common equity Tier 1 ratio of 10.0% as of March 31 was reflective of a 10 basis point increase from year-end, which included 20 basis points of net capital accretion, offset by a CECL transitional impact of 10 basis points. We remain well above our regulatory capital minimum requirements."
},
{
"speaker": "",
"content": "I will now provide forward-looking guidance on Slide 15. We expect net interest income for the second quarter on an FTE basis to be relatively stable with the first quarter level of approximately $4.0 billion. Full year 2024 net interest income on an FTE basis is now expected to be in the range of $16.1 billion to $16.4 billion. Our revised guidance reflects a shift in commercial client deposit behavior in a higher-for-longer rate environment and heightened competitive industry dynamics. For the full year, we continue to expect mid-single-digit growth in noninterest income."
},
{
"speaker": "",
"content": "Given the pressure we are seeing on net interest income, we are reducing our expense guidance for the year. We now expect full year noninterest expense of $16.8 billion or lower, which compares to $17.0 billion in 2023."
},
{
"speaker": "",
"content": "Let me now hand it back to Andy for closing remarks."
},
{
"speaker": "Andrew Cecere",
"content": "Thanks, John. We have been preparing for a wide range of economic scenarios for some time now, and we continue to deliver industry-leading returns despite the current industry stress. Our diverse business mix is allowing us to differentiate in a competitive market, and we are seeing the benefit of the investments we've made and continue to make in our digital capabilities, our technology modernization and our payments ecosystem."
},
{
"speaker": "",
"content": "The message I'd like to leave you with is that we will successfully navigate through the near-term challenges the industry is facing. But more importantly, we are well positioned for the future and continue to manage the company with a long-term lens."
},
{
"speaker": "",
"content": "Let me close by recognizing the many dedicated employees for all they do to support the constituents of our national banking franchise. It is because of our exceptional talent pool that we remain poised to execute on our capital-efficient growth objectives and continue to deliver the financial performance our shareholders have come to expect."
},
{
"speaker": "",
"content": "We will now open up the call for Q&A."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Your first question comes from the line of Scott Siefers with Piper Sandler."
},
{
"speaker": "Robert Siefers",
"content": "Was hoping, either Andy or John, you could talk just in a little more detail about sort of the nuance in the tougher NII guide for the full year. So I guess, at an industry level, we've got a couple of dynamics at play, whether it's the challenging loan growth environment or of course the impact of higher for longer on deposit costs and betas. So maybe the main 1 or 2 kind of pressure points you saw."
},
{
"speaker": "",
"content": "And then I guess as the follow-up. It doesn't feel like there will necessarily be a lot more pressure on NII. It's just that it might not advance in the second half. Is that the best way to think about it?"
},
{
"speaker": "John Stern",
"content": "Sure, Scott. Thanks for the question. So maybe just take a step back just to answer your question. In the -- in January, when we talked about our guidance, we looked at, and we expected our 2024 net interest income, to be in line with the annualized fourth quarter number given that was past MUB actions that we had taken throughout the course of the year. And so to your point, we're 1% to 3% lower than the new guidance -- with our new guidance here."
},
{
"speaker": "",
"content": "And the outlook really speaks to changes or the dynamics that we have in the economy, the interest rate environment, the dynamics in the deposit environment, those sorts of things. The conversation of course has shifted. At the beginning of the year, there was multiple cuts, now we're shifting to more higher for longer."
},
{
"speaker": "",
"content": "And what we've witnessed over that time is that our client behavior, particularly in the corporate and mid-market sections, have been shifting their behavior. And clients are continuing to rotate out of low-cost deposits into higher-cost deposits. And the pace of this action is slowing. We absolutely see that. It's just not slowing as fast as what we would have anticipated."
},
{
"speaker": "",
"content": "So to boil that all together, what we do see now with our guidance is that we have the second quarter net interest income will be relatively stable and we should see growth in the second half of the year. And we provided a range given that uncertainty in terms of client behavior and things of that variety."
},
{
"speaker": "",
"content": "And the final thing I would just say is that we recognize this upfront and we're taking action. We are looking at our expense base and taking action and pulling some levers that we have been looking at. And so that's kind of how we think about the guidance from a big picture perspective."
},
{
"speaker": "Andrew Cecere",
"content": "Thanks, John. And Scott, I'd just add that we continue to look for opportunities to improve efficiencies, particularly in this higher-for-longer rate environment. So we benefited from the $900 million of cost takeouts from the Union Bank transaction. And we continue to focus on additional efficiencies in areas like procurement and third-party spend, our workplace management and our properties and real estate."
},
{
"speaker": "",
"content": "And probably the area of greatest emphasis is operational efficiencies as we centralize our operations activities and technology investments we've made to really improve the effectiveness and efficiency in how we deliver our products and services. So that will continue to be a focus and a lens for us, and that's -- those are the actions we're taking."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Ebrahim Poonawala with Bank of America."
},
{
"speaker": "Ebrahim Poonawala",
"content": "I guess maybe just following up on NII, John, if we could drill a little bit into it. One, the securities yield went down 1 basis point sequentially. Just could you remind us of the dynamic, both in terms of the security book and fixed rate asset repricing that we should be mindful of going forward?"
},
{
"speaker": "",
"content": "And then noninterest-bearing deposits, I think, saw a big surge at the end of the quarter. Again, what's the right way to think about NIB balances and mix as we look forward?"
},
{
"speaker": "John Stern",
"content": "Sure. So maybe I'll start with your first question on the securities yield. It was relatively flat or down 1 basis point, as you cited. This quarter was a little bit different. We had taken some hedging actions that actually offset some of the asset churn that we typically would see. And so I would view this as more of a temporary thing."
},
{
"speaker": "",
"content": "I would look -- as I look forward, the typical churn that you see in asset repricing of that book. As a reminder, it's about $3 million per quarter that is rolling off at the lower level and will replace. And so that's really going to be what we're looking at kind of going forward. So I'd just look at this as an anomaly."
},
{
"speaker": "",
"content": "On the deposit side, yes, we did -- I believe your question was on the surge in deposits. We did see a surge at the end of the quarter. There was a holiday in there, a lot of customers place balances with us. Very much temporary. A lot of those balances kind of hung on in and out here through tax season. And so we typically have that. It's just higher than what we would typically see for various reasons. And so we -- as we mentioned in our comments, we expect that to get to more seasonal levels."
},
{
"speaker": "",
"content": "And then just your follow-on was really on the noninterest-bearing side of things. It's continued to trend down on that mix of NIB versus total deposits. We're kind of in that 17% category right now. As we're in a higher for longer, it's possible that, that continues to drift lower just based on the dynamics that we're seeing in the marketplace."
},
{
"speaker": "Ebrahim Poonawala",
"content": "Got it. And I guess just separately around outlook for fee revenues. So your -- I think Andy addressed that in his prepared remarks, but give us a sense of any -- what areas you're seeing momentum on the fee revenue side. And whether there's any room for sort of upside surprise, if we get additional negative guide-downs on NII."
},
{
"speaker": "John Stern",
"content": "Yes, sure. So I mean, overall, we feel very -- we're pleased with the quarter 1 results. We saw good account growth. We're deepening relationships. We continue to see progress on Union and the growth opportunities that we see there. Consumer spending metrics, all the underlying metrics are strong, capital markets activities are strong. And that is supportive of our continued view on the single-digit growth on the fee aspect of things."
},
{
"speaker": "",
"content": "Areas that we see growth. We particularly have seen that in the capital markets space. We had an extremely strong fixed income capital markets activity. A lot of issuance that came to market and our franchise absolutely benefited from that. Mortgage has continued to be strong in terms of -- even though applications and production has been lower on a year-over-year basis, we're actually seeing much wider spreads just given the areas that we're focusing on. And that's just a constant theme of how we're focusing on more return on equity -- or higher returns overall."
},
{
"speaker": "",
"content": "And then the payments business continues to do well and be in line with our expectations. And so -- and that's just -- that helps us support the payments ecosystem that we have and all the initiatives and investments that we've made over time. So all that is very much coming together, and we feel very, very comfortable about our fee outlook."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of John McDonald with Autonomous Research."
},
{
"speaker": "John McDonald",
"content": "We're wondering about how are you thinking about the outlook for net charge-offs and provision and just kind of the credit trends you saw this quarter. John, you mentioned there was the one idiosyncratic commercial. Other than that, kind of what are you seeing? And are you still kind of thinking about a mid-50s kind of net charge-off outlook for this year? That would be helpful."
},
{
"speaker": "Terrance Dolan",
"content": "Yes, John, this is Terry. Let me take that question. So when we end up looking at credit, again, credit generally is pretty strong. I think that we're continuing to see in nonperforming assets that, that will continue to tick up and did tick up in the first quarter. It's primarily related to commercial real estate office space."
},
{
"speaker": "",
"content": "And I think when we think about kind of the rest of the year, probably in the second quarter, it's going to tick up a bit more. But then, that growth rate is going to really moderate quite a bit. The thing to keep in mind with respect to commercial real estate office space is we've aggressively reserved for that. We feel like we've adequately covered the loss content that's in that portfolio. So even though NPAs are likely to tick up, we don't see that as a real impact from a P&L standpoint."
},
{
"speaker": "",
"content": "From a charge-off point of view in the first quarter, that's principally driven by just credit cards. And our expectation is that, that will probably in the second quarter also come up. But then on a full year basis, the charge-off rate that we would expect in credit cards is probably going to move up a bit in the second quarter and then start to moderate downward again. On a full year basis, we would expect that charge-off rate to be pretty similar to the charge-off rate that we see in the first quarter of about 0.425%."
},
{
"speaker": "John McDonald",
"content": "Okay. Got it. And then for the overall company, kind of still kind of trending to that mid-50s perhaps on the charge-offs?"
},
{
"speaker": "Terrance Dolan",
"content": "Yes. I would say mid-50s, maybe closer to the 60 basis points. And again, I think that it's going to be a little bit lumpy because of just timing of commercial real estate charge-offs that will occur through the year. But again, we feel like we've adequately reserved for it."
},
{
"speaker": "John McDonald",
"content": "Got it. Okay. Great. And then, Andy, how are you thinking about the expense flex? You mentioned offsetting the NII. I guess, within reason, you're going to flex the expenses depending on the revenue environment plays out through the year?"
},
{
"speaker": "Andrew Cecere",
"content": "Yes, John. So it is an environment that it's always important to look at efficiencies, and we're -- that's something we're very focused on. And it is in those areas we talked about, we'll continue to flex where we see opportunities. We've centralized operations. We have other opportunities in spend. It's a company-wide initiative, and we'll continue to focus on that."
},
{
"speaker": "",
"content": "Again, importantly though, I want to tell you John, that we're still investing, but we're looking at operational efficiencies as we deliver our products and services while continuing investments because the investments we've made is helping us with the efficiencies on a go-forward basis."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Betsy Graseck with Morgan Stanley."
},
{
"speaker": "Andrew Cecere",
"content": "Welcome back, Betsy."
},
{
"speaker": "John Stern",
"content": "Welcome back, Betsy."
},
{
"speaker": "Betsy Graseck",
"content": "Thanks so much. So I had a follow-up on the comments around corporate behavior and the deposit shift from NIB. I want to understand two things. One is it should -- do you see your corporate deposits shifting from NIB to IB? Or is it more NIB to MMS?"
},
{
"speaker": "",
"content": "And then separately, typically, corporates are in NIB because it's compensating balances for other services. So as this shift is going on, does it suggest that we're going to see an uptick in, say for example, treasury services or any of the other fee lines?"
},
{
"speaker": "John Stern",
"content": "Betsy, it's John. Thanks for that. So in terms of the behavior, I think what we're seeing is the trends are slowing. The rotation is going, maybe first to answer your question, more from NIB into more IB. And it's more of the -- it's the trade-off for the client."
},
{
"speaker": "",
"content": "And what we're seeing really there is clients are just optimizing and being as -- just looking at their balance sheet, looking at their balances, especially in this higher rate environment. And now that they know it's going to be here for a longer period of time, they're taking a closer eye to it. We're just seeing that more and more. So the trends have been slowing, of that mix shift, it's just taking longer than what we would have anticipated."
},
{
"speaker": "",
"content": "So in terms of compensating balances, those are the things that are on a case-by-case basis with the clients. We look at the ECR rates that we pay and customers will then make decisions based on that. And so those are kind of the trade-offs that we see relative to that right now."
},
{
"speaker": "Betsy Graseck",
"content": "Okay. So treasury services potentially could see a little pop up in growth as how you pay for services changes? Or is that an overreach?"
},
{
"speaker": "John Stern",
"content": "It's possible. But again, the dynamic's pretty fluid is kind of how I would describe it."
},
{
"speaker": "Betsy Graseck",
"content": "Okay. And also folks are staying on your balance sheet as opposed to going off balance sheet into MMS?"
},
{
"speaker": "John Stern",
"content": "That's right. Yes. A lot of this is defending clients and making sure we're there for them. Again, we view this as a temporary phenomenon. This is just a timing thing. It's really just -- the churn here is continuing. It's just being -- the pace of it is taking a little bit longer for it to stabilize than what we would have anticipated. And that's really what's going on here. We want to make sure we're here for the long run for our clients and serving them as we kind of transition through this rate environment."
},
{
"speaker": "Betsy Graseck",
"content": "Got it. Okay. That's super helpful. And then just kind of 30,000-foot question here. Just could you help us understand how you are currently thinking about the asset sensitivity of U.S. Bancorp at this stage? How should we think about what higher for longer means for you for the whole organization?"
},
{
"speaker": "John Stern",
"content": "Yes, sure. So I think in terms of asset sensitivity from a risk management perspective, we are as neutral as you can be. We've taken a lot of different actions to make sure -- because we just don't know where the rate environment is. I mean, it was 7 cuts at the beginning of the year, the market had. Now it's closer to 0. So we just want to make sure we are prepared for different type of rate environments. And so I think as we think about the asset sensitivity, that is really how we're positioning ourselves."
},
{
"speaker": "",
"content": "As we think about higher for longer and what that means, the drivers there are going to be clearly deposit betas and rate and paid and all that sort of thing may creep up. The offset to that is we're going to have asset churn on the loan side as well as the investment portfolio side. And over time, those things will offset and turn ultimately in our favor. But it's going to be that timing that's really going to matter in terms of what do those things move and shift over time."
},
{
"speaker": "Andrew Cecere",
"content": "So Betsy, as John said -- this is Andy. We've tried to narrow the corridor of volatility given the uncertainty in the outlook. And so we are about as neutral as we can be given all the puts and takes John talked about."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Ken Usdin of Jefferies."
},
{
"speaker": "Kenneth Usdin",
"content": "If I could ask a couple of questions on the fee side. One, can we just talk a little bit through the payments businesses? It looks like the overall year-over-year growth rate was 4%. I think you're aspiring for upper single digits. It looks like corporate was down year-over-year and maybe the rate in merchant slowed a little bit. So can you just talk us through some of those dynamics and then how you'd expect that traject going forward?"
},
{
"speaker": "John Stern",
"content": "Sure. Yes. I think -- thanks, Ken. I appreciate that. We can look at -- maybe I'll take them in order. Merchant was kind of in that 4% area, as you mentioned, on the fee side of things. On that side, this quarter, we saw travel being a little bit down, but the other underlying metrics really have strong growth. We saw our tech-led initiatives really continue to propel very nicely. We saw high single digit for virtually other -- all the other categories in that space. So we think that travel is just kind of a short-term nature thing here, and we're well positioned and continue to feel good about high single digits there."
},
{
"speaker": "",
"content": "On the corporate side -- the corporate payment side, as you mentioned, that is -- it was negative over this year-over-year basis, but we are lapping the freight weight that has happened over the past year and that will really churn. There might be a little bit more than that in the second quarter. But we see strong momentum as we look -- again, the fundamentals of business spend and things like that are continuing to be in case. So we feel good about high single digits."
},
{
"speaker": "",
"content": "And then on the card side, really strong fee growth, good spreads, payment rates -- payment, spend trends constructive for how we're thinking about it. So all that -- we feel good about all the underlying trends from a payment standpoint."
},
{
"speaker": "Kenneth Usdin",
"content": "Okay. Got it. And then just in terms of some of the other lines, corporate services and mortgage did a lot better. I think you mentioned DCM and corporate and better gain on sale. Just wondering, are those both sustainable? Or was there any pull-forward on both of those areas this quarter?"
},
{
"speaker": "John Stern",
"content": "I think it is. I think the underlying strength maybe had a little bit of positivity here in the first quarter. But underlying all that, I think the gain on sale in the markets that we're playing is legitimate. Even though the market has been slower from an application standpoint, a production standpoint, it's still kind of double digit, almost 20% down from year-over-year. So there's just -- there's a lot of -- the volumes are lower, but the spreads are wider, and we anticipate that to continue going forward."
},
{
"speaker": "Kenneth Usdin",
"content": "Okay. Great. And last cleanup one. Just the ATM business, it didn't look like service charges changed. Did that close at -- and I know it's not a net profit. I know it's neutral net profit, but can you just update us on that?"
},
{
"speaker": "John Stern",
"content": "Yes. There was some of that in this quarter, and so they'll kind of fully run off here in the second quarter."
},
{
"speaker": "Kenneth Usdin",
"content": "With an offsetting cost?"
},
{
"speaker": "John Stern",
"content": "Yes."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Mike Mayo with Wells Fargo."
},
{
"speaker": "Michael Mayo",
"content": "Another one on net interest income. Andy used the word temporary in your opening remarks when talking about either the decline or the worst guide. And I didn't know what you meant by temporary."
},
{
"speaker": "Andrew Cecere",
"content": "So what we're saying, Mike, is that this pressure that, as John described, we believe, is going to dissipate and has dissipated. It's just dissipating slower than we thought. And we expect a relatively stable into the second quarter and then growth in the back half of '24. So that's what I meant by temporary."
},
{
"speaker": "Michael Mayo",
"content": "Do you have any expectations for 2025 and where the floor is for noninterest-bearing deposits? Or any other color?"
},
{
"speaker": "Andrew Cecere",
"content": "So I would expect that '25 would continue the momentum that we see in the second half of '24. We're not going to give a '25 guide right now because it's so volatile in terms of what rates could be. But importantly, Mike, we see the second half of '24, even in a lower rate cut environment and higher for longer, to start to go up."
},
{
"speaker": "Michael Mayo",
"content": "And I know I've asked this before, but it still applies, I think. So the big picture here is you got $900 million of savings from the Union Bank acquisition. So that's good for the expenses. The revenues you highlighted in your slide, business banking is up 1/3 over 3 years in terms of revenues. And relationships, you have mortgage, you have capital markets, you have payments. The revenues are working, the expenses are working. And then we look at the efficiency ratio for this quarter and the core number is like around 62% for a company that for so long had an efficiency ratio under 60%."
},
{
"speaker": "",
"content": "Now I know you're investing a lot nationally. We heard that at the BAAB conference, but it's just like when do you get under 60%? And I get the NII effect that distorts things, but you do have some peers that are under 60% now. So how should we think about efficiency at U.S. Bancorp?"
},
{
"speaker": "Andrew Cecere",
"content": "Yes, Mike, that's why we're pulling these expense levers and looking at continuing to create efficiency. So I feel very positive about our fee categories. We have a diversified set of businesses, a lot of businesses that other banks don't have, like payments and commercial products, fund services, corporate trust, that helps us drive fee revenue. That's the strength that we talked about, that 7.7%. There are some headwinds on margin for the industry and for ourselves. We'll get past those headwinds, and we'll continue to operate efficiently and look for expense levers to get that efficiency ratio downward, and that's an objective of ours."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of John Pancari with Evercore."
},
{
"speaker": "John Pancari",
"content": "On the deposit growth in the quarter, the surge in growth you saw at the end of period, can you maybe size up the impact that was more seasonal and more tied to the holiday dynamic and how much that could pull back?"
},
{
"speaker": "",
"content": "And then separately, also on the -- on your NII commentary, you did mention the competitive landscape shifting. Is that just regarding the deposit mix and pricing? Or are you also seeing some competitive dynamic impacting you on the loan front?"
},
{
"speaker": "John Stern",
"content": "John, thanks. Maybe to answer your second question first. It's more of the deposit mix and rate paid. It's not necessarily the loan side. I think actually on the loan side, we see -- even though loans are soft at this point, we do see decent momentum on the commercial side. We saw good period-end growth there. Spreads are good. The asset churn is positive all there. I think it's just -- again, it's back on the deposit side of things in the mix."
},
{
"speaker": "",
"content": "And I would say even on the mix, I would say on the commercial side, it's just a rotational thing. The rates environment really hasn't changed in the commercial side. On the retail side, sometimes rates go up, sometimes down, depending on geography and market and all those sorts of things. But we're competitive there, and we want to make sure that we're growing, and we have been growing. We've been growing consumer deposits, as we mentioned."
},
{
"speaker": "",
"content": "Back on your first question on the deposit surge. It's probably in the area of $15 billion to $20 billion that we received. We get a lot of inflow at the end of the quarter as people prepare for outflowing payments, end of the month type payments as -- or first of the month as well as fifth of the month. And then sometimes they just hold it all the way through the tax season. That's exactly what we've seen here, is that you get this kind of surge up at the end of the quarter. It holds for the duration through tax day and then it starts to wind down. Kind of -- that's been very seasonal. It's just a bigger number than what we had typically seen."
},
{
"speaker": "John Pancari",
"content": "Okay. And then separately, on the expense efforts where you're taking a closer look, and you mentioned some of the areas, are those measures that you've taken fully reflected in that updated expense outlook of $16.8 billion for the year? Or could your efforts drive a somewhat lower number as you evaluate the opportunity?"
},
{
"speaker": "Andrew Cecere",
"content": "So John, they're reflected in the efforts. That's why we brought it down to $200 million. And in the note, you'll see that's $16.8 billion at least. So we could pull additional levers as we continue to focus on this, but it is reflected in the guidance."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Vivek Juneja with JPMorgan."
},
{
"speaker": "Vivek Juneja",
"content": "Just want to probe, Andy, a comment that you expect net interest income to go up in the second half of '24. Could you talk a little bit about what you see as the drivers of that?"
},
{
"speaker": "Andrew Cecere",
"content": "I'm going to let John start, and I'll add on."
},
{
"speaker": "John Stern",
"content": "Yes. The driver is really, Vivek, as we talked about the -- it comes down to the deposit side of things really first and foremost. And again, we're seeing the migration and rotation slow. It's just -- again, it's just taking some time. So eventually, as that goes, that will stabilize. And then you're going to have the asset -- continual asset churn on both loans as well as investment portfolio, things like that."
},
{
"speaker": "",
"content": "I would also say that we've taken a lot of action to enhance return on equity. We're looking at capital-efficient ways to grow that. Those underlying themes continue, the Union growth opportunities that we see, and loan spreads have been favorable. So those are kind of the reasons that we see a positive nature and bend to the interest income that Andy talked about."
},
{
"speaker": "Andrew Cecere",
"content": "So as John said, it's the repricing of loans, the expectation of stabilization of the flow of deposits and the securities portfolio churn that we talked about."
},
{
"speaker": "Vivek Juneja",
"content": "And the hedge that you did, which you said was an anomaly this quarter, could you talk a little bit about that? Was that for -- that's not going to have an ongoing impact? Was that just something that you put on for capital protection? Or what was it?"
},
{
"speaker": "John Stern",
"content": "Sure. Yes. So it really was more to get our asset sensitivity to be -- continue to be neutral. So those are actions that we took kind of as a onetime matter. So it's in the rate and go forward. That's why I kind of -- I called it as a temporary measure here in this quarter. Going forward, again, the driver here in investment portfolio is the $3 billion or so that's rolling off at lower yields and will be replaced at now current higher interest rates."
},
{
"speaker": "Vivek Juneja",
"content": "Got it. Because you already said you were neutral, so that's what I was trying to understand, what sort of change to make that you had to do to make it go to neutral."
},
{
"speaker": "John Stern",
"content": "Yes. Those are part of the actions that we take to get neutral. And those are the things that the team looks at on a frequent basis. We're actively managing that on a daily basis. We're looking at markets, we're taking actions, and this is just the result of that."
},
{
"speaker": "Vivek Juneja",
"content": "Okay. And is that what? Just received fixed swaps you added or terminated? Or what did you do?"
},
{
"speaker": "John Stern",
"content": "Well, specifically, they were just -- they were pay-fixed swaps that we had terminated. They were shorter-dated in nature, but it reduced the yield because the pay-fixed carry was -- had been gone. But that just neutralized our interest rate sensitivity."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Gerard Cassidy with RBC Capital Markets."
},
{
"speaker": "Gerard Cassidy",
"content": "John and Andy, can you share with us -- obviously, you had a nice move up and your CET1 ratio is now at 10%. And we all know the Basel III endgame is coming. Nobody knows for certain when that final proposal will be in place. But it seems like, for the category 2 and 3 banks, that the unrealized securities losses will be carried through regulatory capital, which is not the case today, of course."
},
{
"speaker": "",
"content": "So with that as a backdrop, can you update us on where you want that CET1 ratio? And historically, you guys have been so good at giving back 75% to 80% of your annual earnings in dividends and buybacks. And when do you think we could possibly get back on that kind of track?"
},
{
"speaker": "John Stern",
"content": "Sure, Gerard. I'll start. First of all, just to give an update on the unrealized loss. So from a positive standpoint, part of the hedging and activities that we do that I just talked about in prior questions really help here because we had -- even though rates were up 30, 40 basis points throughout the quarter, our AOCI was fairly neutral. So the impact to the AOCI from the investment portfolio in pension right now is about 220 basis points versus the 10.0% that we have on common equity Tier 1."
},
{
"speaker": "",
"content": "You're right. The Basel III endgame and all those sorts of things. That, along with, I would call CCAR results, for us, are two important milestones we need to see before we make any grand declarations on what our capital ratios will be going forward."
},
{
"speaker": "",
"content": "In the meantime, we'll continue to build our capital levels. And what we'll also do is focus on our returns. Obviously, the dividend is a large priority. Additional priority is investing in the company. And so we're pausing on share repurchases at this time as we build the capital. Over time, that will normalize back to kind of where we were. But this is kind of that transitional period that we're in."
},
{
"speaker": "Gerard Cassidy",
"content": "Very good. And coming back to -- stepping back for a moment. Now the Union Bank, I assume is fully integrated. Obviously, that has been your focus since that acquisition. Can you share with us your thoughts about de novo expansion? You had that expand down in the Charlotte area. Is there more to come now that, again, the acquisition is behind you? What's your thoughts there as you look out over the next 12 to 24 months?"
},
{
"speaker": "Andrew Cecere",
"content": "Yes, Gerard, we're focused on building our core customer base and deepening the relationships with the customers we have through those set of products and services that we offer. We have -- we do that through a number of mechanisms. One of them is through our branch system. One of them is through our relationship managers and working together. And that de novo effort is doing well. We also have partnerships with State Farm which increase our distribution base."
},
{
"speaker": "",
"content": "So we'll continue to look at all those levers, but the bottom line is that we continue to focus on more customers, deeper relationships across the diverse set of businesses that we have. And a lot of the opportunity, Gerard, is providing more services to customers who already are customers of U.S. Bank could benefit from some of the other products and services that we offer."
},
{
"speaker": "Gerard Cassidy",
"content": "And Andy, just a quick follow-up on the deepening the customer relationship that you just identified. When it comes to your middle market commercial or your core commercial account, if they only have a loan relationship versus one of your preferred accounts that have multiple relationships, that deepening you just mentioned, what kind of profit differential would you estimate there is between a customer that only has a loan versus your customer that has multiple products?"
},
{
"speaker": "Andrew Cecere",
"content": "It's significantly higher. The more relationships, the higher the return, the more revenue, certainly. So if they have a loan only versus a loan plus deposit, plus treasury management, plus commercial products, plus payments, it all adds up."
},
{
"speaker": "Gerard Cassidy",
"content": "Yes. No, I agree."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Your next question comes from Matt O'Connor with Deutsche Bank."
},
{
"speaker": "Matthew O'Connor",
"content": "There's obviously a lot of puts and takes, like as you think about the net interest margin over time. But we've seen a number of banks put out kind of this medium-term NIM target. And wondering if you have any thoughts on what a more sustainable NIM is for you guys. You talked about the securities kind of cash flowing $3 billion. I don't know if there's any kind of underwater swaps that are chunky and roll off. But I guess the question is, what do you think about NIM kind of medium term versus where you are right now?"
},
{
"speaker": "John Stern",
"content": "Yes. I'll start here. Matt, in terms of the net interest margin, it's going to obviously track net interest income over time, but it may bounce around. Some of the drivers of that, obviously, could be some of the things you just mentioned, the asset churn on the investment portfolio, the creep and -- on deposit costs and things like that. The cash levels and liquidity mix and things of that variety can also drive it as well. So we don't really have a call or a base of here's where our net interest margin. We're more focused on net interest income."
},
{
"speaker": "Matthew O'Connor",
"content": "And then are there any -- again, the securities book, you're pretty clear on the cash flow there, and I think that's fairly long duration from a cash flow perspective. Any swaps that we should be mindful of that could go either way, looking out the next couple of years?"
},
{
"speaker": "John Stern",
"content": "I'm sorry, Matt, I didn't..."
},
{
"speaker": "Andrew Cecere",
"content": "Swaps. So again -- go ahead."
},
{
"speaker": "John Stern",
"content": "The swap activity that we have. Yes. So just as a -- our hedging -- while we're very active in our hedging activities, we -- there's really no fundamental change. We continue to focus on pay-fixed swaps that have -- that hedge the investment portfolio. Obviously, we took some off that impacted, but it's a temporary thing. We still have well over 30% -- or well over 1/3 actually, of our risk hedged on the securities book."
},
{
"speaker": "",
"content": "And then we have been adding receive-fixed swaps as well. Some of that spot, some of that forward-starting, depending on the nature. As the curve has come up here, and the curve has flattened and higher, that's an excellent opportunity for us to add some protection for the downside if and when that does occur. And all that adds up to be kind of that net neutral interest rate risk position that we're in."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Saul Martinez with HSBC."
},
{
"speaker": "Saul Martinez",
"content": "I guess another one on NII. Your guidance does assume modest reacceleration of NII in the back end. I think the second half NII is, at the midpoint, 2% higher than the first half. But what's embedded in -- can you be more specific about what's embedded in the through the cycle deposit beta assumption?"
},
{
"speaker": "",
"content": "And John, you mentioned noninterest-bearing could continue to move down a little bit from 17%. How far could -- what's your best guess now as to how much more deposit migration and where that ultimately could land at? And what's sort of embedded in the guidance for those measures?"
},
{
"speaker": "John Stern",
"content": "Sure, Saul. It's John. So on the beta side specifically, that has continued to slow. I think we're only up 1 or 2 points here this quarter, and was 3 the prior quarter. So it clearly has slowed. And as I mentioned, deposit rates in the commercial side are very flat. They have not changed. Retail bounces around a little bit, but we're going to be competitive and follow the market there, of course. But all in, it's -- if you're higher for longer, it's going to -- it may creep up 1 point here or 2, but we feel like the low 50s is probably the right place for it, for that to be as we kind of look forward."
},
{
"speaker": "Saul Martinez",
"content": "Okay. And in terms of noninterest bearing, the total liability or total deposits, where does..."
},
{
"speaker": "John Stern",
"content": "Yes. I think that -- I think -- yes, as I mentioned a little bit on the noninterest-bearing side, we're at about 17%. It's -- customers are being more efficient and things like that. It could go down a couple of points as we stay a little bit lower -- at this higher-for-longer type period."
},
{
"speaker": "Saul Martinez",
"content": "Okay. Great. And I guess a follow-up on -- just a clarification on the deposits surge, your response to an earlier question on the deposit surge, Forgive me if I missed this, but the $15 billion to $20 billion surge, that's a normal surge in noninterest-bearing deposits? But I guess the question is, what's sort of the incremental to the normal surge? What was incremental this quarter to what you normally see? I'm just trying to get a base on which to forecast noninterest-bearing deposits going forward."
},
{
"speaker": "John Stern",
"content": "Sure. So in terms of the surge, the surge in absolute terms was like it was about $20 billion or so. It's probably $10 or so billion above and beyond what we typically see for this type of the quarter."
},
{
"speaker": "Operator",
"content": "Your next question comes from Mike Mayo with Wells Fargo."
},
{
"speaker": "Michael Mayo",
"content": "Just kind of still a cleanup on NII. Just in very simple terms, if you're neutral to rates, why the guide lower for NII? I just want to make sure I have that rate. Did something happen that you didn't expect? Or you weren't fully neutral before this quarter?"
},
{
"speaker": "John Stern",
"content": "Yes. Sure. Mike, it's John. So the -- yes, we are neutral, to answer your question, to shocks to interest rates. I think what we're explaining is the behavioral aspect of it, which sometimes can be a little more challenging to judge at that point in time. And so again, it's a little bit -- the pace of rotation is a little bit. It's slowing down, just not as much as what we had anticipated. So again, rate shocks moving up and down, we continue to feel very good from a neutral standpoint. It's just that behavioral aspect that we've been talking about here."
},
{
"speaker": "Michael Mayo",
"content": "And do you have a number for fixed asset repricing, say, through the end of next year? Because I think that's what's driving your higher guide for the second half of this year and into next year. So you've talked about $3 billion of securities. But by the end of next year, how much do you have in fixed assets that should reprice? Do you have like one grand number for that?"
},
{
"speaker": "John Stern",
"content": "Well, I think the way I would think about it is about half of our loan book is fixed rate component. The other half is floating rate component and spreads are widening. So you can see some of the floating rate components perhaps improve over time. We're seeing decent growth in payments -- or excuse me, credit card. And so some of the mix is also working at play here. And so commercial loans are coming on. They're coming on at wider spreads. So that's kind of how I think about that from a big picture perspective."
},
{
"speaker": "Michael Mayo",
"content": "And then last one, loan spreads. I mean for a while there, it looked like we're headed into the recession and loan spreads were not widening. Now it looks like we're not having a recession and you have tight spreads in the capital markets and loan spreads are widening. I just -- why are loan spreads widening now? I guess that would be an incremental positive."
},
{
"speaker": "John Stern",
"content": "Yes. So I think it's just different markets. So I think some of the drag you're seeing in the commercial volume side is capital markets. Spreads have been -- and the access has been very good. We saw that reflected in our fixed income capital market fees and things of that variety. And so -- but I think that has taken away volume to a certain extent. In other areas where access to capital markets isn't as pronounced, I would say there has been a decent opportunity for spreads there."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Ebrahim Poonawala with Bank of America."
},
{
"speaker": "Ebrahim Poonawala",
"content": "John, just a quick follow-up to make sure we get this right. The surge deposits that came in, I think you mentioned you expect about $15 billion to leave. Am I -- is all of that going out of noninterest-bearing? So the $91 billion number, does that go into the mid-70s as we think about the second quarter?"
},
{
"speaker": "John Stern",
"content": "Some of this is temporary. So the surge that happens, it can be a mix of both money market as well as NIB. It may surge the NIB for a brief period of time, but it's not going to be material to the quarter. So even though -- so the surge that we've been talking about can be a mix of both."
},
{
"speaker": "Ebrahim Poonawala",
"content": "Mix of both. And so you do expect, just from a very -- dollar balance standpoint, NIB staying north of $80 billion. Is that fair?"
},
{
"speaker": "John Stern",
"content": "Yes. I would expect, as we said, the rotation is continuing. So I wouldn't expect growth necessarily in DDA, but deposits overall, we do expect it to basically be stable."
},
{
"speaker": "Ebrahim Poonawala",
"content": "And just a separate question. Given all these questions on NII, I think, would love to hear the degree of conservatism baked into your NII outlook. Because I guess the concern you're hearing is whether we see another downward guide 3 months from now. And yes, so in terms of what would go wrong in order for us to see another guide down on NII and for you to be surprised?"
},
{
"speaker": "John Stern",
"content": "Yes, Ebrahim, I don't look at it as conservative or aggressive. It's just the range. It's just the range that we provided, just given the uncertainty that's just in the market given all the factors that we've talked about here today."
},
{
"speaker": "Operator",
"content": "There are no further questions at this time. Mr. Andersen, I turn the call back over to you."
},
{
"speaker": "George Andersen",
"content": "Thank you for listening to our earnings call. Please contact the Investor Relations department if you have any follow-up questions."
},
{
"speaker": "Operator",
"content": "Thank you. This concludes today's conference call. You may now disconnect."
}
] |
v | 2,024 | 4 | [
{
"speaker": "Operator",
"content": "Welcome to Visa's Fiscal Fourth Quarter and Full Year 2024 Earnings Conference Call. All participants are in a listen-only mode until the question-and-answer session. Today's conference is being recorded. [Operator Instructions] I would now like to turn the conference over to your host, Ms. Jennifer Como, Senior Vice President and Global Head of Investor Relations. Ms. Como, you may begin."
},
{
"speaker": "Jennifer Como",
"content": "Thank you. Good afternoon, everyone, and welcome to Visa's fiscal fourth quarter and full year 2024 earnings call. Joining us today are Ryan McInerney, Visa's Chief Executive Officer; and Chris Suh, Visa's Chief Financial Officer. This call is being webcast on the Investor Relations section of our website at investor.visa.com. A replay will be archived on our site for 30 days. A slide deck containing financial and statistical highlights have been posted on our IR website. Let me also remind you that this presentation includes forward-looking statements. These statements are not guarantees of future performance, and our actual results could differ materially as the result of many factors. Additional information concerning those factors is available in our most recent annual report on Form 10-K and any subsequent reports on Forms 10-Q and 8-K, which you can find on the SEC's website and the Investor Relations section of our website. Our comments today regarding our financial results will reflect revenue on a GAAP basis and all other results on a non-GAAP nominal basis unless otherwise noted. The related GAAP measures and reconciliation are available in today's earnings release and related materials available on our IR website. And with that, let me turn the call over to Ryan."
},
{
"speaker": "Ryan McInerney",
"content": "Good afternoon, everyone. Thank you for joining us. Our fourth quarter results were very strong with $9.6 billion in net revenue, up 12% year-over-year and EPS up 16%. Our key business drivers were relatively stable compared to Q3. In constant dollars, overall payments volume grew 8% year-over-year, U.S. payments volume grew 5% and international payments volume grew 10%. Cross-border volume, excluding intra-Europe, rose 13%, and processed transactions grew 10% year-over-year. As I reflect on this quarter and the full fiscal year, I am incredibly proud of the more than 31,000 Visa employees who have been focused on delivering our strategy and enabling our clients with compelling solutions, which resulted in the company's strong performance. We have continued to grow our consumer payments business through an intense focus on product design and innovation. In new flows, our targeted strategy for non-consumer payments is paying off. And in value-added services, we have deepened our relationships with our clients through multiple different solutions and continue to expand our services to non-Visa transactions. We have done all this while further increasing our suite of solutions. Now let's dive into some of the highlights for the fourth quarter and the year. In consumer payments, we continued to increase credentials and acceptance. We have over 4.6 billion credentials, up 7% year-over-year and 11.5 billion tokens with more than 30% of our total transactions tokenized. Global merchant locations crossed 150 million. The Olympics and Paralympics certainly helped, with more than 7 million Paris 2024 branded cards issued and more than 130,000 merchant locations added in Europe. And I am particularly excited about new acceptance use cases. For example, we renewed an agreement with Canelo, a leading provider of self-service commerce across sectors such as food and beverage automated retail with over 1 million active devices globally and more than 1 billion transactions annually. And in the Netherlands, we reached an agreement with the country's largest grocer, Albert Heijn to expand in-store acceptance to all Visa products. We also recently renewed our agreement with AppFolio in the U.S. for rental payments acceptance. AppFolio is one of the largest software providers in the property management space and services 8 million-plus units across more than 20,000 clients. Throughout the year, we have continued to innovate in order to expand Visa's capabilities to non-card payments. This quarter, we announced Visa A2A, bringing the power of Visa's brand, infrastructure, and rules as well as consumer protections to enable simpler, safer and more secure account-to-account payments. We are excited to be collaborating with several banks, including NatWest and Nationwide Building Society and several leading fintechs, including Modulr to deliver an industry-driven solution to unlock the full potential of account-to-account transactions in the UK. And Visa A2A is open, open to any eligible bank, open banking provider, and verified biller. Initially, this is targeted at bill payments and we plan to launch in 2025 in the UK. We are very excited to bring this to market. In prior quarters, I've mentioned our account-to-account fraud risk scoring solution, Visa Protect for A2A payments. It was recently announced as Juniper Research's Platinum Winner for Fraud and Security Innovation of the Year Award, and we will be piloting on 10 new RTP networks in 2025. We're also seeing very strong interest in our new Flexible Credential, which enables multiple payment options from one Visa credential. We have hundreds of issuers in the pipeline and several launches planned for 2025 in the U.S., Asia Pacific, Europe, and CEMEA. Last quarter, I mentioned the expansion of tapping use cases on a mobile device. Tap to add card is now enabled by issuers in more than 15 countries across our 5 regions. We know that transit is a key activator for tapping and global tap-to-ride transactions exceeded 2 billion for the first time in fiscal year 2024, up 25% year-over-year. We added more than 110 new transit systems throughout the year in cities such as Boston, Athens, Beijing, Las Vegas, and Lima to total over 870 globally. And more than 40% of these new systems also use our value-added services acceptance solutions. Tap to Pay penetration globally, excluding the U.S., was at 82%, up 6 points from 2023. And in the U.S., it was at 54%, up 13 points from last year with 29 out of the top 30 U.S. merchants accepting Tap to Pay. Now pivoting to some deal highlights. We had some significant renewals this quarter around the globe: first, with one of our largest clients in Latin America, Grupo Promerica in credit, debit, and commercial across 8 countries; second, with our largest Asia Pacific client, SMCC across consumer and commercial credit; third, with our largest CEMEA client, Al Rajhi across consumer, commercial, and value-added services, including CyberSource and Visa Risk Manager, our network-agnostic risk product; and across both Asia Pacific and CEMEA, with Standard Chartered Bank, a credit renewal across key markets in Asia, a debit renewal with key markets in Africa as well as a new expansion in the Middle East for credit. In addition, they will continue to use our value-added services. In North America, we had three very important renewals: in Canada, we renewed our relationship with the country's top issuer, RBC across consumer credit and debit, small business credit, and commercial credit; in the U.S., we recently extended our long-standing partnership with US Bank to grow our relationship across their consumer and commercial portfolios. And we have renewed with USAA across both their consumer debit and credit portfolios. Finally, in Europe, building upon our strong relationship in Italy and across 11 other markets, we are pleased to have renewed the strategic agreement with Intesa Sanpaolo, expanding our collaboration in Italy with the largest bank in the country for innovative solutions amongst businesses and consumers. In addition, together, we will enable new value-added services for their Visa customers. Across all of our regions and all of our fintech partners from early stage to mature, we signed over 650 commercial partnerships, up 30% from last year. As you can see, we have continued to grow our businesses through active engagement with our clients and a relentless focus on new product innovations. Now moving to new flows, where our targeted strategy for capturing newer areas of growth is paying off. This quarter, new flows revenue grew 22% year-over-year in constant dollars. Visa Direct transactions grew 38% for the quarter to 2.8 billion, and commercial volumes grew 5% year-over-year. We finished the year with almost 10 billion Visa Direct transactions and $1.7 trillion in commercial payments volume. Commercial credentials grew at 18% year-over-year, significantly faster than the 7% growth for total credentials that I mentioned earlier. We are very focused on growing B2B in new verticals such as travel. We are pleased to announce that we signed a virtual card issuing deal with JPMorgan Chase in Europe. This is a significant opportunity for Visa to further build on our strong issuing relationship in North America as well as further grow in the B2B travel vertical. Additionally, in Europe, we will be partnering with Adyen so that they can offer online travel agencies, or OTAs, Visa virtual cards as part of their B2B travel solution. Another area of focus is the cross-border B2B space, where we offer significant value for complex payments through both card and Visa B2B Connect. For Visa B2B Connect, we increased the number of banks that have signed on by almost 40% year-over-year, and the number of transacting banks is up nearly 60%. In Korea, we reached two agreements with Hana Card. The first is a commercial and consumer credit and debit issuance partnership, with enhanced multicurrency capabilities targeted towards the cross-border needs of its customers. The second is an agreement with Hana Card and the Government Trade Agency, KOTRA, so that small business exporters can receive cross-border B2B payments via card. In Canada, we are very pleased to have won the multicurrency credit issuance with fintech Loop, a cross-border banking platform for Canadian-based SMBs. In addition, our cross-border capabilities through Currencycloud will provide FX solutions across accounts, digital wallets and international payments. In Australia, we reached a multicurrency commercial debit agreement with OFX, a leading global money transfer company that offers foreign exchange services, international payment, and spend management controls. Now moving to Visa Direct, where we have continued to grow through new and expanded relationships. In Europe, we expanded our existing cross-border P2P partnership with Revolut to now allow real-time card transfers for their business customers via the Visa Direct platform in over 78 countries supporting over 50 currencies. In the U.S., we are excited about an expanded partnership with DailyPay, whose users are currently accessing earnings on demand via Visa Direct to now seamlessly send those earnings as international remittances to friends and family around the world. In Brazil, we reached a new agreement with Travelex Banco de Cambio, one of the largest foreign exchange banks in the country and the first to specialize in FX operations regulated by the Central Bank. The client will use Visa Direct for import and export payments and for remittances to a broad range of destinations. So across our new flows, we have seen our specific strategies succeeding in the marketplace. And now on to value-added services, where revenue was up 22% in the fourth quarter and full year in constant dollars. Let's look at the progress we have made across our value-added services. In our issuing solutions, our core banking and issuer processing platform, Pismo has a good pipeline and its solutions are resonating with clients with nearly 12 billion API calls a month. Recently, Pismo renewed its agreement with Itau in Brazil. And in 2025, we plan to expand Pismo's offerings to clients in more than 5 countries across four regions. In Risk and Identity Solutions, we recently announced our intent to acquire Featurespace, a developer of real-time artificial intelligence payments protection technology. It will enable Visa to provide enhanced fraud prevention tools to our clients and protect consumers in real-time across various payment methods. And Worldline, already a Visa partner and leading European acquirer, will soon be launching an optimized fraud management solution, utilizing Decision Manager to provide businesses with AI-based e-commerce fraud detection capabilities. In acceptance, food delivery platform, Foodpanda, has been a long-standing CyberSource client in Asia across several markets. They will also soon be using our AI-powered data token solution, which we announced earlier this year, enabling customers to control how their data is used to experience tailored shopping experiences. In Advisory Services, Visa Consulting and Analytics delivered more than 3,000 consulting engagements during the year, and we estimate that we helped clients realize over $5 billion of incremental revenue as a result. So our value-added services have continued to show strong momentum across both Visa and non-Visa transactions and nonpayment value-added services. Before I close, I wanted to make a few comments on the recent lawsuit by the Department of Justice. We believe the lawsuit is meritless and shows a clear lack of understanding of the payments ecosystem in the United States. We will defend ourselves vigorously and are confident in our ability to demonstrate that Visa competes for every transaction in a thriving debit space that continues to grow and see new entrants. In closing, I am proud of our team and all that we have accomplished. We delivered on our financial expectations while also investing in Visa's future through important product innovation. Back at 2020 at our Investor Day, we set a goal for new flows and value-added services revenue to represent more than 30% of net revenue by the end of 2024. I am pleased to say that we have exceeded that goal. And we will be hosting another Investor Day on February 20, 2025, here in San Francisco when we can talk more about our strategy to continue growing value-added services, new flows, and consumer payments. I see tremendous opportunity ahead and feel confident in our plans to get us there. Now over to Chris."
},
{
"speaker": "Chris Suh",
"content": "Thanks, Ryan. Good afternoon, everyone. We closed the year with another strong quarter. In Q4, we saw relatively stable growth across payments volume, cross-border volume, and processed transactions when compared to Q3. In constant dollars, global payments volume was up 8% year-over-year and cross-border volume, excluding intra-Europe, was up 13% year-over-year. Processed transactions grew 10% year-over-year. Fiscal fourth quarter net revenue was up 12%, above our expectations, primarily due to lower-than-expected incentives, stronger-than-expected other revenue and FX being less of a drag than expected. Net revenue was also up 12% in constant dollars. EPS was up 16% year-over-year and 17% in constant dollars, higher than expected from the strong net revenue performance and a lower-than-expected tax rate. Let's go into the details. In the U.S., total payments volume grew 5% year-over-year, in line with Q3. Credit and debit also each grew 5%. Card-present volume grew 2% and card-not-present volume grew 6%. Consumer spend across all segments from low to high spend has remained relatively stable to Q3. Our data does not indicate any meaningful behavior change across consumer segments from last quarter. Moving to international markets. Total payments volume was up 10% in constant dollars, stable to Q3. In most major regions, payments volume year-over-year growth rates in constant dollars were strong for the quarter, with Latin America up 24%, CEMEA up 19%, and Europe up 12%. Asia Pacific payments volume saw a marginal improvement from Q3 in constant dollars for the quarter but was still less than 1% year-over-year growth, primarily due to the macroeconomic environment, most notably in Mainland China. Asia Pacific payments volume growth, excluding Mainland China, was relatively consistent to Q3. Now to cross-border volume, which I will speak to today in constant dollars and excluding intra-Europe transactions. Total cross-border volume was up 13% in Q4, below Q3, in line with our expectations. Q4 cross-border e-commerce measured as card-not-present volume, excluding travel and crypto purchases, grew 15%, which was faster than cross-border travel volume growth at 12%, in line with our expectations. Indexed to 2019, cross-border travel was relatively consistent with Q3. As we look at the travel corridors, the primary driver of the lower year-over-year cross-border travel volume growth was Asia Pacific inbound and outbound, which continued to be impacted by the same primary factors we've been mentioning all year: macroeconomic conditions, currency weakness, and flight bookings being below pre-COVID levels. We also saw a step-down in CEMEA outbound travel volume growth compared to Q3 due to Ramadan timing. Normalized for this, the CEMEA growth was stable. Now let's review our fourth quarter financial results. I'll start with the revenue components. Service revenue grew 8% year-over-year versus the 7% growth in Q3 constant dollar payments volume due to mix and improving utilization of card benefits. Data processing revenue grew 8% versus 10% processed transaction growth primarily due to fees and penalties being lower than the prior year. International transaction revenue was up 9% versus the 13% increase in constant dollar cross-border volume, excluding intra-Europe, impacted by lapping higher currency volatility from last year, even with the average quarterly volatility being slightly higher in Q4 versus Q3. Other revenue grew 30%, primarily driven by strong marketing services revenue growth related to the Olympics, consulting and, to a lesser extent, pricing. Client incentives grew 6%. As expected, Q4 was the annual low point for year-over-year growth due to lapping significant renewals from the prior year. In addition, it was further lowered from some onetime adjustments due to client performance. While Ryan mentioned a significant amount of renewal activity in his remarks, the majority of that impact will begin in Q1 of '25. Now on to our three growth engines. Consumer payments revenue growth was driven by relatively stable payments volume, cross-border volume, and processed transaction growth. New flows revenue grew 22% year-over-year in constant dollars, helped by a onetime rebate adjustment due to deal timing. Visa Direct transactions grew 38% year-over-year helped by growth in Latin America for interoperability among P2P apps. Commercial volume rose 5% year-over-year in constant dollars, below Q3, primarily due to days mix. Value-added services revenue grew 22% in constant dollars to $2.4 billion, led by strong growth in marketing services and consulting and issuing solutions. Operating expenses grew 11%, led by increases in marketing and personnel expenses. FX was a minimal drag instead of the 0.5 point benefit we had expected. Our acquisition of Pismo represented an approximately 0.5 point drag as well. Non-operating income was $69 million. Our tax rate was 16.5% due to an update in our tax position across jurisdictions. EPS was $2.71, up 16% over last year, with an approximately 1 point drag from exchange rates and an approximately 0.5 point drag from Pismo. In Q4, we bought back approximately $5.8 billion in stock and distributed over $1 billion in dividends to our stockholders. We also funded the litigation escrow account by $1.5 billion, which has the same effect as a stock buyback. At the end of September, we had $13.1 billion remaining in our buyback authorization. As we closed out fiscal 2024 and readied for fiscal 2025, I reflected on our full year performance relative to what we had expected at the start of the year. With the strong Q4, full year net revenue grew 10%, in line with our expectations, and EPS grew 15%, above our expectations, a testament to Visa's diversified business model. Volatility started strong in Q1 but then declined and remained at lower-than-expected levels throughout most of the year. For incentives, we anticipated year-over-year growth will be lower than fiscal 2023 due primarily to smaller impacts from renewals in fiscal 2024. The growth rate ended up being even lower than we expected due to client performance adjustments and deal timing. On the business driver front, processed transactions grew 10% as expected. Payments volume grew 8% in constant dollars, below expectations due to a combination of weakness in Asia Pacific, as we have discussed, and in the U.S. from ticket size not improving as expected and, to a lesser extent, from the Reg II impact. Total cross-border volume growth, excluding intra-Europe, was 15% in constant dollars, generally in line with our original expectations, though the growth in cross-border travel volume was lower, primarily due to Asia Pacific travel and card-not-present excluding travel volume growth, performed better than we expected. As we've seen this year, volumes and transactions can swing quarter-to-quarter. As these drivers fluctuate, we work carefully to manage our business to deliver on our expectations. So as we thought about our budget and guidance philosophy going into fiscal 2025, it's largely the same approach and represents our best view based on today. So let's get into the guidance details and a quick note. When I reference 2024 and 2025, I'm referring to our fiscal years. As we regularly say, we are not economic forecasters so we're assuming the macroeconomic environment stays generally where it is today. As such, we expect payments volume and processed transaction growth to remain strong and generally in line with full year 2024 levels. For cross-border volumes, we expect the Q4 '24 trend to generally continue with card-not-present excluding travel volume growing slightly more than travel volume. Now let's cover our underlying assumptions for net revenue growth. First, volatility. We're expecting that the full year currency volatility levels are roughly in line with the Q4 '24 average, which implies that volatility will no longer be a drag starting with Q2 '25. Next, pricing. We will continue to price to value in 2025 with the pricing impact being generally the same as 2024. However, the cadence is expected to be different as we expect the vast majority of the incremental pricing impact will take effect in April versus being more balanced between October and April as it was in 2024. On incentives, first, there were a significant amount of renewals in Ryan's remarks that will be impacting Q1 '25 incentives. In total, we expect more than 20% of our payments volume to be impacted by renewals in 2025 compared to less than 15% that was impacted in 2024. Second, remember that in the first and second quarters of 2024, we called out client performance and deal timing as helping incentives. And in Q4, we had additional onetime performance adjustments. Adding this up, 2025 year-over-year incentives growth is expected to be significantly higher than 2024. We expect to close on Prosa and Featurespace in 2025, and when we do, we will update our estimates for the acquisition impacts. We pulled these assumptions together on an adjusted basis, defined as non-GAAP results in constant dollars and excluding acquisition impacts. You can review these disclosures in our earnings presentations for more detail. In 2025, we expect full year adjusted net revenue growth to be in the high single to low double digits, with incentives being the key driver of the difference between '24 and 2025. As always, revenue performance is sensitive to several factors so to the extent that there are deal delays or significant deal performance adjustments and or macro volatility and driver performance that is better than expected, adjusted net revenue growth would be on the higher end of the range. In terms of quarterly variability, we expect the second half revenue performance to be better than the first due to some of the dynamics I have spoken about, volatility, pricing and, to a lesser extent, incentives. Now moving to expenses. We currently expect to grow adjusted operating expense in the high single digit to low double digits as we continue to fund new flows and value-added services projects, our sales efforts and growth initiatives in specific countries. Non-operating income is expected to be between $150 million and $200 million as a result of lower interest rates. Our tax rate is expected to be between 18% and 18.5%. On capital return, the Board has declared an increase to our quarterly dividend by 13%, and we intend to return excess free cash flow to shareholders through buybacks. All this results in adjusted EPS growth to be in the high end of low double digits. Now moving to Q1. For the first three weeks of October through the 21st, with volume growth in constant dollars, U.S. payments volume was up 6%, with debit up 7% and credit up 6% year-over-year. Cross-border volume, excluding intra-Europe, grew 13% year-over-year. Processed transactions grew 11% year-over-year. Now to financial expectations. We expect Q1 adjusted net revenue growth in the high single digits. Three things to note when we look at the step-down in adjusted net revenue growth from the fourth quarter in 2024 to the first quarter in 2025. First, incentives. There are a number of factors impacting incentives, especially in Q1 and H1 so let me go through each part. As I mentioned earlier, Q4 incentives growth was even lower than expected, with the combined impact of the lapping of significant renewals in 2023 and the onetime adjustments due to client performance. As I also mentioned, in 2025, we expect a significantly higher amount of our payments volume to be impacted by renewals, approximately 20% compared to under 15% in 2024. This is a combination of the large amount of renewals in Q4 '24 that will go into effect plus the amount of renewals we expect in 2025. In addition, the timing of the deal terms in 2025 is such that we expect about 60% of the 2025 renewal volume to go into effect in Q1. Putting those all together, we expect a significant step-up in the dollar amount of incentives from Q4 of '24 to Q1 of '25. Second, the timing of pricing actions. As I mentioned, whereas in 2024, the pricing impact was similar quarter-to-quarter, this year, we expect less pricing impact in the first half than the back half with Q1 having the smallest impact. Third, other revenue. As we do not have a major event in Q1 like the Olympics or FIFA, we anticipate lower growth in consulting and marketing services-related revenue compared to Q4. We expect adjusted operating expense growth to be in the high single digit to low double digits. On a year-over-year basis, remember that the first quarter of 2024 had a lower operating expense growth rate, both from lapping FIFA-related expenses in 2023 and from the allocation of Olympic-related marketing spend to other quarters. Non-operating income is expected to be between $35 million and $45 million, and our tax rate is expected to be around 18.5%. This puts our first quarter adjusted EPS growth in the low double digits. As always, if the environment changes and there are events that impact our business, we will remain flexible and thoughtful on balancing short- and long-term considerations. As we are several weeks into fiscal 2025, Visa's underlying business continues to be healthy and the growth opportunities are significant. We look forward to discussing this and our long-term growth algorithm at the upcoming Investor Day. And now, Jennifer, I'll hand it back to you."
},
{
"speaker": "Jennifer Como",
"content": "Thanks, Chris. And with that, we're ready to take questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Our first question comes from Harshita Rawat from Bernstein. Please go ahead."
},
{
"speaker": "Harshita Rawat",
"content": "Good afternoon. Thank you for taking my question. A lot going on in the U.S. regulatory front with regards to the DoJ lawsuit, Reg II, MDL, CCA. Can you share your overall thoughts on the regulatory and litigation environment in the U.S.? And Chris, just as a follow-up, can you help us maybe size your revenue exposure to U.S. debit, both including as well as excluding Visa DPS? Thank you."
},
{
"speaker": "Ryan McInerney",
"content": "Yeah, thanks for the question. As you note, a lot going on not just in the U.S. but all over the world. I think regulators appropriately are looking at the payments ecosystem and want to ensure that there's fair competition, that there's multiple options, both for consumers and merchants. And that's a process of engagement that we have in the U.S. to your question, but also with regulators, elected officials all around the world. And we feel very good about our ability to manage through that complexity. We feel very good about the ability to continue to run and grow our business. And we feel very good about the ability to continue to innovate and to continue to serve our clients. In terms of revenue exposure, that's not something that we disclose as it relates to U.S. debit or other parts of the business like that. But in terms of our ability to compete, we feel really, really good about it."
},
{
"speaker": "Jennifer Como",
"content": "Next question?"
},
{
"speaker": "Operator",
"content": "Next, we'll go to the line of Ramsey El-Assal from Barclays. Please go ahead."
},
{
"speaker": "Ramsey El-Assal",
"content": "Hi. Can you give us your updated thoughts on the competitive environment, especially as it pertains to or specifically as it pertains to pay by bank? We're seeing Walmart move forward with a new product and chatter around some other offerings. We've seen these products in the past, but I'm just wondering if there's anything that sort of changed on the ground to make these a little more interesting for consumers. I know you guys are involved as well serving that part of the market now, so curious to get your comments."
},
{
"speaker": "Ryan McInerney",
"content": "Yeah, there's a lot going on with account-to-account payments in the U.S. and around the world as you know it as well. Pay by bank is not a new capability. It's not a new capability in the United States. It's not a new capability for Walmart. Actually, I think as of today, you can load three different bank accounts into your Walmart.com wallet to pay for things. And as you alluded to, they've also put some news out that they're going to have a new partnership that I think is going to further enhance that. We expect that account-to-account payments will continue to proliferate here and around the world. We think there's a lot that we can add in terms of value to account-to-account payments. I mentioned some of those things in my prepared remarks. But as I've talked about several times on this call, it's a very, very competitive environment in which we operate. But we feel very, very good about our products, our innovation, our ability to provide value to end users in terms of buyers and also sellers, and therefore, our ability to continue to grow the business."
},
{
"speaker": "Jennifer Como",
"content": "Next question?"
},
{
"speaker": "Operator",
"content": "Next, we'll go to the line of Sanjay Sakhrani from KBW. Please go ahead."
},
{
"speaker": "Sanjay Sakhrani",
"content": "Thank you. I had a question on commercial volumes. I know they decelerated in days mix. I'm just wondering what kind of growth rate we should expect on a go-forward basis. I mean -- and are there some macro impacts? Maybe just talk about that specifically."
},
{
"speaker": "Chris Suh",
"content": "Hi, Sanjay, this is Chris. Yeah, as you noted, we did see a days mix impact in Q4 with commercial volumes. But if I just back way up, we're excited about the opportunity in new flows. We're optimistic about the big opportunity ahead. And over time, we do anticipate that we'll see continued growth of commercial volumes ahead of consumer volumes over time."
},
{
"speaker": "Jennifer Como",
"content": "Next question?"
},
{
"speaker": "Operator",
"content": "Next, we'll go to the line of Paul Golding from Macquarie. Please go ahead."
},
{
"speaker": "Paul Golding",
"content": "Thanks so much. With the Featurespace acquisition in process, I just wanted to ask how you see AI playing into the business model. Do you see it more as driving VAS or incremental business model, uplift revenue or cost improvement? Or is it more of a competitive differentiator that will just keep you ahead of your competition? Thanks."
},
{
"speaker": "Ryan McInerney",
"content": "Yeah, thank you. In short, I see it as both but let me unpack a couple of things that you said. First, in terms of Featurespace, we're very excited about the opportunity to close on the Featurespace acquisition. As I travel around the world, financial crime, fraud is at the top of mind of clients, partners, regulators all around the world. And Featurespace is a world leader in providing AI-driven solutions to combat that fraud, to reduce that fraud, to enable our clients and partners to continue to serve their customers in a safe way. So we're very excited about that. As it relates more broadly to especially Generative AI at Visa, I see it really in two different buckets. The first is we are adopting it aggressively across our company to drive productivity. And we've seen some great results from everywhere to our engineering teams, to our accounting teams, to our sales teams, our client service teams. And we're still in the early stages of, I think, the very significant impact this will have on the productivity of our business. I also see it as a real differentiator to the products and services that we're putting in market. You've heard me talk about some of the new risk capabilities, risk management capabilities, for example, that we've deployed in the account-to-account space, which are all enabled with generative AI. You mentioned Featurespace. We've had some really good success in other parts of both our value-added services business and the broader consumer payments business as well. And we've got a product pipeline that is very heavily tilted towards some, we think, very exciting Generative AI capabilities that hopefully you'll hear more from us on soon. One of those I mentioned in my prepared remarks, which was the data token that we're starting to pilot with Foodpanda, which is 1 example of that."
},
{
"speaker": "Paul Golding",
"content": "Thank you."
},
{
"speaker": "Jennifer Como",
"content": "Next question."
},
{
"speaker": "Operator",
"content": "Next, we'll go to the line of Tien-Tsin Huang from JPMorgan. Please go ahead."
},
{
"speaker": "Tien-Tsin Huang",
"content": "Thank you. Just wanted to ask how growth in '25 might look different than '24 across consumer payments, new flows, and value-added services."
},
{
"speaker": "Chris Suh",
"content": "Hi, Tien-Tsin. This is Chris. So we don't guide by consumer payments, new flows, and value-added services. But let me just give you a little bit more color on how we think about the guide that we did give. At the highest level, we took the same approach to guidance as we did a year ago, which is really to provide guidance based on our best estimate of what we expect to happen throughout the year. And so if we take all our assumptions and those assumptions play out as we've articulated, we'd expect total revenue growth, adjusted net revenue growth to be in the middle of the range that we provided. And obviously, if those assumptions, those variables turn out to be better, that could push us to the high end of revenue growth, and vice versa if those assumptions turn out to be slightly worse. The key variables that I would call out are, there's three-- there's probably four here to talk about. So one is incentives. Our plan is based on our best estimate of renewals and deal activity. But as we saw in FY '24, those results can vary quarter-to-quarter with client performance and timing of deals, and lower growth could push revenue growth towards the upper end of the range. Two would be cross-border volumes. Higher or lower growth in cross-border volumes would also contribute toward higher or lower within that revenue range. Third would be volatility. We've assumed FY '25 full year on average to the levels that we saw in Q4, and any significant swing could impact revenue in '25. And of course, across all of it is the assumption on the macro economy. As we've always said, we're not forecasters of the economy. But in the event the U.S. -- in the U.S. or globally, if PC grows faster than currently forecasted, then we should also see stronger growth as well. And so all of these factors can play a role. We feel good about the plan that we shared here for the full year at the start of the year. And we'll obviously continue to update you as the year unfolds."
},
{
"speaker": "Jennifer Como",
"content": "Next question?"
},
{
"speaker": "Operator",
"content": "Next, we'll go to the line of Rayna Kumar from Oppenheimer. Please go ahead."
},
{
"speaker": "Rayna Kumar",
"content": "Good afternoon. Thanks for taking my question. Last week, the CFPB issued a final open banking rule for the U.S. Can you talk about what opportunities this could present for Visa from Tink's perspective and what potential headwinds that could create? Thank you."
},
{
"speaker": "Ryan McInerney",
"content": "My understanding is that the new rules that they, I guess, finalized are largely consistent with the CFPB's initial proposal. And we are strong advocates for consumers having more control and more access to the financial data but ensuring that it's in a safe and secure way. We're still evaluating all the details of the potential impacts from the more detailed regulations across the industry. But it goes without saying, our own capabilities will comply with the CFPB's rules as well as our clients' very high bar for security and privacy. Widening the aperture a little bit to the opportunities that it creates, I think in an environment that open banking is even more available in the United States, like it is in places like Europe, what we found is that the Visa brand can be a meaningful differentiator. The Visa brand can give confidence to end users and data providers, and that if we can bring our capabilities to market like we've done in Europe with Visa A2A, we can give more confidence to the whole ecosystem and help resolve a lot of the complexities that exist in open banking. So we remain excited about the opportunities to add value, especially in the U.S., where we're still in the pretty nascent stages of all this."
},
{
"speaker": "Jennifer Como",
"content": "Next question?"
},
{
"speaker": "Operator",
"content": "Next, we'll go to the line of Andrew Schmidt from Citi. Please go ahead."
},
{
"speaker": "Andrew Schmidt",
"content": "Hi, Ryan. Hi, Chris. Thanks for taking my questions this afternoon. I wanted to ask about value-add services growth. It's really good to see the consistency there. Maybe you could just talk about the predictability, and then maybe comment a little bit more on the planning process of how you sort of feed the engine and continue to drive that growth. I know there's an organic and inorganic components penetration aspects to this but if you could help unpack that. I know it's a lot of things in there but if you could help unpack that, it'd be great. Thanks so much."
},
{
"speaker": "Ryan McInerney",
"content": "We, too, are very excited about the consistent growth we've been able to deliver year after year with the value-added services businesses. And we deliver that through planning, sales planning, client planning, product road mapping, all the things that you would expect we do business by business, in the issuer solutions business, the acquirer solutions business, risk and advisory business, and so on and so forth. When you think about the opportunity, here's how I would encourage you to think about it, which is the same way we kind of plan to go to market. We deliver value-added services for Visa transactions. And these are offerings that are built to enable Visa to be the best way to pay and be paid market by market around the world. And we're continuing to invest to add new functionality to improve the payment success and the security on the network. So these are products and services like Visa Account Updater, the risk products that we talk a lot about like Visa Secure, the dispute tools that we deliver like Visa Resolve Online, the benefits that we offer. So that's kind of 1 component of the opportunity. The second part of the opportunity is services for non-Visa transactions. This is an area you've heard me and us talking a lot more about in recent quarters. This includes acceptance services like CyberSource, Authorize.net, Verifi, risk tools like Decision Manager, processing solutions like DPS, like Pismo, and again, these are all capabilities that we're bringing to market for our clients that add value for all different types of payment transactions. And then the third set of opportunities that we're going after are services beyond payments. This is a much broader category. It includes things like our consulting and analytics teams, our marketing services teams, open banking services such as Tink, we were talking about earlier in terms of their data aggregation solutions. We're now offering core banking platform services as part of the Pismo acquisition as well. So that hopefully gives you a sense of how we look at the opportunities, we look at the competitive sets, we build and deliver products, we build and deliver our sales motions and go-to-market and ultimately deliver the consistent growth that you referenced."
},
{
"speaker": "Jennifer Como",
"content": "Next question?"
},
{
"speaker": "Operator",
"content": "Next, we'll go to the line of Dave Koning from Baird. Please go ahead."
},
{
"speaker": "Dave Koning",
"content": "Hey, guys. Thank you. On the cross-border line, revenue growth was stable at 9% this quarter, same as last quarter, but reported volumes accelerated 1%. And I would think FX volatility was less bad so that probably helped a little bit, and mix seemed about the same. So I was wondering, is there anything else, any other little headwinds emerging there? What -- maybe what created the gap?"
},
{
"speaker": "Chris Suh",
"content": "Yeah, sure. So a couple of things. So as you pointed out, international revenue grew slower than total cross-border volumes. It really did have to do with the volatility. So Q4 volatility did improve from Q3 a bit but it was lower than the volatility that we saw last year. And secondly, the associated volume, the cross-border volume, 13% in Q4, as expected, but also lower than the volume growth that we saw in Q4 a year ago. And so when you combine those things that had impacted the differential that you see between volumes and revenue."
},
{
"speaker": "Jennifer Como",
"content": "Next question?"
},
{
"speaker": "Operator",
"content": "Next, we'll go to the line of Tim Chiodo from UBS. Please go ahead."
},
{
"speaker": "Tim Chiodo",
"content": "Great. Thank you for taking the question. So I wanted to dig into two specific aspects of value-added services, so first being DPS and the second being CyberSource. I believe those two combined make up a reasonably large portion of the transaction-based value-added services. I think the last disclosure on DPS was about $2.5 trillion in volume, and CyberSource is in the roughly $1 trillion. I was hoping you could give sort of relative growth rates relative to the rest of value-added services and maybe some updated stats if possible. Thanks."
},
{
"speaker": "Ryan McInerney",
"content": "Yeah, thanks for the question. We're super proud about the progress that we're making in DPS and CyberSource, DPS being primarily in the U.S. and CyberSource being a really at-scale global platform now. But we don't provide transaction volume growth or break out other metrics at that level of reporting. So I appreciate the interest. Sorry not to be able to provide any more detail."
},
{
"speaker": "Jennifer Como",
"content": "Next question?"
},
{
"speaker": "Operator",
"content": "Next, we'll go to the line of Bryan Keane from Deutsche Bank. Please go ahead."
},
{
"speaker": "Bryan Keane",
"content": "Hi, guys. Good afternoon. I wanted to ask about the pickup you've seen in October for volume growth, especially in debit. Looks like it's perked up a little bit to 7%. Anything you're seeing there in new wins or is that potentially a better economic environment driving that? And then just quickly, secondly, on the price to value, just the change in timing, what was the reason for the change? Why is the timing different this year?"
},
{
"speaker": "Chris Suh",
"content": "Sure. Okay, I'll start with your question about October and then I think Ryan will handle your second part of your question. So in terms of October, so as we've consistently said, three weeks don't make a trend. It was true in July when we started a little bit slower and then Q4 ended up being stable. And we think it's true now as we see a strong start to October. Now that said, here's a couple of things that we see in terms of relative strength between the month of October and how we ended Q4. Two things that I'd point to: one is days mix. So the growth in the month of September was lower due to days mix. Last year, September had an extra Friday and Saturday, which are two of the highest spend days of the week. And this September, that was replaced with a Sunday and Monday, which are two of the lower spend days. And so that had an impact on September growth. And then secondly, in the U.S., in addition to that days mix point, we are starting to lap the modest impact of Reg II that we started to talk about a year ago in Q1. And so those combined things are contributing to what we see as the start of October. But as we said, it's three weeks. Let's see how the quarter plays out."
},
{
"speaker": "Ryan McInerney",
"content": "Bryan, yeah, as you noted and we've said many times, we price to value. So when we price to value, we have to ship products. We have to ship services. We have to deliver solutions that are adding value and increasing value to our clients. And our product pipeline in 2025 is a bit more backloaded, especially as we bring some new and exciting products and services to the market, and so that really drives the difference in pricing cadence in 2025."
},
{
"speaker": "Jennifer Como",
"content": "Next question?"
},
{
"speaker": "Operator",
"content": "Next, we'll go to the line of Jason Kupferberg from Bank of America. Please go ahead."
},
{
"speaker": "Jason Kupferberg",
"content": "Thanks, guys. Just looking at the U.S. card-present volume growth, I think we've been in the 2% range here for the past two or three quarters. So wondering if you're expecting that to accelerate in fiscal '25. And Chris, can you just quantify what that favorable adjustment to Q4 new flows revenues were? Thank you."
},
{
"speaker": "Chris Suh",
"content": "Got it. Jason, you cut out a little bit at the end. What was the second part of your question, Jason?"
},
{
"speaker": "Jason Kupferberg",
"content": "That onetime helper to new flows revenue in Q4, if you could quantify that?"
},
{
"speaker": "Chris Suh",
"content": "Okay, got it. I'll start with the second one since you just asked it. Yeah, we feel great about the momentum of new flows. Q3 was 18%, now to 22% in Q4. As I said on the call though, Q4 was helped by this onetime rebate adjustment due to deal timing. So we had expected a client to earn a rebate, which was contingent on them achieving a milestone, and they didn't achieve it. So as such, we recorded a onetime adjustment to that rebate, which landed in Q4. And I think your first question was around card-present and just sort of volumes as we look forward into FY '25. And maybe that's why I'll go out, just broaden it a little bit and say, per our call, our overall assumptions on underlying drivers is that in '25, they remain relatively stable to the trends that we see, both for the full year on payment volume and payment transactions relative to '24 and then on cross-border to the trends that we see in Q4. And so they will remain relatively strong and healthy. And like I said, we'll continue to update you throughout the course of the year."
},
{
"speaker": "Jennifer Como",
"content": "Next question?"
},
{
"speaker": "Operator",
"content": "Next, we'll go to the line of Craig Maurer from FT Partners. Please go ahead."
},
{
"speaker": "Craig Maurer",
"content": "Hi, thanks everybody for taking my questions. I wanted to ask first, haven't asked in a long time about your thoughts on operating leverage, and you're growing expenses at a similar rate to revenue in the forecast for fiscal year '25. And going forward long term, is there a commitment to grow revenue faster than expenses or are we looking at limited operating leverage in the future? And secondly, considering the fiscal year '25 guide, what are your assumptions around APAC embedded in the guide? Do you need acceleration in China to achieve that or is it basically assuming the same steady no growth situation there? Thanks."
},
{
"speaker": "Ryan McInerney",
"content": "I'll take the first question and you can take the second question, Chris. On your first question, as I said on this call and earlier calls, we have an enormous set of opportunities that we're pursuing. And the way we're running the business day in and day out, quarter in and quarter out, year in and year out is we're going through the assessment of those opportunities, we're figuring out the product pipeline that we can deploy. We're looking at inorganic and organic opportunities. And we're putting together a plan that we think maximizes the long-term growth that we can deliver. That's the way we approach it. That's the way we think about it. And you see the results that we've delivered, and you heard what Chris's comments were in the guide for this year. So that's kind of where we are with that."
},
{
"speaker": "Chris Suh",
"content": "I'll address your comments on AP specifically. So again, at a global basis, we expect overall trends to be relatively similar to where we're ending FY '24. And the situation in AP, so much of that has been driven by the macroeconomic conditions in China. And as we've consistently said, we don't forecast the economy. And so again, in the context of relatively stable drivers, we'll see how AP performs but again, it will really be dependent on the health of the overall economy."
},
{
"speaker": "Jennifer Como",
"content": "Next question."
},
{
"speaker": "Operator",
"content": "Next, we'll go to the line of Trevor Williams from Jefferies. Please go ahead."
},
{
"speaker": "Trevor Williams",
"content": "Great, thanks a lot. Yeah, I wanted to follow up on value-added services. I think the general framework you've given is roughly two thirds of VAS revenue is transaction-linked in some form. Of that portion that's tied to transactions or volume, how much of that today needs to be running over VisaNet for you to be earning those vast revenue streams? Ryan, it sounds like most of it today is still running over your network but maybe the off-network piece should be increasing as a percentage of the mix over time. But anything more specific there would be helpful. Thanks."
},
{
"speaker": "Ryan McInerney",
"content": "Yeah. I mean, the largest component of our VAS revenue today is that first bucket of services I mentioned for Visa transactions, and obviously, we've been doing that the longest time. And just to comment on that, what that really does is it drives additional yield on top of our Visa transactions. So we're adding more value to the transaction. We're adding more value to the clients and ultimately driving additional yield on top of the Visa payments volume growth that we see. But as I said, we also see -- we've made meaningful progress building out our platforms to service non-Visa transactions. CyberSource I mentioned, Verifi I mentioned, Pismo I mentioned, Decision Manager I mentioned. These are all becoming meaningful platforms for us with meaningful opportunity. And you can just imagine the TAM that we're able to go after when we're not just delivering services for Visa transactions but we're able to work with clients to deliver services on top of a much broader array of payment transactions is just significant. So we remain very excited about both."
},
{
"speaker": "Jennifer Como",
"content": "Last question, please."
},
{
"speaker": "Operator",
"content": "Our final question goes to the line of Darrin Peller from Wolfe Research. Please go ahead."
},
{
"speaker": "Darrin Peller",
"content": "Hey, thanks, guys. Look, just coming off of the, I think it was 12% growth in incentives and rebates in '24, and now you're saying obviously higher in '25. It's obviously great to see the activities [indiscernible] growth. Maybe just help us understand a little more around, you mentioned a lot of renewals but what about just net new business and market share gains. How does that build in? And I guess related to that, looks like this year is a big year of that constant revenue growth rate. So does that have an impact on how you think about this year's growth versus long term? We think it could be actually even better this year being a little bit of an outlying year in terms of growth in incentives and rebates, if we're thinking about that correctly. Thanks, guys."
},
{
"speaker": "Ryan McInerney",
"content": "Yeah, Darrin, I mean, I don't think we're going to get into like the outer years but I'd say a couple of things. One is we're winning, like we're winning region by region and market by market around the world. You look at the size and sophistication of some of those names that I mentioned in my prepared remarks and I've mentioned for the last couple of quarters. We are winning and we feel really good about that market by market around the world. Second thing is, as we've also talked about in the past, we can't necessarily predict the time of when these renewals are going to happen, when a competitive situation is going to happen to our client. We have to be ready at any given time to give our best and hopefully, ultimately win. And as you were alluding to, there's been kind of a string of those recently and more of them this quarter that we're excited about. So we'll continue to deploy a great product. We'll continue to -- we've got a great team that I acknowledged during the prepared remarks that's serving these clients, which is ultimately a big reason they choose to both continue to do business with us and expand the business that they're doing with us, expand the consumer business, expand in the commercial business, expand into new flows, and we feel really good about it."
},
{
"speaker": "Jennifer Como",
"content": "And with that, we'd like to thank you for joining us today. If you have additional questions, please feel free to call or e-mail our Investor Relations team. Thanks again, and have a great day."
},
{
"speaker": "Operator",
"content": "Thank you, all, for participating in Visa's fiscal fourth quarter and full year 2024 earnings conference call. That concludes today's conference. You may disconnect at this time, and please enjoy the rest of your day."
}
] |
v | 2,024 | 3 | [
{
"speaker": "Operator",
"content": "Welcome to Visa's Fiscal Third Quarter 2024 Earnings Conference Call. [Operator Instructions] Today's conference is being recorded. [Operator Instructions] I would now like to turn the conference over to your host, Ms. Jennifer Como, Senior Vice President and Global Head of Investor Relations. Ms. Como, you may begin."
},
{
"speaker": "Jennifer Como",
"content": "Thank you. Good afternoon, everyone, and welcome to Visa's fiscal third quarter 2024 earnings call. Joining us today are Ryan McInerney, Visa's Chief Executive Officer; and Chris Suh, Visa's Chief Financial Officer. This call is being webcast on the Investor Relations section of our website at investor.visa.com. A replay will be archived on our site for 30 days. A slide deck containing financial and statistical highlights has been posted on our IR website. Let me also remind you that this presentation includes forward-looking statements. These statements are not guarantees of future performance, and our actual results could differ materially as a result of many factors. Additional information concerning those factors is available in our most recent annual report on Form 10-K and any subsequent reports on Forms 10-Q and 8-K, which you can find on the SEC's website and the Investor Relations section of our website. Our comments today regarding our financial results will reflect revenue on a GAAP basis and all other results on a non-GAAP nominal basis unless otherwise noted. The related GAAP measures and reconciliation are available in today's earnings release and related materials available on our IR website. And with that, let me turn the call over to Ryan."
},
{
"speaker": "Ryan McInerney",
"content": "Good afternoon, everyone. Thank you for joining us. We delivered strong third quarter results with $8.9 billion in net revenue, up 10% year-over-year, and EPS up 12%. Our key business drivers were relatively stable as compared to Q2, adjusted for leap year. In constant dollars, overall payments volume grew 7% year-over-year, U.S. payments volume grew 5%, and international payments volume grew 10%. Cross-border volume excluding intra-Europe, rose 14%, and processed transactions grew 10% year-over-year. We recently received the results from our annual Global Client Engagement Survey where Visa achieved a Global Net Promoter Score, or NPS, of 76, up three points from last year. We saw NPS increases across all of our client types, merchants, issuers, fintechs, and processors and across our regions, the results remain strong, with a notable 6-point NPS improvement in North America. I want to thank all of our 30,000 employees who helped deliver these fantastic results. And as I review some highlights from the quarter, you'll see how this focus on serving our clients by meeting their needs, innovating, and helping them grow is fueling our success across consumer payments, new flows, and value-added services. Let's start with consumer payments, where we see more than $20 trillion of opportunity to capture cash, check, ACH, domestic schemes and other forms of electronic payment. In our client engagement survey, our clients ranked our strategic partnership and our brand as two of the most important factors to our successful relationships. I'll share some examples of how each of these played out this quarter. In strategic partnerships, we are constantly seeking ways to add more value and grow together with our clients. We are pleased to have been named the Preferred Network Partner by Lloyds Banking Group, renewing our debit relationship and significantly expanding our relationship in credit, winning 10 million additional credit credentials across the Group's consumer and commercial business. Also in the U.K., NatWest has launched a new Visa Travel Reward credit card, following the signing of our partnership last year. They will also be utilizing many value-added services, including transaction controls and card benefits. On the European continent, we worked with Raiffeisen Bank International AG, a leading bank in several markets. And recently, in the Czech Republic and Romania, we renewed our commercial business and expanded our consumer debit and credit business totaling over two million potential new credentials. In Korea, we deepened our partnership with leading issuer KB Kookmin Card. Already a user of Visa Direct cross-border money movement and a Visa consumer and commercial issuer, they will grow their consumer credit and debit portfolios with Visa and use value-added services, including consulting and marketing services. In Peru, we extended our partnership with leading issuer, Banco de Credito de Peru, across consumer and commercial portfolios with plans to launch additional new flows offerings and value-added services. In the U.S., we extended our agreement with Wells Fargo. This will allow us to continue to support Wells Fargo's strategy to reinvent their credit business and provide additional growth by leveraging key Visa assets like consulting and Visa sponsorships such as FIFA and the Olympic and Paralympic Games. On the brand front, with the Olympic Games opening ceremony later this week, it is exciting to see the engagement with the Visa brand and activation across the world in marketing campaigns, cardholder experiences and Olympic and Paralympic-branded Visa issuance, which I am happy to report in Europe is at nearly six million cards compared to the five million number I quoted just last quarter. We have also added nearly 100,000 new merchant locations in France in advance of the event. Our brand also plays an important role in winning co-brand partnerships. In India, growing credit issuance and reaching affluent and cross-border consumers remain areas of focus. We are excited about the launch of a co-brand card with Adani One and ICICI Bank as India's first co-branded credit card with rich airport-linked benefits for their target base of 400 million customers through the Adani One platform. We also signed an agreement to launch a new co-brand card with Tata Digital, along with an Indian banking partner, building on the success of our existing credit co-brand relationship. This new co-brand offering consists of a multicurrency prepaid foreign exchange card that will target travelers from India, also benefiting from the rewards of the Tata Digital Super App, Tata Neu. Across seven countries in Latin America, we will work with Unicomer, a major retailer and financial services provider with numerous brands to deliver a co-brand credit card in addition to using CyberSource. And in CEMEA, we reached a de novo co-brand arrangement with BinDawood, a leading grocer in the Kingdom of Saudi Arabia with 88 outlets and over five million loyalty program members. On the travel side, we extended our relationship with Malaysia Airlines from a prepaid co-brand card targeting millennials and Gen Z customers to also launch a new co-brand credit card for the travel-minded affluent. And in the U.S., Turkish Airlines have chosen Visa to be their exclusive network partner for their new Miles and Smiles co-brand credit card. Our consumer payment strategy is focused on growing credentials as we are doing across all the partnerships I just mentioned and increasing acceptance locations. And wallets are a great example of where this comes together, where Visa can be a funding source, an embedded credential, and an accepted form of payment by wallet merchants. This increases the value proposition for wallet providers and their users. Two wallet highlights this quarter are in Peru and Vietnam. Yape is a Peruvian super app with more than 15 million users who already have a Visa credential that enables them to send money across P2P apps via Visa Direct. And just recently, they launched Tap to Phone functionality for their more than two million merchants to accept Visa. And in Vietnam, a country with approximately 50 million wallet users, the three leading digital wallets, MoMo, VNPAY, and ZaloPay are now enabling their users to utilize Visa cards as a funding source for transactions at over 500,000 QR acceptance points managed by these wallets. One additional area that we are very focused on is delivering simple, easy, and secure checkout experiences. Let me share a few recent examples. First, we are integrating Click to Pay and the Visa Payment Passkey Service, enabling a customer to authenticate themselves using biometrics. Already, we have hundreds of issuers enabled for passkeys in Europe and a number of issuers who represent more than 50% of our e-commerce payments volume in Europe piloting the solution. Second, we crossed 10 billion tokens this quarter, a significant milestone. And in 2023 alone, Visa tokens helped generate more than an estimated $40 billion in incremental e-commerce revenue for businesses globally and saved more than $600 million in fraud. Third is the ability to tap for more use cases on a mobile device. With tapping as one of the best in-person commerce experiences, we want to provide Visa users with more ways to tap, including Tap to Pay, tap to authenticate an identity, tap to add a card, or tap to send money to family or friends. And finally, this quarter, Tap to Pay grew four percentage points from last year to 80% of face-to-face transactions globally, excluding the U.S. In the U.S., we surpassed 50% and have 30 U.S. cities above 60% penetration. Now moving on to new flows. This quarter, new flows revenue grew 18% year-over-year in constant dollars with Visa Direct overall transactions growing 41% for the quarter to 2.6 billion and commercial volumes up 7% year-over-year in constant dollars. Let me provide some updates, starting with B2B, where we have focused on penetrating new verticals and delivering innovative products and solutions. In healthcare, we will work with AXA and Paysure to launch a commercial virtual card solution to simplify the claims processes for their customers worldwide. We have also expanded our virtual card acceptance with a key business services provider, Cintas, who offers uniform, safety, and fire protection services to over one million customers. Together with our partner, Billtrust, we will help Cintas streamline their payments, automate processes, and manage costs on Billtrust's Business Payments Network or BPN. We also just recently extended our long-standing BPN collaboration with Billtrust that connects suppliers and buyers to facilitate straight-through processing of virtual card payments with rich data that optimizes acceptance costs. Our products and solutions in B2B remain very important in winning and growing our business. One such solution is the enhanced B2B data that we can provide. In Brazil, together with Solero, a leading business financial management solution, we will provide issuers with enhanced visibility into small business spend by aggregating data across cards, bank accounts, boletos and more, enabling them to better manage their client relationships and offer compelling products. Another solution is Spend Clarity, which provides expense program management, including card issuance, controls, and reporting. Wells Fargo has white-labeled our solution called Wells One Expense Manager, which has now onboarded 6,000 corporate clients representing over one million users, providing access to their spend data. Now moving on to Visa Direct. We continued to grow our transactions through expanded and new relationships. Over the past year, total Visa Direct cross-border P2P transactions have nearly doubled, with Europe and CEMEA being the largest regions. In CEMEA, we are very excited to have renewed our Visa Direct relationship with fintech Monobank in addition to renewing their consumer and commercial credit, debit, and prepaid portfolios. In Asia Pacific, we are partnering with China Zhongsheng Bank on cross-border capabilities, including Visa Direct and Currencycloud, allowing the bank to support cross-border payments for their merchant clients. Canadian fintech Nuvei has extended its agreement with us for Visa Direct across all cross-border use cases in more than 30 countries for their merchant clients and recently became the first Visa Direct enabler in Colombia. We also executed our first global agreement with WorldRemit and Sendwave, enabling their customers to eventually send Visa Direct cross-border remittances from 50 countries to recipients in 130 countries. Quickly, a leading South Asian marketplace, has enabled Visa Direct cross-border remittance solutions for U.S. customers to send money to relatives and friends in India and the rest of South Asia. And in earned wage access, we reached an agreement with Weaver, a U.K.-based embedded finance provider. In addition to card issuance, they will be utilizing Visa Direct to enable Weaver's business clients to offer employee expense reimbursement, reward and recognition, and earned wage access. Earned wage access provider PayActiv, who serves 4,000 businesses has renewed its agreement with us and will enable Visa+ for payouts. Similarly, we expanded our relationship with enabler, Astra. In addition to domestic disbursements, Astra will now offer cross-border remittances, implement Visa+ to reach domestic wallets in the U.S., and expand to additional use cases, including payroll, earned wage access and marketplaces. Visa+ is still in the early stages but is fully rolled out and live for PayPal and Venmo users and more providers continue to join the platform. Wrapping up new flows, we also renewed an agreement with FIS, an important issuer processing partner to enable a suite of value-added services and new flows capabilities for their clients, including Visa Direct. And now on to value-added services, where revenue was up 23% in the third quarter in constant dollars. Let me highlight some of the progress we have made in driving adoption and growth among our value-added services portfolio. First in issuing solutions. One area of strong revenue growth this quarter was in card benefits, where we enable our clients to offer unique value propositions tailored to their customer base in travel, entertainment, restaurants, insurance and more. Strong issuance in premium cards across most of our regions has fueled this growth in the third quarter. For example, in Latin America, travel benefits have grown with over 370,000 unique visits to our Visa Infinite Airport Lounge in Brazil, representing customers from a number of leading issuers. In addition, since its launch in 2022, our Visa Infinite Fast Pass in Brazil, which allows cardholders to get through airport security more quickly, has screened over one million travelers. These are among the top five card benefits in Brazil and deliver value to customers, issuers and Visa. We continue to add more benefits like the recently launched partnership with OpenTable to offer eligible Visa cardholders access to coveted restaurant reservations and experiences in the U.S., with plans to expand into Canada and Mexico. In Acceptance Solutions, third quarter growth was driven by increasing utilization across both token and e-commerce-related services. In e-commerce, one such example is with iFood, the largest food delivery platform in Brazil who is utilizing our Verifi solution to help prevent disputes before they become chargebacks. In addition, they will be using our authentication solutions. In Risk & Identity Solutions, we continued to see strong adoption by new and existing clients, driven in part by growth in card-not-present transactions. In North America, acquirer Worldpay will be expanding their use of our authentication solutions from CardinalCommerce, fostering collaboration and real-time enhanced data exchange between Worldpay merchants and issuers during card-not-present transactions, reducing fraud and allowing more transactions to be properly authenticated and authorized securely. We are also pleased that the pilot of our account-to-account risk scoring solution Visa Protect with Pay.UK has had great results, showing an average 40% uplift in fraud detection over the 3-month pilot period. In addition, we are now launching Visa Protect in Argentina with a core payments technology company, Celsa after successfully piloting the solution there as well. The last two value-added services are open banking and advisory services. We continue to sign new partners with Tink in Europe and the U.S. And as I mentioned earlier, we continue to see strong growth in client demand for our consulting and marketing services, particularly around marquee events such as the Olympic and Paralympic Games. Our value-added services portfolio solutions is strong and is driving meaningful growth for our clients and for Visa. Before I close, I wanted to speak to the fact that the settlement reached for the injunctive relief class was rejected by the court. We are, of course, disappointed with this decision. We believe that the prior settlement provided meaningful relief to all merchants and we will continue to work towards another settlement. To close, so far this fiscal year, we have seen strong revenue and EPS growth as a result of relatively stable volume and transaction growth. I remain very excited about the opportunity that lies ahead of us. At Visa, we come to work in service of our clients and partners and are focused on building and deploying the best solutions possible across consumer payments, new flows, and value-added services. Now over to Chris."
},
{
"speaker": "Chris Suh",
"content": "Thanks, Ryan. Good afternoon, everyone. In Q3, we had another strong quarter with relatively stable growth across payments volume, cross-border volume, and processed transactions when compared to Q2, adjusted for leap year. In constant dollars, global payments volume was up 7% year-over-year and cross-border volumes, excluding intra-Europe, was up 14% year-over-year. Processed transactions grew 10% year-over-year. Fiscal third quarter net revenue was up 10% in both GAAP and constant dollars, in line with our expectations. EPS was up 12% year-over-year and 13% in constant dollars. Now let's go into the details. In the U.S., payment volumes growth numbers were generally in line with Q2 adjusted for leap year, with total Q3 payments volume growing 5% year-over-year, with credit and debit also growing 5%. Card-present volume grew 2% and card-not-present volume grew 7%. In the U.S., while growth in the high spend consumer segment remained stable compared to prior quarters, we saw a slight moderation in the lower spend consumer segment. Moving to international markets. Total payments volume was up 10% in constant dollars, relatively stable with Q2 when adjusted for leap year. Payments volume growth rates were strong for the quarter in most major regions, with Latin America, CEMEA, and Europe ex U.K. each growing more than 16% in constant dollars. Asia Pacific payments volume slowed to less than 0.5 point of year-over-year growth in constant dollars for the quarter, driven primarily by the macroeconomic environment, most notably in Mainland China. Now to cross-border volume, which I will speak to today in constant dollars and excluding intra-Europe transactions. Total cross-border volume was up 14% in Q3, relatively stable to Q2 adjusted for leap year. Cross-border card-not-present volume growth, excluding travel and adjusted for cryptocurrency purchases, was in the mid-teens, helped by continued strength in retail. Cross-border travel volume growth was also up in the mid-teens or 157% indexed to 2019. This quarter, we saw the inbound Asia Pacific Index improve nine points at a similar pace to Q2 to 151% of 2019. The improvement in Asia Pacific outbound travel, however, slowed from Q2 with the index increasing by less than one point to 125% of 2019. We continue to see the same primary drivers as last quarter with some additional pressure from macroeconomic conditions. Now let's review our third quarter financial results. I'll start with the revenue components. Service revenue grew 8% year-over-year versus the 8% growth in Q2 constant dollar payments volume, with revenue yield improving sequentially and versus last year due to improving utilization of card benefit. Data processing revenue grew 9% versus 10% processed transaction growth with the revenue yield generally in line sequentially and versus last year. International transaction revenue was up 9% versus the 14% increase in constant dollar cross-border volume, excluding intra-Europe, impacted by lapping higher currency volatility from last year. Volatility levels remain consistent on average to last quarter. Other revenue grew 31%, primarily driven by strong consulting and marketing services revenue related to the Olympics and, to a lesser extent, pricing. Client incentives grew 11%. Now on to our three growth engines. Consumer payments growth was driven by relatively stable payments volume, cross-border volume and processed transaction growth. New flows revenue grew 18% year-over-year in constant dollars. Visa Direct transactions grew 41% year-over-year, helped by growth in Latin America for interoperability among P2P apps. Commercial volumes rose 7% year-over-year in constant dollars. In Q3, value-added services revenue grew 23% in constant dollars to $2.2 billion, primarily driven by Issuing and Acceptance Solutions and Advisory Services. Operating expenses grew 14%, primarily due to increases in general and administrative personnel and marketing expenses, including spend related to the Olympics. FX was 0.5 point drag versus the 1.5 point benefit we expected. Pismo represented an approximately one point drag. Nonoperating income was $73 million. Our tax rate was 18.8% and EPS was $2.42, up 12% over last year, inclusive of an approximately 1.5 point drag from exchange rates and an approximately 0.5 point drag from Pismo. In Q3, we bought back approximately $4.8 billion in stock and distributed over $1 billion in dividends to our stockholders. At the end of June, we had $18.9 billion remaining in our buyback authorization. Now let's move to what we've seen so far in July through the 21st with volume growth in constant dollars. Cross-border is excluding intra-Europe. U.S. payments volume was up 4% with debit up 4% and credit up 3% year-over-year. The slight deceleration from Q3 does not appear to be from any one factor but likely a number of smaller factors such as weather, timing of promotional shopping events, and the technology outage, among others. Cross-border volume grew 13% year-over-year, below Q3 levels with travel-related volume growing slightly less, which continued to be impacted by Asia Pacific and card-not-present ex travel volume growing at similar levels to Q3. Processed transactions grew 9% year-over-year. Now on to our expectations. Remember that adjusted basis is defined as non-GAAP results in constant dollars and excludes acquisition impacts. You can review these disclosures in our earnings presentation for more detail. Let's start with the fourth quarter. We expect payments volume and processed transactions to grow at a similar rate to Q3. For total cross-border volume growth, we are expecting to end up slightly below Q3. Currency volatility continues to average around 4-year lows through July 21. And as such, we are making an adjustment to currency volatility expectations for Q4, now assuming volatility will stay in line with Q3 levels. Incentives are expected to be at their lowest growth rate all year. Pulling it all together, we expect adjusted net revenue growth in the low double digits, which equates to a slight improvement from the 10% adjusted revenue growth rate in the third quarter. We expect our Q4 adjusted operating expenses to grow in the high single digits. Nonoperating income is expected to be between $40 million and $50 million. The tax rate is expected to be between 19% and 19.5% in Q4, which puts Q4 adjusted EPS growth rate in the high end of low double digits. Moving to the full year. With three quarters now complete, our expectations for full year adjusted net revenue growth remains unchanged from what we shared at the start of the year. Whilst absorbing the impact of lower currency volatility and the macroeconomic challenges in Asia, which have affected volumes, we still expect to reach low double-digit adjusted net revenue growth for the full year. Full year adjusted operating expense growth will be in the high single digit to low double digits, reflecting the less favorable impact of FX. This keeps full year adjusted EPS growth in the low teens. In closing, we delivered strong results this quarter, with new flows and value added services revenue growing faster than consumer payments. We extended our existing relationships, one new clients and invested to develop innovative products and solutions, all positioning us for continued growth into the future. But now Jennifer, it's time for some Q&A."
},
{
"speaker": "Jennifer Como",
"content": "Thanks Chris. And with that, we're ready to take questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Our first question comes from Darrin Peller from Wolfe Research. Please go ahead."
},
{
"speaker": "Darrin Peller",
"content": "Hi, thanks guys. Look, let me just start. The U.S. volume growth rate obviously is a bit softer. And if you could help us distill what you consider structural versus cyclical, I think that'd be a good place to start. But adding on to it really is, just the ability for you to grow double-digit revenue with only four, five, six, mid-single-digit U.S. volume growth is, coming from value added services. It's coming from cross border. Can you help us understand if that kind of trend, you believe the company has that capability to grow those rates on revenues, even in this context of U.S. volume trends? Thanks guys."
},
{
"speaker": "Chris Suh",
"content": "Yes. Hi Darrin. So let me start with the U.S. Let me start with the first part of your question, and then we'll maybe get into zoom out and talk about maybe the longer question. So in the U.S. in Q3, we did see stable drivers relative to Q2, once you adjust for leap year. That's 5% payment volumes growth in the third quarter. In the 21 days since in July, that number did tick down to 4%. Maybe I'll just sort of give you the full arc of what we're seeing. So 4%, we'll just level set on those numbers, 4% in the 21 days versus 5% in Q3. And so for that, we did stare at a lot of the drivers, the factors that impacted those three weeks. And there was a lot going on and I referenced a few of them on the call and maybe I'll expand on those a bit. First, we had a major hurricane, Hurricane Beryl, and it impacted Texas and other parts of the U.S. nearby. The second, I referenced the timing of promotional e-commerce events. Maybe I can expand on that a little bit. The timing this year was later and then e-commerce customers are billed, when the goods are shipped. And so, some of that shipping periods fell out of that 21 period. So we had a little bit of difference in the 21 day period, to the comparable year ago. And third, obviously the major tech outage that happened at the end of last week, that also had some impact. So, when we look at that, no single factor drove that one point of change from Q3, to the first part of July. But all things considered, we actually feel pretty good about the three week results. Now the second part of your question really was around sort of the low double-digits in the context of cross-border, VAS and CMS. I'll sort of back into the question. We've had consistent strong performance in VAS, over $2 billion of revenue, over 20% growth for many quarters consecutively. And we're seeing strength across the business in issuing solutions and acceptance and advisory. That's a business that we feel great about the momentum in. With our new flows business, 18% growth, as Ryan talked about, in the quarter, that's the second quarter in a row, where we're seeing growth in the teens, great execution, stable volumes, and visa direct transactions growing at a high level. As you know, that business also, quarter-to-quarter, can vary a little bit in the growth rates, as we saw in the first half of the year. But all in all, feel really good about the continued strength in that business. And then cross-border, well, cross-border, maybe I'll just zoom out a little bit and talk about cross-border and what we've seen over the course of time. If you recall, pre-pandemic, cross-border grew, travel grew in the high single-digits to low double-digits. And e-commerce, which was about a third of the business, grew into the teens, sometimes into the mid-teens. Obviously, the pandemic happened, travel really contracted, e-commerce grew faster. And since then, now post-pandemic, what we're seeing now is that e-commerce is roughly 40% of the business. And the growth rate has normalized. It's stabilized back to pre-pandemic levels. And so let's say, teens growth on e-commerce on 40% of the cross-border business. Travel after the post-pandemic run-up has normalized. It's a little hard to tell exactly where it's going to stabilize at, but we've seen high growth. We've seen it continue to normalize. But what we do know structurally, is that with e-commerce being a bigger portion of the business, that's a tail into the total cross-border growth. And so, we are confident that that will continue to be healthy relative to the domestic spend. I'll pause there and certainly if there's anything else to add, Ryan, or others, please jump in."
},
{
"speaker": "Ryan McInerney",
"content": "No, nothing to add from me, Chris. Thanks, Darrin."
},
{
"speaker": "Jennifer Como",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "Next, we'll go to the line of Andrew Jeffrey from William Blair. Please go ahead."
},
{
"speaker": "Andrew Jeffrey",
"content": "Hi. Good afternoon. Appreciate you taking the question. Very impressive value-added services growth this quarter at 23%. And I think as you mentioned, Chris, it's approaching 25% of total revenue, so perhaps driving more than half your consolidated revenue growth. Can you talk a little bit about at what point we might expect value-added services to sort of bend up the growth curve of Visa consolidated?"
},
{
"speaker": "Ryan McInerney",
"content": "It's Ryan, Andrew. Thanks for the question. And yes, we're very excited about not only what we delivered, in terms of value-added services growth for the quarter. What we've been delivering consistently for several years now, since we shared with you all the strategy, and kind of became very purposeful about our go-to-market approach. I mean, you go back to I think it was 2021, we did about $5 billion in revenue, 2022, $6 billion. Last year was $7 billion. Like you said, we did $2.2 billion this quarter, up 23%. So I think what we've shown, is that we have delivered consistent growth quarter-after-quarter, and year-after-year in these businesses. And we're super optimistic about where we go from here. I mean, we think about the opportunities really in three different segments. The first is, we have a series of value-added services, some of which Chris outlined in his previous answer that, are very focused on enhancing value for Visa transactions. Risk products like Visa Secure, dispute tools like Visa Resolve Online, card benefits, like I mentioned in my prepared remarks. And we've - that has historically been the largest part of our value-added services business. And we've shown that we can drive great growth in that area. Increasingly, we're building out a set of services that add value for non-Visa transactions. We've done some things in this space before. Some of our platforms like CyberSource, Authorize.Net, Verifi. But then you've heard me talk in the last couple of quarters about expanding our risk capabilities. For example, to not just other card networks, but also to RFCP and account-to-account services. And I mentioned the great results we've had in both the U.K. and in Argentina on that front. And then the third area of opportunity for us, is expanding our value-added services beyond payments. Historically, we've had things like Visa Consulting and Analytics and our marketing services And some of the open banking services delivered by Tink, but we're continuing to build out a portfolio of value-added services, for our clients and partners beyond payments things like the cyber protection capabilities that we've been bringing to market. So, we've demonstrated consistent growth. We believe we'll be able to continue to demonstrate consistent growth. We've got a product pipeline, and a go-to-market approach all over the world with a diverse set of clients, and we feel good about the opportunity."
},
{
"speaker": "Jennifer Como",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "Next, we'll go to the line of Bryan Keane from Deutsche Bank. Please go ahead."
},
{
"speaker": "Bryan Keane",
"content": "Hi guys, good afternoon. Chris, just want to ask about incentives, being the lowest expectation will be for the fourth quarter. Can you just talk a little bit about how much of that is volume-driven, versus the amount of renewals you're seeing? And just trying to think about, as we head into next fiscal year, just what kind of growth or sustainable growth should we think about for incentives? Thanks."
},
{
"speaker": "Chris Suh",
"content": "Thanks for the question. I'll even take us back a little bit about the expectations that, we had for incentives coming into the fiscal year. As we ended fiscal '23, that was a high year for us in terms of volume of renewals, a little higher than our typical sort of normal cadence. That did impact how we thought about the incentive volumes in FY '24. And even last year, we had sort of a different growth rate in the first half and the second half of the year. And so as we looked across this year, we had a slightly lower volume of renewals this year. Obviously, year-to-date incentives have played out slightly differently, largely due to client performance, deal timing, things like that. And overall, it's been better than, as it's been lower, I guess, than what we anticipated. When we go into Q4, sort of the same trend applies. We still expect Q4 to benefit from the lapping of the high incentives that, we saw in the second half of last year, which informs, again, the growth rate that we anticipate in Q4. We don't have a lot to share about FY 2025 at this point, but we'll share plenty in the next earnings call."
},
{
"speaker": "Jennifer Como",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "Next, we'll go to the line of Ken Suchoski from Autonomous Research. Please go ahead."
},
{
"speaker": "Ken Suchoski",
"content": "Hi, good afternoon. Thanks for taking the question. I wanted to ask about VAS and I think the team has talked about, how some of the VAS revenue is correlated with transaction growth. But you also have parts of that business that are more recurring, or less recurring in nature. So can you just help us understand how, you think about the cyclicality of VAS, and how that business might perform in a lower volume growth environment? And I also think the team has talked about pricing, for value in VAS. So how much more room is left to go there? And how does that help with the resiliency of the business? Thank you."
},
{
"speaker": "Ryan McInerney",
"content": "Yes Ken, it's Ryan. On the second part of your question, our ability to price for value is a function of the value that we bring to the market, and we feel great about the value that we're bringing to the market. And I think you see it in our results. Across the various different areas of issuing solutions, Acceptance Solutions, Risk & Identity Solutions, Advisory. I mean, we just continue to bring products and services that are ultimately, helping our clients grow their business, helping our clients reduce fraud, grow authorizations, those types of things. And we believe we'll continue to do that, and we believe we'll be able to continue to price for value. As I think I was saying earlier, there is - the biggest portion of our value-added services, are a function of Visa transactions. And so obviously, Visa transactions, as they go up or down, have an impact on that, but so does our ability to sell more services. On previous calls, I've talked about the fact that we still have the majority of our clients that have yet to have the type of penetration and depth that, we've been able to achieve with others. So, as we continue to penetrate our clients, all around the world in the various markets that we deliver, as I was saying earlier, to the earlier question, I'm very optimistic about our ability to continue to grow this business as we have."
},
{
"speaker": "Jennifer Como",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "Next, we'll go to the line of Tien-Tsin Huang from JPMorgan. Please go ahead."
},
{
"speaker": "Tien-Tsin Huang",
"content": "Hi, thanks, good afternoon. Just curious if you're - if you've updated your U.S. outlook here in the second half, are you still expecting transaction sizes to accelerate in the U.S., especially in the fourth quarter?"
},
{
"speaker": "Chris Suh",
"content": "Hi, Tien-Tsin. Thanks for the question. Yes, we had forecasted ATS, as you know, growth to improve throughout the pace of this year from quarter-to-quarter, and we did see that. We saw ATS improve in the third quarter. Specifically in the U.S., ATS was slightly better in Q3 than in Q2. It got to basically flat year-over-year in Q3. We saw improvement in a number of categories, sequentially, restaurant, QSR fuel, telecom, utilities, insurance, to name a few. And we do anticipate in Q4 that we'll continue to see, slight improvement sequentially again. The one thing - the one watch out I'll call out is the fuel prices could impact that trajectory and so, we'll watch that closely. So yes, it is playing out as we anticipated. The pace is slightly varied from what we anticipated, but it is continuing to improve. And I think that's the important thing."
},
{
"speaker": "Jennifer Como",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "Next, we'll go to the line of Gus Gala from Monness, Crespi, Hardt. Please go ahead."
},
{
"speaker": "Gus Gala",
"content": "Hi, guys. Thank you. Can we talk a little bit about the contactless payments penetration? Can you maybe highlight maybe what the gap is in penetration rates, across maybe some of your older cardholders or young cardholders? Just trying to get around to what a terminal level of penetration could look like? Thanks."
},
{
"speaker": "Ryan McInerney",
"content": "You're asking - just so I heard, you're asking about Tap to Pay?"
},
{
"speaker": "Gus Gala",
"content": "Yes."
},
{
"speaker": "Ryan McInerney",
"content": "I mean, yes, maybe just back up first in the big picture of things. The fact that outside of the United States, eight out of 10 of all the Visa face-to-face transactions around the entire planet are Tap to Pay now, I mean, that just tells you right there that it's all segments, all demographics, all use cases, all product types. I mean, we're at 80% overall around the world. We've got, I think, more than 55 countries that are now more than 90% contactless penetration. So increasingly, in most countries for most customers, for most products all around the world, that's just the default way that people are paying. And in the U.S., the curve is maturing exactly how we'd expect it based on what we've seen in 100-plus countries all around the world. As I said in my prepared remarks, now one out of every two transactions in the U.S. are taps. In a place like New York City, where many of you on the call spend time, we're above 75% now. So in New York City, where - which is one of the early adopters of transit, we're above, I think, 75%-plus of all face-to-face transactions. That's up from just 50% two years ago. So again, at that level of penetration in a market the size of New York City, it's across the board in terms of products and issuers, and segments and the like. So, I think as we continue to see this growth happen, buyers, sellers, they love tapping as a way to pay. And we're going to continue to see that growth accelerate in a place like the U.S."
},
{
"speaker": "Jennifer Como",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "Next, we'll go to the line of Will Nance from Goldman Sachs. Please go ahead."
},
{
"speaker": "Will Nance",
"content": "Hi, guys. Thanks for taking the question. We've been getting a lot of questions around the litigation updates, and I totally understand the level of uncertainty is a lot higher now. But I guess the most common investor question that we're getting is, around the potential impacts to the overall ecosystem, if we see a much greater reduction in interchange rates from what was proposed. And I guess specifically how the production and interchange rates, could reverberate through renewal negotiations with issuers, and then longer term, how this may impact the trajectory of incentives and net yields. So just wondering if we could hear kind of your perspective, about the potential reduction, or a larger reduction in the overall size of sort of ecosystem revenue, and if that changes the direction of any of the key indicators that we're focused on over time? Thanks."
},
{
"speaker": "Ryan McInerney",
"content": "Hi, Will. Thanks for the question. And you're asking about the MDL litigation. I guess I'll just back up. The first thing I would say is we strongly disagree with the judge's decision. We believe the settlement was fair. We believe the settlement provided meaningful relief to all merchants. The second thing, I would say is the decision failed to take into consideration a number of things, especially the complex multisided ecosystem that we operate in. The role that - the complicated role that many different players in the ecosystem delivered. So, but having said that, we're pursuing a revised settlement. It's too early to speculate on what that settlement is. So I just - I won't do that today. But I would ask everybody to keep in mind, a settlement can occur at any point before, during, or even after the trial. So just keep that in mind as the process plays out."
},
{
"speaker": "Jennifer Como",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "Next, we'll go to the line of Timothy Chiodo from UBS. Please go ahead."
},
{
"speaker": "Timothy Chiodo",
"content": "Hi. Thanks for taking the question. I want to hit on that at the same time tackles, both incentives and value-added services revenue. So it's the concept of value in-kind incentives. I was hoping you could talk a little bit about whether or not, these are becoming more prominent, meaning you're using them a little bit more in discussions with issuers. And then, if you could just briefly recap some of the mechanics around the revenue recognition, the contra revenue, the addition to deferred revenue. And then eventually, the value-added services revenue? Thanks a lot."
},
{
"speaker": "Ryan McInerney",
"content": "Yes. I'll just give you the high level on this. The value in-kind is a great way for us to, as it says, to deliver value to our clients. And increasingly, our clients, as you see in our performance are preferring to buy our value-added services, versus just take incentives that might drop to the bottom line. So that is absolutely something that, our clients are asking for more of. It's something that is helping our clients grow their businesses. And I talked earlier about just the last several years about our product pipeline, how we've gone to market, how we built new products to solutions and services for our clients. And that's what's driving the demand. So that's kind of become a more important part of our client renewals and our client renewal discussions. And increasingly value-added services are becoming a way for us to differentiate ourselves with our clients, and grow our consumer payments business. Do you want to talk about the organics?"
},
{
"speaker": "Chris Suh",
"content": "Tim, to the second part of your question, maybe I'll just give you a high-level summary. I think you have sort of the pieces you called out. At a high level, when value in-kind is offered in lieu of a cash incentive, it can - it would be recognized as a contra revenue at the time that it's granted or earned, depending on the nature of the contract. And then on the other side, when the client is able to utilize that value in-kind for services from Visa, commonly in our value-added services business, that's then recognized as revenue and the associated costs are also recognized in our P&L."
},
{
"speaker": "Jennifer Como",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "Next, we'll go to the line of James Faucette from Morgan Stanley. Please go ahead."
},
{
"speaker": "James Faucette",
"content": "Great. Thank you very much. I wanted to just ask a follow-up question on near-term trends. We've seen a little bit of further slowing in credit than in debit over the last couple of months, and in the past has been a little bit of an indication of consumer stress. And I'm just wondering how you're thinking about that. And it seems like you're looking for the rest of the September quarter that, there's a little bit of a re-acceleration, as we get past some of the issues that you identified in July. Just want to make sure that I'm understanding that correctly, and kind of how we should interpret a little bit of the divergence in credit and debit growth right now? Thanks."
},
{
"speaker": "Ryan McInerney",
"content": "Let me just give a little context on it and then Chris, feel free to add or correct. Like Chris said, we're three weeks into the quarter. We had a hurricane. We had a tech outage across the country. We had a number of things happen. So, we're not kind of taking three weeks as a trend. We'll see kind of how things progress from here, in just terms kind of what happens for the rest of the quarter. I don't know if you want to talk about the credit-debit divergence."
},
{
"speaker": "Chris Suh",
"content": "Yes. Well, I think I'll refer back to a little bit of a comment that we made, and we're seeing the July results. I also commented on the call that we are seeing a little bit of moderation in what I would call the lower spend band cohorts. And I think that's a little bit correlated, to some of the volume numbers that we're seeing in the quarter, related to credit versus debit. But all in all, when we look at it relative to, again, Q2 and Q3, we see it to be relatively stable once you factor in sort of the days mix with the leap year."
},
{
"speaker": "Jennifer Como",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "Next, we'll go to the line of Bryan Bergin from TD Cowen. Please go ahead."
},
{
"speaker": "Bryan Bergin",
"content": "Hi, good afternoon. Thank you. Wanted to ask on new flows here. So you had a nice acceleration in growth really over the last two quarters on consistent comps. Can you add more color on the particular areas of strength that have picked up? I know Visa Direct was one of those. I'm just curious if you think you could sustain that level of expansion, or may that moderate a bit?"
},
{
"speaker": "Chris Suh",
"content": "Yes. Thanks for the question. 18% growth, as I mentioned, feel really good about the execution and the momentum in the business. It is an enormous opportunity that we have in front of us, across both our commercial business and money movement with Visa Direct. I think you're familiar with the numbers, 41% growth in the transactions and stable commercial volumes as well. I think what - this acceleration that you're referring to, we had a unique situation in Q1 where we had some onetime items that really kind of depressed the growth, reported growth in Q1. And if you look at the last couple of quarters, it's more reflective, I think, of the underlying health in the business. That said, as we saw in Q1, that growth rate can vary from quarter-to-quarter, based on deal timing and terms and one-time items like the one that impacted Q1. And so overall, I'd say at the macro level, good momentum. The underlying business is healthy, and we're continuing to see that level of growth. And the growth rate should be healthier, and should continue to grow faster than consumer payments, with some normal expected variability quarter-to-quarter."
},
{
"speaker": "Ryan McInerney",
"content": "And just to build on Chris' points, I think we're in the very early stages of Visa Direct growth. We spent many, many years investing and building the platform, the infrastructure, the connectivity, domestic cross-border, working with issuers and acquirers and processors. And now we're able to be out there selling all around the world, finding new use cases, some of which I highlighted in my prepared remarks. You go back to 2019, we did 2 billion Visa Direct transactions. We did 2.6 billion transactions this quarter. So this is just another great example of, when we go and we systematically identify the need in the market, we spend the time, we build the infrastructure. We build 8.5 billion end points, the connectivity, the reliability, the security, the fraud capabilities. I just think we're in the very early stages of what we're going to see, in terms of the growth of this business and the number of use cases and partners, many of which I highlighted in my prepared remarks that, are going to want to build their use cases on this platform."
},
{
"speaker": "Jennifer Como",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "Next, we'll go to the line of Sanjay Sakhrani from KBW. Please go ahead."
},
{
"speaker": "Sanjay Sakhrani",
"content": "Thank you. I guess most of my questions have been asked and answered. But just on that last point, Ryan, you were making, I'm just wondering, where are we in the evolution of yield there? Can those go higher as you continue to expand in some of those categories with Visa Direct? And then just in terms of Reg II, is the full impact of Reg II now in the run rate, or should we expect there be any uncertainties related to that? Thank you."
},
{
"speaker": "Ryan McInerney",
"content": "Yes. I'll take both of them. On the first one, we're still in the early evolution of the use cases. I mean, we weren't even talking about earned wage access a couple of years ago, Sanjay. And so as we've got - I think we've got 65 or so use cases now on the platform, our teams are finding new use cases all the time. So I think we're continuing to see the evolution of all of that and the economics of all that will play out. What I would point you back to, is what I mentioned in my prepared remarks, the tremendous success we're having in cross-border. We've had great success in selling new use cases, and driving cross-border transaction growth in Visa Direct. As you know, the yields are higher in cross-border, given the value that we add. So again, feel good about all of that. Listen, I want to just emphasize in terms of Reg II, the e-commerce debit market is a very competitive market, and is going to be competitive for as far as we can see. So while Chris noted, I think noted that the impact has remained the same, we haven't seen any change in impact, and I don't - and we're not expecting any change in impact for the fourth quarter. It is a competitive business. We are out there with clients day in and day out, helping them understand the benefits of processing transactions on Visa. And there are a lot of them, which is why we feel good so far in the evolution of Reg II, about how we've been able to grow that business. We feel great about the capabilities that a Visa data transaction offers, many of which I've talked about on these calls in the past. So we're out there, we're competing, we're selling, we're delivering our products, and we feel good about our win rate."
},
{
"speaker": "Jennifer Como",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "Next, we'll go to the line of Jason Kupferberg from Bank of America. Please go ahead."
},
{
"speaker": "Jason Kupferberg",
"content": "Thanks guys. So just a clarification on revenue, and then a question on volumes for this fiscal year. So it sounds like for Q4, you're looking for revenue growth of, call it, 11% to 12%. I think that would put you at the low end of the low double-digit guide, you're maintaining for the year. So that's what I wanted to clarify. And then just a question on volumes. I think you said Q4 should be in line with Q3, which I think would bring the full year to around 7%, versus the high single-digit updated guide last quarter. So just as we start to tune our models for next year, what are some of the potential accelerants off that 7% level we should be considering?"
},
{
"speaker": "Chris Suh",
"content": "Hi, Jason, let's unpack that. You had a couple of things in there, and I just want to - I think this is important, so we'll just be super clear. For Q4, my guidance, our guidance for our Q4 adjusted net revenue would be low double-digits. And sort of the directional guidance I also gave is it would be slightly above the Q3 level that we reported, which was the 10% growth in the quarter. And so sort of take that - take those two points and I would triangulate around that. And that would still get you sort of to the math of the low end of low double-digits, as you called it, for the full year. The second point was on drivers from Q3 to Q4. I did say that payment volume, payment transactions, we anticipate Q4 to be consistent with Q3. The one exception to that is in cross-border, where I did say it'd be slightly below the Q3 levels. And that really is based on the travel circumstances and situation in Asia that we've talked about extensively, with outbound travel in Asia, in particular, being impacted and recovering slower than we anticipated at the beginning of the year. And so, those are the two variables in terms of the - to get the Q4 guidance consistent with the intent - that I communicated. And then as far as FY '25 goes, we're at the beginning end of planning, and as we always do, we'll share our expectations on '25 at the end of Q4."
},
{
"speaker": "Jennifer Como",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "Next, we'll go to the line of Dan Perlin from RBC Capital Markets. Please go ahead."
},
{
"speaker": "Dan Perlin",
"content": "Thanks. I guess more of a big picture question here, Ryan. So your AI and gen AI investment, you've talked about, I think at conferences, your desire to kind of build out your own large language model. So I'm wondering, one, where do those investments stand today? I guess, two, what would be your expectation for early use cases of those investments, and kind of the payback period? And then three, is there an opportunity to drive, like true incremental sales, or better outcomes for your merchant constituents as opposed to just the banks? Thanks."
},
{
"speaker": "Ryan McInerney",
"content": "Yes. Hi, Dan, thanks for the question on AI. First of all, to frame it is, we are all in on gen AI at Visa as we've been all in on predictive AI, for more than a decade. We're applying it in two broad-based different ways. One is, sort of adopting across the company to drive productivity, and we're seeing real results there. We're seeing great results, great adoption, great productivity increases from technology, to accounting to sales all across the company. The second is applying generative AI to enhance the entire payment ecosystem. And to the latter part of your question, absolutely. I guess I'd give you one set of examples or some of the risk tools and capabilities that we've been deploying in the market. I mentioned the risk products that we're using on RTP and account-to-account payments. That is an opportunity to reduce fraud, both for merchants and for issuers. I think I mentioned on a previous call, we have our Visa Provisioning Intelligence Service, which is using artificial intelligence to help predict token provisioning fraud before it happens. That also is a benefit to both issuers and merchants. And the list goes on. So, we are very optimistic about the positive impact that generative AI can have, not just on our own productivity, but on our ability to help drive increased sales and lower fraud across the ecosystem."
},
{
"speaker": "Jennifer Como",
"content": "We'll do one more question, please."
},
{
"speaker": "Operator",
"content": "For our final question, we'll go to the line of Harshita Rawat from Bernstein. Please go ahead."
},
{
"speaker": "Harshita Rawat",
"content": "Good afternoon. Ryan, Chris U.S. card volume growth of 5% in surface kind of suggests a little bit more of a mature market. Now I understand the category differences between card volume growth and DC growth, which influence the delta here. Ryan, you discussed your global down estimate of $20 trillion in consumer payments for Visa. How should we think about, the secular digitization opportunity and the growth algorithm for the U.S., which is your biggest market? Thank you."
},
{
"speaker": "Ryan McInerney",
"content": "Okay. It was a little hard for us to hear you, Harshita, but I think I got the gist of your question around the growth algorithm for consumer payments, especially in mature markets. So as I've said before, we see more than $20 trillion of opportunity around the world. About a quarter of that is in the U.S., by the way. And that's cash, that's check, that's ACH, that's electronic transactions, that's cards that run on domestic networks and the like. And we're capturing that opportunity through a few different ways. One is continuing to expand acceptance and expand the places, where people can use cards. In the U.S., rent would be a great example. We've been having some really good success, penetrating the rent vertical. The second is making it easier to drive e-commerce growth and e-commerce transactions, which has an outsourced impact on our ability to drive growth on Visa, for those types of things. And third is just continuing to innovate with new products and services that, make our issuers want to issue Visa and consumers want to use them. We announced a full slate of new product innovations at our Visa Payments Forum this year. And those are the types of products that, we believe are going to help us win in the marketplace, and help us capture and digitize a big chunk of that opportunity on the Visa network."
},
{
"speaker": "Jennifer Como",
"content": "And with that, we'd like to thank you for joining us today. If you have any additional questions, please feel free to call or e-mail our Investor Relations team. Thanks again, and have a great day."
},
{
"speaker": "Operator",
"content": "Thank you, all, for participating in the Visa fiscal third quarter 2024 earnings conference call. That concludes today's conference. You may disconnect at this time, and please enjoy the rest of your day."
}
] |
v | 2,024 | 2 | [
{
"speaker": "Operator",
"content": "Welcome to Visa's Fiscal Second Quarter 2024 Earnings Conference Call. All participant lines are in a listen-only mode until the question-and-answer session. Today's conference is being recorded. If you object, you may disconnect at this time. I would now like to turn the call over to your host Ms. Jennifer Como, Senior Vice President and Global Head of Investor Relations. Ms. Como, you may begin."
},
{
"speaker": "Jennifer Como",
"content": "Thanks, Holly. Good afternoon, everyone, and welcome to Visa's fiscal second quarter 2024 earnings call. Joining us today are Ryan McInerney, Visa's Chief Executive Officer; and Chris Suh, Visa's Chief Financial Officer. This call is being webcast on the Investor Relations section of our website at investor.visa.com. A replay will be archived on our site for 30 days. A slide deck containing financial and statistical highlights has been posted on our IR website. Let me also remind you that this presentation includes forward-looking statements. These statements are not guarantees of future performance and our actual results could differ materially as a result of many factors. Additional information concerning those factors is available in our most recent annual report on Form 10-K and any subsequent reports on Forms 10-Q and 8-K, which you can find on the SEC's website and the Investor Relations section of our website. For non-GAAP financial information disclosed on this call, the related GAAP measures and reconciliation are available in today's earnings release and related materials available on our IR website. And with that, let me turn the call over to Ryan."
},
{
"speaker": "Ryan McInerney",
"content": "Good afternoon, everyone. Thank you for joining us. We delivered strong second quarter results with $8.8 billion in net revenue up 10%, GAAP EPS up 12% and non-GAAP EPS up 20%. For our key business drivers, we saw relative stability. Overall payments volume grew 8% year-over-year in constant dollars, US payment volume grew 6% year-over-year and international payments volume grew 11%. Cross-border volume excluding Intra-Europe rose 16% year-over-year and process transactions grew 11%. Visa's business performance demonstrates our strategy at work in consumer payments, new flows, and value-added services. Furthermore, across all of these growth levers, tremendous opportunity remains. I'll spend a few moments on each growth lever. Let's start with consumer payments. The opportunity in consumer payments is enormous. Based on the latest public data from calendar year 2022 and our analysis, we estimate that the total global purchase personal consumption expenditure or PPCE excluding Russia and China was approximately $40 trillion. Within that $40 trillion, our addressable opportunity is more than $20 trillion. This includes three components. One, cash and check, which is about half of the addressable opportunity. Tap-to-pay is a great example of how we are converting small ticket cash transactions to Visa credentials. Two, ACH and other electronic transactions. We have many examples in this space, including the work we are doing to extend Visa as a bill pay method in acceptance categories like rent, education and loan repayments. And three, cards that run primarily on domestic networks. We have been focused on converting these domestic based cards to Visa credentials in countries around the world and I'll share a good example from Europe in a moment. There is a very long runway ahead and I remain excited about Visa's future growth opportunity in consumer payments. We continue to capture that growth by delivering innovative and secure payment solutions for buyers and sellers, including new credentials and issuance, tap-to-pay and e-commerce. I'll briefly talk about each. First, we're making great progress in expanding the number of Visa credentials. We have added over 100 million credentials from September to December for a year-over-year growth rate of 6%. One area of focus is in Europe. With the UK growing credentials at its fastest rate since 2016, driven in part by strong growth from fintech clients. In addition, from 2018 to 2023, we converted more than 20 million credentials in Europe that primarily ran on domestic networks to Visa debit credentials with millions more in the process of being migrated. This is a great example of the opportunity I mentioned a moment ago. We're particularly excited as we prepare for the Paris Olympics, which are less than 100 days away. We have close to 300 clients across 85 countries globally working with Visa to activate our Olympic sponsorship for marketing campaigns and cardholder engagements such as credential issuance and onsite cardholder events. And in Europe alone, we expect our clients to have issued over 5 million Olympic and Paralympic branded Visa credentials before the start of the games. Also this quarter in Europe, we renewed our relationship with Caixa Geral de Depositos in Portugal across consumer credit, debit and prepaid and commercial credit and debit as well as a suite of value-added services, including risk solutions and analytics. Another area of strength is our co-brand issuance. Visa is the primary network partner for eight of the top 10 co-brand partnerships in the US today and we are pleased that Visa has finalized a multi-year extension of our successful credit co-branded partnership with Alaska Airlines, a portfolio that benefits from a loyal customer base and high cross-border usage. We have also had significant co-brand momentum in CEMEA. First, we launched a new co-brand card in partnership with Qatar Airways, British Airways and the National Bank of Kuwait. Second, we expanded our strong global Marriott relationship to launch Qatar's first hospitality co-branded card with Qatar Islamic Bank. Across the United Arab Emirates, we now have exclusive agreements with all the leading airlines marked by a recent agreement with Emirates Skywards. And we also signed an inaugural Airline co-brand agreement in Morocco with Royal Air Maroc. Now newer digital issuers are equally important to our future growth in consumer payments. And in Saudi Arabia, fintech stc pay, which has over 12 million customers is transitioning from a digital wallet to a full digital bank and expanding its Visa prepay business into Visa debit and credit. Digital Bank Maya in the Philippines has chosen Visa to offer its millions of mobile wallet users and bank depositors access to consumer credit cards with new issuance of affluent products. In the US, we signed a newly expanded credit deal with brokerage platform Robinhood, including the launch of a new Robinhood Gold Card, which offers 3% cashback for all purchases. In Europe, broker and savings platform Trade Republic has launched a new Visa card that combines spending and savings for their 4 million customers across 17 markets. Over 1 million people joined the waitlist for the card in just a few weeks. As I've mentioned in the past, we feel great about our products, our value-added services, our new flows capabilities, our brand, and our people, all coming together to deepen and expand our partnerships with our clients around the world. As we think about Visa's growth, tap-to-pay and e-commerce are key drivers in the digitization of payments. This quarter, tap-to-pay grew five percentage points from last year to 79% of face-to-face transactions globally, excluding the US. Of note, Japan nearly doubled its penetration since last year to almost 30%. In the US, in the second quarter, we're nearing 50% penetration with New York City at over 75%. The first US city to reach this milestone up from 50% two years ago, demonstrating the impact that transit and our focused issuance and acceptance have on accelerating growth. On the e-commerce front, we continued to see Visa's US e-commerce payments volume grow several points faster year-over-year than face-to-face spend. And the same is true in many key countries around the world, including Canada, Brazil, Australia and India. And this matters to Visa's growth because in the e-commerce space, cash is not usually an option. And although e-commerce payments are a highly competitive environment, we believe our capabilities and our focus on safety, security, reliability, and user experience position us very well. Adding to the potential for growth is tokenization, which brings several benefits to the ecosystem, especially in e-commerce, including reducing fraud, improving authorization rates and therefore making it easier for a customer to purchase a good or service. As of the second quarter, we have over 9.5 billion tokens globally and have surpassed a milestone of 1 billion tokens in Asia-Pacific joining the ranks of the US and Europe. We continue to be focused across all of these efforts in addition to seeking new areas of acceptance and spending. Now moving to new flows. We mentioned last quarter that we see $200 trillion of opportunity excluding Russia and China and we are delivering Visa's commercial and money movement solutions to help digitize these flows. This quarter, new flows revenue growth improved to 14% year-over-year on a constant dollar basis with Visa Direct overall transactions growing 31% for the quarter to $2.3 billion and commercial volumes up 8% year-over-year in constant dollars. Throughout the quarter, we remain focused on our Visa Direct strategy across several areas of growth, including through new use cases, expansion to new geographies and enablers. One recent example is our expanded agreement with Thunes, which increased the number of countries in which Visa Direct can enable push-to-wallet from 78 to 108. In addition, Thunes is implementing Visa Direct's push-to-card capability to enable payouts made to eligible Visa cards and accounts. We have also expanded earned wage access in Canada through an agreement with Payfare and have brought our first Visa Direct cross-border capability into Taiwan with Taishin Bank. On the enabler front, we are pleased that our long-time partner JPMorgan Payments will be seamlessly integrating Visa Direct into their acquiring operations to offer their business clients faster push payments capabilities. In addition, we continued to deepen our relationship with Chase in the small business market with investment and enhancements in products and services. And in accounts receivable and payable, we renewed and expanded our multi-year agreement with Bill on their accounts payable, spend and expense management platforms. We have also reached a global partnership with Taulia, an SAP company and a leading provider of working capital management solutions. The collaboration will incorporate Visa's digital payments technology into Taulia's virtual cards, a solution that integrates with SAP ERP solutions and business applications to make embedded finance accessible for businesses through a seamless and streamlined payments experience for buyers and suppliers. One vertical in new flows that has immense potential is government payments, representing over $15 trillion in annual payments volume opportunity, where we are in a strong position to combine many of our new flows offerings. A recent example is in Kenya, where we signed an agreement with Pesaflow, a technology partner for the government of Kenya to expand card payments on eCitizen, the government's electronic platform with over 12 million users. We achieved this by bringing together Visa Virtual credentials and Visa Direct into the platform. Now let me move on to value-added services, where revenue was up 23% in the second quarter in constant dollars. The growth and opportunity in value-added services continue to be significant and broad-based. In Acceptance Solutions, we signed an agreement with Millicom International Cellular in Latin America for cybersource gateway, decision manager and token management solutions. As it relates to open banking, just about two years ago, we acquired Tink as we saw the opportunity in open banking to enable the movement of data and money and to provide consumers with control over their financial data. Over those two years, we have been expanding our presence in Europe, winning deals with such as Adyen and Revolut. We're now expanding open banking solutions through Tink into the United States having signed several data access agreements, including with Capital One, Fiserv, and Jack Henry, so that their customers may share data with Tink. We've also signed partnerships on the fintech and merchant side including Dwolla and Max Rewards. And across our risk offerings, we continue to bolster them through our technology, innovation and AI expertise and are expanding their utility beyond the Visa network. Recently, we announced three such capabilities in our Visa Protect offering. The first is the expansion of our signature solutions Visa Advanced Authorization and Visa Risk Manager for non-VISA card payments making them network agnostic. This allows issuers to simplify their fraud operations into a single fraud detection solution. The second is the release of Visa Protect for account-to-account payments, our first fraud prevention solution built specifically for real-time payments, including P2P digital wallets, account-to-account transactions and Central Bank's instant payment systems. Powered by AI-based fraud detection models, this new service provides a real-time risk score that can be used to identify fraud on account-to-account payments. We've been piloting both of these in a number of countries and our strong results thus far have informed our decision to roll these out globally. The third solution is Visa Deep Authorization. It is a new transaction risk scoring solution tailored specifically to the US market to better manage e-commerce payments powered by a world-class deep learning recurrent neural network model and petabytes of contextual data. We also continue to make our offerings available through third-party platforms. We mentioned ServiceNow last quarter and we are excited to have recently joined the AWS Partner Network to help seamlessly provide our clients running systems in the cloud access to Visa's solutions, initially starting with Currencycloud, now known as Visa Cross-Border Solutions and Pismo. We also signed an agreement with Stripe for them to distribute Verify solutions through a self-service dispute management platform for their merchants. All of these efforts are part of our strategy to build and offer our solutions for both Visa and our network of networks. Before I hand it to Chris, I wanted to note that we have commenced the exchange offer for Visa's Class B1 common stock that is set to expire at the end of next week. I also wanted to highlight that this quarter, after nearly 20 years of litigation, we have agreed to a landmark settlement with US merchants, more than 90% of which are small businesses, lowering credit interchange rates and capping those rates into 2030 once approved by the court. The injunctive relief class settlement also provides updates to several key network rules, giving merchants more choice in how they accept digital payments. Last, let me share a few closing thoughts on the quarter and beyond. First, our second quarter was marked by stable results and strengthened relationships with clients across the globe. Second, as we head into the back half of our fiscal year and beyond, new flows and value-added services remain key areas of focus. We also see significant opportunity in consumer payments by digitizing cash and check, enhancing our capabilities in e-commerce, and building new solutions for our network of networks. I could not be more excited for what lies ahead. Finally, all of this is possible because of the 30,000 Visa employees who come to work every day in service of our clients and partners, I am grateful for everything that you do, thank you. And now over to Chris."
},
{
"speaker": "Chris Suh",
"content": "Thanks, Ryan. Good afternoon, everyone. As Ryan said, Q2 was a strong quarter with relatively stable growth across payments volume, process transactions, and cross-border volume. Looking at our drivers, in constant dollars, global payments volume was up 8% year-over-year and process transactions grew 11% year-over-year. Cross-border volume growth excluding Intra-Europe was up 16% year-over-year in constant dollars. Fiscal second quarter net revenue was up 10% in nominal and constant dollars, which was slightly above our expectations, primarily due to lower-than-expected incentives and better-than-expected value-added services revenue that collectively more than offset lower-than-expected currency volatility. GAAP EPS was up 12% and non-GAAP EPS was up 20% in nominal and 21% in constant dollars. So let's go into the details, starting with total payments volume. Global payments volume growth in Q2 was 8%, consistent with Q1 growth. There are a couple of things I'd like to highlight when comparing Q2 to Q1. First, the extra day for the leap year was a benefit to the quarter. This was offset primarily by slowing payments volume growth in Asia-Pacific mostly due to macroeconomic weakness in Mainland China. When we adjust for Asia and some other smaller factors, we see second quarter global payments volume growth generally in line with the first quarter. Now on to the US. US payments volume grew 6% year-over-year, credit grew 6% and debit grew 6%. Card present spend grew 4% and card not present volume grew 8%. Reg II had a similar modest impact in Q2 as we saw in Q1. When we normalize for leap year, we see relatively stable US payments volume growth. Consumer spend across all segments from low to high spend has remained relatively stable. Our data does not indicate any meaningful behavior change across consumer segments. Moving to international markets, where total payments volume growth was up 11% in constant dollars. Payments volume growth rates were strong for the quarter in most major regions with Latin America, CEMEA, and Europe, ex-UK, each growing more than 19% in constant dollars. Normalized for leap year and weakness in Mainland China, total international payments volume growth was relatively stable to the first quarter. As a reminder, domestic volumes in Mainland China drive a very small amount of revenue and therefore the impact to our financial statements is not significant. Now to cross-border, which I'll speak to in constant dollars and excluding Intra-Europe transactions. Total cross-border volumes were up a healthy 16% in Q2 generally in line with our expectations. Cross-border card not present volume growth, excluding travel and adjusted for cryptocurrency purchases was in the mid-teens, stronger than expected. Cross-border travel volume was up 17% or 152% indexed to 2019. Consistent with our expectations for the year, we continue to see strong travel volume growth in and out of LAC, Europe, and CEMEA and out of the US ranging from 158% to 192% of 2019 levels. The US inbound travel volume has continued to recover within our expectations up several points from Q1 versus 2019 levels. Asia-Pacific travel volume continues to recover, but the pace has been slower than we anticipated. Travel volume into Asia indexed at 142% of 2019 levels for the quarter, up eight points from Q1, while travel volume out of Asia was up two points to 124% of 2019. We see the primary drivers being one, macroeconomic weakness in key markets like Australia and Mainland China two, weakness in some Asia-Pacific currencies, which is impacting consumer purchasing power, particularly for Japan and three, airline capacity that is still below 2019 levels, particularly the Mainland China and North American corridor. Altogether, we're pleased with our total cross-border volume growth with e-commerce growth generally offsetting the travel weakness in Asia and this is a great testament to the strength and diversification of our model. Now let's review our second quarter financial results starting with the revenue components. Both service revenue and data processing revenue grew generally in line with their underlying drivers, which resulted in their respective revenue yields remaining relatively consistent to the first quarter. Service revenue grew 7% year-over-year versus the 8% growth in Q1 constant dollar payments volume. Data processing revenue grew 12% versus the 11% process transaction growth. International transaction revenue was up 9% versus the 16% increase in constant dollar cross-border volume, excluding Intra-Europe, impacted by lapping strong currency volatility from last year. As volatility reached lows that we haven't seen in about four years, the revenue growth was lower than we expected. Other revenue grew 37%, primarily driven by strong consulting and marketing services revenue growth and to a lesser extent, pricing. Client incentives grew 12%, lower than we expected due to client performance and deal timing. Across our three growth engines, consumer payments growth was driven by relatively stable payments volume, process transactions and cross-border volume. New flows revenue improved as expected to 14% year-over-year growth in constant dollars. Visa Direct transactions improved to 31% year-over-year growth helped by growth in Latin America for interoperability among P2P apps. Commercial volumes rose 8% year-over-year in constant dollars. In Q2, value-added services revenue grew 23% in constant dollars to $2.1 billion, primarily driven by issuing and acceptance solutions and advisory services. GAAP operating expenses increased 29% driven by increases in the litigation provision and G&A expenses. Non-GAAP operating expenses grew 11% primarily due to increases in G&A and personnel expenses. FX and Pismo each represented an approximately half point headwind. Excluding net losses from our equity investments of $30 million, non-GAAP non-operating income was $189 million. Our GAAP tax rate was 15.4% and our non-GAAP tax rate was 16% due to the resolution of some non-US tax matters. GAAP EPS was $2.29 and non-GAAP EPS was $2.51, up 20% over last year, inclusive of an almost one point drag from exchange rates and an approximately half point drag from Pismo. In Q2, we bought back approximately 2.7 billion in stock and distributed over 1 billion in dividends to our stockholders. At the end of March, we had 23.6 billion remaining in our buyback authorization. Now, let's move to what we've seen so far in April through the 21st. US payments volume was up 4% with debit up 4% and credit up 5% year-over-year, down from March, primarily due to Easter timing. Process transactions grew 9% year-over-year. Constant dollar cross-border volume, excluding transactions within Europe grew 15% year-over-year. Travel-related cross-border volume, excluding Intra-Europe grew 15% year-over-year in constant dollars or 151% indexed to 2019. And cross-border card not present ex-travel grew 15% in constant dollars. Now on to our expectations. Remember that adjusted basis is defined as non-GAAP results in constant dollars and excluding acquisition impacts. You can review these disclosures in our earnings presentations for more detail. Let's start with the full year. We are reaffirming our prior year guidance for the full year for adjusted net revenue and operating expense growth in the low-double-digits and EPS growth in the low-teens. As for drivers, things are progressing generally as we expected, except for the trends in Asia that we discussed. Accordingly, we are making a small adjustment to our outlook for total payments volume growth to the high-single-digits from the low-double-digits. Total cross-border volume, excluding Intra-Europe is expected to continue to grow strongly in the mid-teens with the strength in e-commerce generally offsetting weakness in Asia travel. Remember that our drivers assume no recession or no further increase in Reg II impacts. Currency volatility remains low and we are assuming volatility in the third quarter continues at a similar rate to the second quarter and adjusts up slightly in the fourth quarter. Now on to the third quarter expectations. We expect adjusted net revenue growth in the low-double-digits, generally in line to the adjusted second quarter growth rate. Adjusted operating expenses in the third quarter are expected to grow in the low-teens, driven primarily by Olympic-related marketing expense due to the strong client engagement that Ryan referenced. Non-operating income is expected to be between $50 million and $60 million and the tax rate is expected to be between 19% and 19.5% in Q3 with the full year unchanged. This puts third-quarter adjusted EPS growth in the high end of low-double-digits. For the third quarter, Pismo is expected to have minimal benefit to net revenue growth and an approximately one point headwind to non-GAAP operating expense and an approximately half point drag to non-GAAP EPS growth. FX for the third quarter is expected to have an approximately one point drag to net revenue growth and approximately one and a half point benefit to non-GAAP operating expense growth and an approximately half point drag to non-GAAP EPS growth. In summary, we had another solid quarter in Q2 with relatively stable underlying drivers and strong financial results. We feel good about the momentum in our business as we head into the second half across consumer payments, new flows and value-added services. We remain thoughtful with our spending plans as we continue to balance between short and long-term considerations in the context of a changing environment. So now, Jennifer, let's do some Q&A."
},
{
"speaker": "Jennifer Como",
"content": "Thanks, Chris. And with that, we're ready to take questions, Holly."
},
{
"speaker": "Operator",
"content": "Thank you. [Operator Instructions] Our first caller is Sanjay Sakhrani with KBW. You may go ahead."
},
{
"speaker": "Sanjay Sakhrani",
"content": "Thank you. Chris, a clarification question. You mentioned Easter was mainly affecting the quarter-to-date trends. Is it fair to assume that the growth rate would be commensurate with the last quarter if you adjust it for that? And then just on a related matter, did the tax refund timings have any impact later in the quarter or in the quarter or into the quarter-to-date trends? Thanks."
},
{
"speaker": "Chris Suh",
"content": "Yeah. Thanks for the question. So April volumes, as I said on the call, through the first three weeks were lower than March -- the month of March. This was due to the timing of Easter, which again was in March this year and April of last year. And so once you factor that into March and April growth rates, the change between the months are -- the change in growth rate is not meaningful. As far as tax payments at this point, I don't really have an update. Largely they've been consistent at this point year-to-date."
},
{
"speaker": "Jennifer Como",
"content": "Next question, Holly."
},
{
"speaker": "Operator",
"content": "Our next caller is Timothy Chiodo with UBS. You may go ahead."
},
{
"speaker": "Timothy Chiodo",
"content": "Great. Thank you for taking the question. There were some helpful comments around the e-commerce strength within cross-border offsetting some of the travel weakness. When we think about the components of overall cross-border, clearly, there's the traditional travel, so card present and card not present. And then there's the traditional e-commerce, right, so retail e-commerce. But there are other faster growing but smaller portions, whether it be the remittances or marketplace payouts or you gave the Thunes example earlier. I was wondering if you could maybe size the, in aggregate, how large some of those other maybe faster growing portions of cross-border have become as a part of the overall mix?"
},
{
"speaker": "Chris Suh",
"content": "Yeah, sure. Why don't I start? Yeah, we don't have specifics to break-out. As we talked about, the e-commerce business has been strong. It continues to grow above what we expected. The yields across our entire cross-border business are positive and accretive to Visa overall. And so we're happy with all flavors of cross-border, but I don't have a further breakout for you in terms of the pieces that you were asking about."
},
{
"speaker": "Jennifer Como",
"content": "Next question, Holly."
},
{
"speaker": "Operator",
"content": "Our next caller is Craig Maurer with FT Partners. You may go ahead ."
},
{
"speaker": "Craig Maurer",
"content": "Yeah, thanks for taking the question. I wanted to ask a question on US debit trends. April continued the trend of weakening that we've seen -- that we saw also in March and basically since February. I wanted to know to what degree your guidance for both third quarter and the year embeds continued weakening in US debit. It seems if we look at the restaurant data released by the likes of Darden that the lower-income portion of the US is significantly reducing spend in certain areas. So curious about commentary there. Thanks."
},
{
"speaker": "Chris Suh",
"content": "Yeah. As we talked about on the call, we see quite stable -- relatively stable volumes in the US across credit and debit, normalizing for the things that I talked about. And so in addition, as I talked about Reg II, the impact remains stable as well. And so from our perspective, our data indicates stable volume growth in the US."
},
{
"speaker": "Jennifer Como",
"content": "Next question, Holly."
},
{
"speaker": "Operator",
"content": "Our next caller is Bryan Bergin with TD Cowen. You may go ahead."
},
{
"speaker": "Bryan Bergin",
"content": "Hi. Good afternoon. Thank you. I wanted to ask on new flows, so a nice recovery there in growth. Can you give a comment on what areas were most pronounced in the underlying growth recovery relative to what you saw last quarter?"
},
{
"speaker": "Chris Suh",
"content": "Yeah. Let me talk about Q2 growth. The two pieces of information that we gave you in terms of Q2 growth. We saw commercial volume growth globally 8%, stable to Q1 and in fact, stable over the last several quarters. And we saw very strong growth in Visa direct transactions, growing 31% for the quarter. New flows revenue in total growing 14%, which was in line with our expectations that we shared with you at the start of the year. I think the recovery that you're referencing to was because Q1 growth was lower and that was really due to some lapping issues that were one-time and non-recurring, which we passed at this point."
},
{
"speaker": "Jennifer Como",
"content": "Next question, Holly."
},
{
"speaker": "Operator",
"content": "Our next caller is Will Nance with Goldman Sachs. You may go ahead."
},
{
"speaker": "Will Nance",
"content": "Hey, guys. I appreciate you taking the question. A bit of a dual-part question on just some of the prior guidance commentary you made around first-half versus second-half dynamics and some of the drivers of acceleration over the course of the year. And I guess specifically, I guess, incentives, you talked about a step-down in the growth rate from first half to second half. Is that still your expectation despite that coming in a lot lower in the most recent quarter? And then for the similar question on the volume growth trends, I guess, I hear you on the Asia trends, but I guess overall, you had some kind of upbeat commentary on ticket sizes over the course of the year and kind of easing inflation in comps, it seems like gas prices might help that as well. So just any commentary on ticket sizes and specifically the negative ticket sizes you've seen in the US? Any commentary on kind of what's structural versus kind of more environmental there? Thanks."
},
{
"speaker": "Chris Suh",
"content": "Yeah. Okay. Let me start first with incentives, the first part of your question. So, as you all have seen from quarter-to-quarter, incentive growth can vary based on a number of factors, client performance, deal timing, which is what caused half one to come in lower than anticipated. For our outlook for the second half of the year, our expectations remain largely unchanged. We still expect year-over-year growth to be lower in the second half than in the first half as we lap the higher incentives that we saw starting in the second half of last year. And we do expect the Q4 incentive growth rate will be the lowest growth quarter of the year. So expectations for half two are unchanged. To your second question on ATS, let me -- there's a lot of moving parts in here. And so maybe I'm just going to kind of go through it in detail and unpack bit by bit. Globally, Q2 ATS year-over-year growth was down slightly, which is consistent with the growth that we saw in Q1. Breaking that apart between the US and international. In the US, ticket size growth actually continued to improve from Q1 to Q2, still slightly negative, but the trend improved from Q1 to Q2. And looking ahead in the US, this is something that we've spoken to previously, we do continue to expect ATS will turn positive in the second half of this year as we lap the lower ticket sizes in the second half of last year. Internationally, outside of Asia-Pacific, let's set that aside for a second, we saw improvement in several regions, including the impact from higher inflation in several markets. And so overall, excluding Asia, we still expect ATS to turn positive in the second half based on the expected improvements in the US with the impact of Asia factored in, global ATS will be slightly negative and that was factored into the revised payment volume outlook that I gave for the full year."
},
{
"speaker": "Jennifer Como",
"content": "Next question, Holly."
},
{
"speaker": "Operator",
"content": "Our next caller is Moshe Katri with Wedbush Securities. You may go ahead."
},
{
"speaker": "Moshe Katri",
"content": "Hey, thanks for taking my question. It seems that there was a pretty significant uptick sequentially in growth for value-added services. Is there anything to call out there? Thanks."
},
{
"speaker": "Ryan McInerney",
"content": "I mean, I'll talk about the business just for a minute, Moshe. Thanks for the question and then, Chris, you can add any specific callouts. As I think I said in my prepared remarks, the business is really hitting its strides in a lot of different areas in terms of the product we're bringing to market, the success our sales teams are having around the world, we're really focused on three big areas of trying to drive growth. One is just deepening the penetration of products we have with existing clients. That's -- if you think about it is the most near-term opportunity that we have and we've got metrics, client-by-client all around the world, what are they using, what are they not using. We're arming our sales teams with that. We're building case studies on how we can help them and we're driving progress in terms of deepening the relationship we have with our existing clients. And then we're building new products that we're bringing to market. I mentioned a few of those in my prepared remarks today, both in the risk and fraud space as well as in the open banking space and then driving geographic expansion. I mentioned I think just one cybersource deal in my prepared remarks, but cybersource has been a great example of a platform where we've been having success growing in markets where we hadn't traditionally been as deep. AP is actually a positive example of that in the cybersource space. So those are a couple of call-outs, Moshe, in terms of kind of how we're just seeing the broader business."
},
{
"speaker": "Jennifer Como",
"content": "Next question."
},
{
"speaker": "Operator",
"content": "Our next caller is Cris Kennedy with William Blair. You may go ahead."
},
{
"speaker": "Cristopher Kennedy",
"content": "Good afternoon. Thanks for taking the question. You talked about bringing Tink into the US. Can you talk about the open banking opportunity in the US relative to Europe? Thank you."
},
{
"speaker": "Chris Suh",
"content": "Yeah. Thanks, Chris. I think Europe is the most developed open banking market in the world. We bought Tink two years ago believing that it was the best platform in Europe and I think that's proven true over the couple of years that we've had a chance to own it. On the client side, in Europe, we've been making great progress. I think I mentioned a couple in my prepared remarks, we've been -- we've been winning business and winning share with both fintechs as well as more traditional banks, merchants, and others, both in the payment side of things and in the account information side of things. I would describe the US market as less developed as Europe. And so I think it's an opportunity for us to take the learnings that we've had in the much more developed Europe market as well as the success we've had with our clients, the products, the services, the wins and the losses and bring all of that to the US market. So we're excited to do that. And as I mentioned, I think the US market is still at the very early stages of its development. So I think it's a good time for us to be a competitor in the market. And we're hopeful that over the coming quarters and years, we'll have a chance to share with you a lot of the success that we have in the US market."
},
{
"speaker": "Jennifer Como",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "Our next caller is Dan Perlin with RBC Capital Markets. You may go ahead."
},
{
"speaker": "Daniel Perlin",
"content": "Thanks. Ryan, I just wanted to ask a question on the Visa Deep Authorization commentary and kind of that market there. I just want to make sure I understand, are you -- are you doing this as a means with which to like equalize kind of e-commerce across the market for authorization rates, so that like acquirers need to be partnered with you more specifically and therefore, they're not competing maybe shows individually on kind of author rates within e-commerce or is there something different within this platform? Thank you."
},
{
"speaker": "Ryan McInerney",
"content": "Hey, Dan. Let me backup. I think this is a little different than what you were describing. What we found in the US e-commerce market is that it's the most -- on the one hand, it's the most developed e-commerce market on the planet. On the other hand, it's become the place of the most sophisticated fraud and attack vectors that we see anywhere in the world. And so what we were bringing -- we are bringing to market with Visa Deep Authorization is an e-commerce transaction risk scoring platform and capability that is specifically tailored and built for the unique sets of attack vectors that we're seeing in the US. So it's -- as I was mentioning in my prepared remarks, it's built on deep learning technology that's specifically tuned to some of the sequential and contextual view of accounts that we've had in the US market. And the whole goal is what we do with a lot of our fraud and authorization products. We want to -- we want to make it a better buyer and seller experience. We want to reduce fraud rates, increase authorization rates, increase shopping conversion for our merchant partners. And we think Visa Deep Authorization is going to be yet another tool that will help do that."
},
{
"speaker": "Jennifer Como",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "Our next caller is Tien-Tsin Huang with JPMorgan. You may go ahead."
},
{
"speaker": "Tien-Tsin Huang",
"content": "Thanks so much. It sounded like the Middle East deal activity is in a good place here. I believe Emirates is a takeaway for you. I'm just curious if there's something new going on there from a pipeline perspective. It sounds like maybe some investing. Is this the growth market we should be paying more attention to maybe? Thanks."
},
{
"speaker": "Chris Suh",
"content": "Thanks, Tien-Tsin. I think what you're seeing is good execution from our sales team, doing what we do when we do it best, which is in with our clients, listening, learning, obsessing about what's important to them and then bringing them products and value propositions that are helping meet their needs and drive their strategies and really just kudos to our team on the ground there and the great work that they're doing."
},
{
"speaker": "Jennifer Como",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "Our next caller is Trevor Williams with Jefferies. You may go ahead."
},
{
"speaker": "Trevor Williams",
"content": "Great. Thanks a lot. This one is for Ryan. Just wanted to go back to the merchant settlement in the US, clearly you guys aren't directly impacted by lower interchange, but I'm just curious kind of what you're expecting the downstream impact to be on Visa, the relationships between you and your issuing banks. And if you think it in any way kind of changes the competitive dynamics at all within the US credit market? Thanks."
},
{
"speaker": "Ryan McInerney",
"content": "Thanks, Trevor. I think the good news on this front is it brings clarity and stability to the market. This is litigation that's been out there for the better part of 20 years or so. I think there's been a lot of great work that's been done to bring this to a resolution. Just to remind everyone what the main planks of the resolution are. It really is two different sets of things. One is it will reduce interchange for US -- for credit cards in the US market for both Visa and Mastercard and it will have no increases in interchange for the five years of the agreement. And then the second set of things are tools that give merchants more flexibility to how they manage payments significant -- specifically as it relates to surcharging and things like that. I think, overall, it's what I said, Trevor, which is clarity and stability that lets everybody who operates in the US market move on and move on continuing to grow the digitization of this great payments ecosystem that we've all collectively built in the United States."
},
{
"speaker": "Jennifer Como",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "Our next question is from Harshita Rawat with Bernstein. You may go ahead."
},
{
"speaker": "Harshita Rawat",
"content": "Good afternoon. So, Ryan, I want to follow up on value-added services, such an important part of your growth story. I know you've talked about the five types of services you offer and how your top 250 clients use almost 2x the number of services versus the rest of your client base. Can you give us some sense on how these penetration numbers have evolved over time? And finally as you kind of think about pricing for these services, to what extent it's a bundle pricing along with core versus kind of a separately priced service? Thank you."
},
{
"speaker": "Ryan McInerney",
"content": "Okay. You have a great memory. As we've said, our top 265 clients or so use on average about 22 of our value-added services. We don't talk about like how that's moved quarter-to-quarter, but the opportunity is enormous just when you think about the number of clients we have around the planet. And so as I was mentioning earlier kind of what we've done is we've armed our frontline teams with kind of client-by-client, what are they using, what are they not using, what are the opportunities to create value for the client by putting value-added services A, B, C or D to work for them and we're having great success and you see that in the numbers. In terms of the pricing, it's -- it's different pricing models for different products and different suites of solutions in different places around the world. We're always trying to come up with the right product pricing mix that's going to work best for our products in the market. And we have a portfolio of value-added services that span from issuing to acceptance to risk and identity to advisory into open banking and the competitive sets are deep and different in all of those markets. So we're bringing different pricing approaches to each and every market around the world to help meet the best that we can for our clients."
},
{
"speaker": "Jennifer Como",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "Our next caller is Ramsey El-Assal with Barclays. You may go ahead."
},
{
"speaker": "Ramsey El-Assal",
"content": "Hi. Thanks for taking my question. I wanted to ask about one of the consumer payment opportunities that Ryan called out, namely taking share from domestic card networks. How do you drive that? Is it just a question of getting banks to issue more of your cards or is it more on the acceptance or consumer side? What are the levers that you have to basically speed that up?"
},
{
"speaker": "Chris Suh",
"content": "Yeah. Thanks for the question. On the -- it's really the first of the things that you mentioned. Now, of course, we need to have great acceptance. We need to have great capabilities and all those types of things, which we do in every market we operate around the planet. So then it becomes sitting down with clients, helping them understand the value of, for example, a Visa debit card versus a card that runs primarily on domestic schemes. And then you get into e-commerce capabilities that Visa Debit is able to provide their clients that maybe they don't get the same type of capabilities from the domestic scheme. You get to cross-border travel opportunities that their customers would have if they were using a Visa card versus one of those domestic schemes that I mentioned. You also get into the risk and fraud prevention capabilities that I mentioned earlier and the ability to have more transactions approved and lower fraud rates, tokenization, I mean, all these kind of benefits, you've heard us talk about over and over again, those are what our teams can sit down with the clients and explain to them. Often the clients will do some pilots and some tests, they'll see the results, they'll see higher spend, they'll see higher client satisfaction. And then ultimately the decision to issue Visa cards to their clients becomes a very clear decision for them."
},
{
"speaker": "Jennifer Como",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "Our next caller is Jamie Friedman with Susquehanna. You may go ahead."
},
{
"speaker": "James Friedman",
"content": "Hi. I was wondering if you could share some color on how Prosa is doing so far and how you view the opportunity in Mexico as you start to press and productize into the Mexican market. Thank you."
},
{
"speaker": "Ryan McInerney",
"content": "Yeah. Thanks, Jamie. We view the Mexican opportunity as a very significant one. And coincidentally, I was just down there a couple of weeks ago meeting with clients and meeting with the Prosa team as well. So as I think I explained on one of these calls, today, because we don't process transactions domestically in Mexico, we're not able to deliver a lot of the value-added services that I've mentioned over the course of this call to our clients. And so first and foremost, our clients are very excited about us having the opportunity to have a majority ownership stake in Prosa and then bring these world class capabilities that we've built to the Mexican market, the things I mentioned earlier, tokenization or the risk scoring algorithms that I mentioned or the e-commerce capabilities that I mentioned those types of things. Now Prosa itself is a great asset. It's been operating for 50 years in Mexico has deep processing experience, it has scale. They do more than 10 billion transactions annually. They have a great base of clients. So it's really the combination of both Prosa's experience and deep footprint in the Mexican market combined with our experience, our technology, our track record in bringing a lot of these services to market, the combination of those two things gives us a lot of confidence and our clients a lot of confidence that we can digitize the significant amount of cash and check and electronic payments that exist today in Mexico."
},
{
"speaker": "Jennifer Como",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "Our next question is from Andrew Schmidt with Citi. You may go ahead."
},
{
"speaker": "Andrew Schmidt",
"content": "Hey, Ryan. Hey, Chris. Thanks for having me on the call here. I wanted to go back to cross-border for a second. Obviously, a part of the back-half growth is the narrowing of the spread between cross-border revs and volumes. Maybe if you could talk a little about how, whether those assumptions have changed at all with FX volumes coming down or if there's other puts and takes we should consider there? Thanks a lot."
},
{
"speaker": "Chris Suh",
"content": "Yeah, sure. Yeah, I spoke at length about volatility. So we had -- in Q2 we saw volatility -- currency volatility at multiyear lows. This one is hard to predict. In Q3, our assumption, what's embedded in the guidance for Q3 is that the currency volatility levels remain at this low level. We do have, again, embedded in our forecast. We do anticipate that Q4 improves slightly. That's generally in line with market expectations. But, yeah, that is our view of currency volatility. That said, the underlying health of our business as we enter the second half of the year, we feel really good about across consumer payments, across new flows, across value-added services. And so volatility is sort of the variable and we'll have to see how it comes in."
},
{
"speaker": "Jennifer Como",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "Our next question comes from Jason Kupferberg with Bank of America. You may go ahead."
},
{
"speaker": "Jason Kupferberg",
"content": "Thank you, guys. Can you talk about your second half expectations for new flows and VAS revenue growth as well as cross-border travel volume growth? Thanks."
},
{
"speaker": "Chris Suh",
"content": "Sure. Let me unpack that a little bit. From a -- as you heard us, we reaffirmed our prior year guide for the full year, adjusted net revenue growth, OpEx, EPS. And within that, I spoke about the fact that volatility is going to cause our currency volatility -- treasury revenues in international to be lower than we anticipated in Q3. But again full year unchanged within that. Our expectations for new flows in that are consistent with the ones that we shared at the beginning of the year, which we anticipated. For the full year, new flows will grow faster than consumer payments with weighted toward faster growth in the second half of the year. We're seeing that with the 14% growth in Q2. We anticipate continuing to see a good growth in the second half of the year. Value-added services has grown over 20% in each of the first two quarters. The momentum there is pretty evident. The second part of your question was, I think, around cross-border travel of volumes in total. So we did make a little bit of adjustment. You heard me talk about based on half-one trends. And so again, this is one with a couple of parts, so let's just go through it in detail. First of all, we feel really good, feel great about our first-half total cross-border performance, 16% growth in Q2, in line with our expectations, and within that, travel was 17% and e-commerce growth mid-teens better than expected. And so that unpacking travel a bit, we've seen most of our travel volume expectations play out actually as we planned at the beginning of the year, which continues to be strong and healthy in most regions LAC, Europe, CEMEA and all the ones that I talked about on the call, with Asia being the exception to that, which again continues to improve with the pace of recovery being slower than expected, offset again by strength in the e-commerce cross-border business, which is performing better than we expected.So we expect these trends to continue into the second half and thus, we've moderated our outlook for travel due to AP and upped our expectations on e-commerce. So putting that all together, overall, our view is that total cross-border volumes remain strong, growing in the mid-teens in the second half, which is frankly the better measure in relation to our financial performance given the strong yields across both travel and e-commerce."
},
{
"speaker": "Jennifer Como",
"content": "Next question, please."
},
{
"speaker": "Operator",
"content": "And our last question comes from Ken Suchoski with Autonomous Research. You may go ahead."
},
{
"speaker": "Kenneth Suchoski",
"content": "Hey, good afternoon. Thanks for taking the question. A lot of my questions have been asked. I just want to ask about the service yields, though, because they came in a little bit lighter than we were expecting. So can you just talk about what drove that? It looks like the service yield declined year-over-year, but maybe there's some offset with client incentives also coming a little bit lower in the quarter. So any detail there would be helpful. Any thoughts on how to think about the year-over-year change in that yield going forward? Thanks."
},
{
"speaker": "Chris Suh",
"content": "As we talked about both service revenue and data processing revenue grew generally in line with the underlying drivers, service revenue at 7% versus the 8% in constant dollar PV, Q1 constant dollar PV that's impacted by a number of smaller things, none of which I would call out as a single thing. Data processing revenue grew a little bit above processed transactions, 1.12 versus 11 and that was helped aided a little bit by pricing. From a yield perspective, I think the thing that's important is that our second quarter yields remained consistent with Q1 and consistent with the average over the last several quarters. And so we're seeing very stable yields across the business and we're pleased to see that. And even more broadly, our net revenue yield across the whole company remained quite stable."
},
{
"speaker": "Jennifer Como",
"content": "Great. And last question please, Holly."
},
{
"speaker": "Operator",
"content": "And our last question comes from Paul Golding with Macquarie Capital. You may go ahead."
},
{
"speaker": "Paul Golding",
"content": "Thanks so much. Ryan, you were talking about the addressable opportunity of $20 trillion of which cash and check was half. I was wondering if you can give any thought to quantifying the ACH versus the domestic network conversion and where you think you are in that opportunity capture for each of those. Thanks."
},
{
"speaker": "Ryan McInerney",
"content": "Yeah, thanks. We're having great success in all three. I gave you examples. Some of our teams are ahead of others in different parts of the world and domestic schemes are more prevalent in some parts of the world than others like I mentioned Europe as an example. But the opportunity is enormous in all three of these areas and we've been having really good success in all three of the areas."
},
{
"speaker": "Jennifer Como",
"content": "And with that, we'd like to thank you for joining us today. If you have additional questions, please feel free to call or email our Investor Relations team. Thanks again and have a great day."
},
{
"speaker": "Operator",
"content": "And this concludes today's conference. Thank you for participating. You may disconnect at this time and have a great rest of your day."
}
] |
v | 2,024 | 1 | [
{
"speaker": "Operator",
"content": "Welcome to Visa's Fiscal First Quarter 2024 Earnings Conference Call. All participants are in a listen-only mode until the question-and-answer session. Today's conference is being recorded. If you have any objections, you may disconnect at this time. I would now like to turn the conference over to your host, Ms. Jennifer Como, Senior Vice-President and Global Head of Investor Relations. Ms. Como, you may begin."
},
{
"speaker": "Jennifer Como",
"content": "Good afternoon, everyone, and welcome to Visa's Fiscal First Quarter 2024 Earnings Call. Joining us today are Ryan McInerney, Visa's Chief Executive Officer; and Chris Suh, Visa's Chief Financial Officer. This call is being webcast on the Investor Relations section of our website at investor.visa.com. A replay will be archived on our site for 30 days. A slide deck containing financial and statistical highlights has been posted on our IR website. Let me also remind you that this presentation includes forward-looking statements. These statements are not guarantees of future performance and our actual results could differ materially as the results of many factors. Additional information concerning those factors is available in our most recent Annual Report on Form 10-K and any subsequent reports on Forms 10-Q and 8-K, which you can find on the SEC's website and the Investor Relations section of our website. For non-GAAP financial information disclosed in this call, the related GAAP measures and reconciliation are available in today's earnings release and related materials available on our IR website. And with that, let me turn the call over to Ryan."
},
{
"speaker": "Ryan McInerney",
"content": "Hi, everyone. Good afternoon and thank you for joining us. We are off to a solid start in 2024. Consumer spending remained resilient with first-quarter year-over-year payments volume growth at 8%. U.S. payments volume grew 5% year-over-year. International payments volume grew 11%. Cross-border volume excluding intra-Europe rose 16% year-over-year in constant dollars with cross-border travel at 142% of 2019 levels, up from 139% in the fourth quarter. Processed transactions rose 9%. Our net revenues increased 9% with GAAP EPS up 20% and non-GAAP EPS up 11%. As I reflect on the execution of our strategy this quarter across consumer payments, new flows and value-added services, I wanted to highlight a few key themes. One, we remain obsessed about serving our customers including traditional bank partners, neobanks, fintechs, wallets, sellers, acquirers and everyone else. Our focus on clients has enabled us to deepen our relationships with partners across all three pillars of our strategy. Two, we continue to seek new partnerships, new use cases and new verticals to drive our business forward with a particular emphasis on cross-border. Three, we have gone to market with innovative solutions across our network of networks, seeking to add value for all transactions, no matter the network. And four, we are always looking for new and innovative ways to amplify our brand in service of our partners. With those themes in mind, let me provide some more details on the quarter. Let's start with consumer payments. We saw continued growth in credentials, acceptance and engagement. Credentials grew 6% and we now have more than 8.7 billion network tokens, up 55%. Acceptance locations grew 17%. And let me highlight two recent examples of where we have expanded acceptance. The first was in Brazil with Caixa for cash conversion at their over 10,000 lottery branches. They are now accepting Visa credit and debit cards to pay for utilities, tax collection, lotteries and voucher payments which are called boletos. Another example was in Asia-Pacific where we signed an agreement with Bcash, the largest mobile financial services player in Bangladesh. Already a client with Visa Direct, they now have enabled Visa's 15 million plus cardholders in the country to use their in-app QR code to pay at more than 550,000 Bcash merchants. These examples demonstrate our local approach to expanding our global acceptance footprint. Tap to pay grew five percentage points from last year to 77% of face-to-face transactions globally, excluding the U.S. In the U.S., we reached 45% penetration. One highlight from the first-quarter is that Lowe's has enabled tap to pay acceptance. We believe the tapping provides the best buyer and seller experience in the face-to-face environment and we've seen that play-out in the results. In a recent Visa study in the U.S., we saw on average two more transactions a month and spend lift of $70 a month for those who tap with a Visa debit card versus those who don't tap. Now on to some noteworthy updates from the quarter, which demonstrate our ability to deepen and expand partnerships as well as create new ones. In Europe, we renewed our agreement with isbank, the largest private bank in Turkey with 33 million cards for its consumer and commercial credit and debit portfolios. As part of that renewal, they will be issuing the first Olympic and Paralympic Games credit card in Europe outside of France, leveraging our sponsorship. In Poland, we signed a new issuing agreement with PKO Bank Polski, the largest issuer and acquirer in Poland and Central Eastern Europe for consumer and commercial debit. In Greece, we expanded our partnership with Piraeus Bank, the largest bank in the country to become their exclusive payment network across their consumer and commercial credit and debit portfolios. These are all fantastic examples of the attractive position and strong pipeline in Continental Europe I spoke about last quarter. In Japan, we expanded our credit issuance partnership with e-Pass, one of the fastest-growing issuers in the country, affiliated with department store Marui. They will use Visa Managed Services, which is a part of our advisory solutions where we embed Visa employees within a client organization to help execute against key initiatives. In Korea, we renewed and expanded our partnership with Shinhan Card, the largest issuer in the country for a consumer and commercial credit and debit. Shinhan has also committed to utilizing a suite of Visa's value-added services, including consulting and marketing to advance their business. In Mexico, we renewed our agreement with BBVA across consumer and commercial credit and debit along with value-added services, including risk, advisory and data tools. And last, in the U.S., we extended our agreement with Bank of America for multiple value-added services, including visas loyalty platform service, CardinalCommerce 3D secure service, Verifi Order Insight digital service and DPS debit processing. We also continue to be a partner of choice for fintechs around the world. First, in the U.S., we renewed with leading fintech chime, further debit and credit builder secured card portfolios as well as for Visa Direct. In Latin-America, we renewed our debit and credit contracts with Rappi, one of the largest fintech and merchant clients in the region with more than 30 million customers. They will also utilize numerous value-added services, including CyberSource and Decision Manager. And finally, we are excited about a new global partnership with HSBC for their fintech initiative Zing. Starting with the U.K., we are supporting the ambition to launch this multi-currency proposition in more than 30 markets. Visa's capabilities through Tink, currency cloud and our consumer payment solutions offer a powerful customer proposition and rapid deployment for Zing and HSBC. Through these renewals and new partnerships, you can see how we are focused on building a deep relationship across all the capabilities Visa offers. Now moving to new flows. We have updated our sizing of the new flows opportunity using the latest market data available. Excluding Russia and China, we see $200 trillion of opportunity annually across B2B, B2C, P2P and G2C, certainly an enormous number. We are working with our clients to deliver Visa's commercial and money movement solutions to help digitize these flows on our network of networks. Starting with Visa Direct. Total transactions this quarter grew 20% to $2.2 billion. And on the P2P cross-border front, transactions grew more than 65% year-over-year. In terms of client highlights for this quarter, we have been developing partnerships for new use cases in verticals and we are continuing to drive cross-border volumes. First, in new use cases, in addition to our existing P2P partnership in the U.S., we have expanded our Visa Direct relationship with Meta, launching the ability for content creators on Meta's family of apps to cash out their earnings to a debit card. This launch, now live in the U.S., U.K., France and Italy, allows for creators to receive their payout quickly and safely. Second, on cross-border volumes, we have continued to make progress in enabling global money movement across our 8.5 billion endpoints in nearly 200 countries and territories. Western Union is a great example. We just signed a long-term global partnership agreement with Western Union covering issuance, Visa Direct and other services across 40 countries in five regions. This long-term collaboration will bring product innovations and digital-first customer experiences to enhance cross-border money movement. We also expanded our relationship with Remitly to enable customers from 30 countries to send cross-border payments to eligible debit cards and bank accounts in over 100 countries globally. In Canada, we recently announced our agreement with CIBC and Simplii to provide millions of clients the ability to send money to digital wallets in key remittance destinations including the Philippines, China and Bangladesh. On to the commercial side, total payments volume grew 8% in constant dollars. And throughout the quarter, we continued to focus on new verticals. Let me highlight a few specific areas. First, in the cross-border travel vertical, we recently expanded our agreement with Singapore based B2B platform Nium. Their virtual card B2B travel program will expand from the U.S. and Europe into Australia, Singapore, Hong-Kong and Japan. Also in B2B travel, we signed a new virtual card agreement with Worldline, a leading global payment provider for travel intermediaries to pay their suppliers more quickly. In the contractor vertical, we recently signed an agreement with United Overseas Bank and Doxa, a Singapore fintech for contractors. In partnership with Visa, the Doxa platform has further been enhanced to provide embedded financing capabilities. Subcontractors will be given the option to be paid for their services through UOB virtual cards. And also with UOB, we renewed and expanded our commercial relationship across commercial debit and credit including the enablement of payment flows for the Singapore government. Let me move on to value-added services. Our network of networks strategy is also playing a key role in value-added services. As a reminder, this has three components. One, moving money to all end-points and to all form factors. Two, using all available networks and being a single connection point for our partners. And three, providing our value-added services on all transactions, no matter the network. We have continued to develop and expand our value-added services as part of this strategy. Let me cover three recent examples. Processing capabilities for RTP networks, Pismo and Prosa. Last quarter, I noted that Visa is becoming a certified service provider for FedNow, enabling financial institutions to receive funds through the FedNow service. We have now enabled the ability to also send funds. The second example is Pismo, which we just closed last week. As I talk to clients around the world, particularly issuing clients, there are two priorities that are increasingly on the minds of CEOs. The first is for many of our issuing clients, they've either recently embarked on or they're considering embarking on a transformation of their tech-stack from their legacy infrastructure to cloud-native API-based tech stacks. The second is that many clients, whether they'd be traditional issuers or fintechs, are increasingly looking to rapidly expand their issuance to new regions and countries, especially the more developing markets around the world. Our clients are looking to Visa to help them with both of these priorities. And with Pismo, we will be able to deliver to our clients the best cloud-native issuer processor in core banking platform in the world. Pismo offers global core banking and multi-product issuer processing covering credit, debit and commercial with connectivity to local payment networks such as Pix. Our goal is for Pismo to be the platform of choice for our issuing partners around the world, enabling them to accelerate their global expansion and transition to cloud-native platforms. And the third example of our network of networks is our announcement to acquire a majority interest in Prosa, a payments processor in Mexico. A couple things about the Mexican market. One, cash and check represent more than 50% of personal consumption expenditures. And two, today Visa has limited ability to process domestically. We believe we can bring enhanced technology infrastructure and lay the groundwork to develop new innovative ways for consumers, small businesses and local issuers and acquirers in Mexico to pay and be paid. This includes improving safety, security and reliability and providing better experiences through our value-added services such as tokenization, risk products and more. We can also bring our innovation and commitment to continued investment for both face-to-face and online transactions. Together, these efforts will help further digitize payments in the country. The investment is subject to regulatory review and we hope to close in the second-half of calendar year 2024. And finally, I want to highlight the opportunities to drive further growth in value-added services via the development of new partnerships. These enable us to enhance our overall offering and distribution reach. Yesterday, we announced an agreement with digital workflow leader ServiceNow to build solutions and distribute Visa's products and solutions to joint customers. To start, ServiceNow will launch in end-to-end disputes management solution for issuers with plans to expand to additional segments and products over-time. This partnership showcases the demand for our value-added services and provides a compelling distribution channel to reach more customers around the globe. So, across consumer payments, new flows and value-added services, you can see the enormous opportunity as well as Visa strong relationships, commitments to our clients and innovation in new ways to pay and be paid. What helps to amplify all of these efforts is our brand. We recently renewed our long-standing partnership with FIFA, creating a powerful opportunity to drive business for both Visa and our clients, improve brand lift and maximize global reach. Not to mention, providing an opportunity to showcase and implement Visa's innovative payment technology. We're also launching our first new global sports sponsorship in more than 15 years with the Red Bull Formula One teams. The partnership aligns our brand with two teams within Formula One which is one of the fastest-growing sports on the planet, providing another opportunity to drive business for our clients. As we look ahead this year, we're excited to be activating our brand with our clients across all of these partnerships as well as the Olympic and Paralympic games in Paris. Before I hand it over to Chris, I wanted to mention that we hold our Annual Meeting on Tuesday. All of the proposals that the Board recommended past including the exchange offer program proposal. As such, we will be moving promptly to file an S-4 with the SEC relating to the initial exchange offer. I also wanted to give a special thanks to my colleague, partner and friend, Alf Kelly, as Tuesday he officially retired as Executive Chairman. Alf, on behalf of the entire Visa family, thank you for your exceptional leadership. You led this business to incredible heights, while also driving innovation, deepening our client relationships and strengthening our culture in so many ways. Your impact on Visa will be visible for generations. In closing, in the first-quarter, Visa once again demonstrated the effective execution of our strategy across the globe. While uncertainty seems to be the norm, Visa has the experience and discipline to manage through the challenging environments and I remain optimistic and confident about our future. Now over to Chris."
},
{
"speaker": "Chris Suh",
"content": "Thanks, Ryan. Good afternoon, everyone. As Ryan said, Q1 was a solid quarter with relative stable-growth in overall payments volume and processed transactions and strong growth in cross-border volume. Looking at our drivers, in constant dollars, global payments volume was up 8% year-over-year and processed transactions grew 9% year-over-year. Cross-border volume growth excluding intra-Europe was up 16% year-over-year in constant dollars. Fiscal first-quarter net revenues were up 9% in nominal and constant dollars, which was on the high-end of our expectations, primarily due to lower-than-expected incentives and less FX drag. GAAP EPS was up 20% and non-GAAP EPS was up 11% in nominal and 10% in constant dollars. Now on to the details, starting with the U.S. U.S. payment volumes grew 5% year-over-year, credit grew 6% and debit grew 5%. Card-present spend grew 3% and card not present volume grew 7%. As we look at the monthly total U.S. payments volume growth rates throughout the quarter, we saw low in October and a peak in November with December in between. Putting it all together, the step-down of about 80 basis-points in total US payments volume growth from Q4 to Q1 was primarily due to a less favorable mix of weekends and weekdays compared to last year and a combination of a few small items, including a softer October and modest impact from Reg II. Consumer spend across all segments from low to high spend has remained relatively stable. Our data does not indicate any meaningful behavior change across consumer segments. Moving to holiday spend, which is the period from November 1 to December 31. In the US, consumer holiday spend growth was in the mid-single-digits on a year-over-year basis. Consumer retail spending growth was similar to last year. However, retail spending growth on key shopping days from Thanksgiving to Cyber Monday was much stronger. E-commerce increased its share of retail spending versus last year. Moving to international markets, where total payments volume growth was up 11% in constant dollars, stable to Q4. Payments' volume growth rates were strong for the quarter in most major regions of Latin-America, CEMEA and Europe ex-U.K. each growing about 20% in constant dollars. Now on to cross-border, which I'll speak to in constant dollars and excluding intra-Europe transactions. Total cross-border volume was up 16% year-over-year. Cross-border card-not-present volume growth excluding travel grew slightly faster-than-expected in the low-teens adjusted for cryptocurrency purchases. Cross-border travel-related spend grew 19% year-over-year. The cross-border travel volume index to 2019 increased from 139% in Q4 to 142% in Q1. Travel volume into Asia indexed at 132% of 2019 levels for the quarter, up three points from Q4, while travel volume out of Asia was up four points to 118%. This was lower than last quarter's expansion, primarily due to relative weakness in Australia and Japan. Travel in and out of Mainland China continued to improve, but both remain below 2019 levels. U.S. travel inbound continued to improve several points from Q4 versus 2019 levels. And we continued to see healthy travel volumes in and out of LAC, Europe and CEMEA and out-of-the US, ranging from 145% to 170% of 2019 levels. Now let's review our first-quarter financial results, starting with the revenue components. First, as any new pricing usually goes into effect in April and October, this quarter, each of our revenue components benefited as a result and the growth rates were either further enhanced or offset by the additional factors as follows. Service revenues grew 11% year-over-year versus the 9% growth in Q4 constant dollar payments volume with some additional help from card benefits. Data processing revenues grew 14% versus 9% processed transaction growth, helped by business mix and value-added services. International transaction revenues were up 8% versus the 16% increase in constant dollar cross-border volume, excluding intra-Europe, impacted by lapping strong currency volatility from last year. Other revenues grew 18% with strong consulting revenue growth, but impacted by lapping 31% growth from 2023, primarily from FIFA related value-added services revenue. Client incentives grew 20%, but ended-up lower-than-expected due to client performance and deal timing. Across our three growth engines, consumer payments growth was driven by relative stability in payments volume growth and processed transactions as well as strong growth in cross-border volume. This quarter, in new flows, the underlying drivers remained relatively stable. Commercial volumes rose 8% year-over-year in constant dollars and Visa Direct transactions grew 20%. Total new flows revenue grew in the low-single-digits year-over-year in constant dollars due to several one-time items and business mix impact. As you know, for any given period, there can be puts and takes, but most importantly drivers are stable and we continue to expect full-year 2024 new flows revenue to grow faster than consumer payments revenue. In Q1, value-added services revenue grew 20% in constant dollars to $2.1 billion with strength and issuing and acceptance solutions. GAAP operating expenses declined 6%. The decrease in expenses was driven by a decrease in the litigation provision, somewhat offset by an increase in personnel expenses. Non-GAAP operating expenses grew 7%, primarily due to an increase in personnel expenses. Excluding net gains from our equity investments of $4 million, non-GAAP non-operating income was $84 million. Our GAAP tax-rate was 19.1% and our non-GAAP was 19%, helped by larger-than-expected tax benefits. GAAP EPS was $2.39; non-GAAP EPS was $2.41, up 11% over last year, inclusive of an approximately 0.5 point benefit from exchange rates. In Q1, we bought back approximately $3.4 billion in stock and distributed over $1 billion in dividends to our stockholders. At the end of December, we had $26.4 billion remaining in our buyback authorization. Now let's move to what we've seen so far in January through to the 21st. U.S. payment volume was up 4% with debit up 3% and credit up 4% year-over-year, down from December, largely due to severe weather conditions in parts of the U.S. Process transactions grew 8% year-over-year. Constant dollar cross-border volume, excluding transactions within Europe, grew 16% year-over-year. Travel-related cross-border volume, excluding intra-Europe, grew 16% year-over-year or 146% indexed to 2019; and cross-border card-not-present ex travel grew 16%. Now on to our expectations. Remember that adjusted basis is defined as non-GAAP results in constant dollar and excluding acquisition impacts. You can review these disclosures in our earnings presentation for more detail. For the full year, we have no material changes to our prior outlook for drivers, adjusted net revenues or EPS growth. Remember that our drivers assume no recession or a further increase in Reg II impacts. Pismo is expected to have minimal benefit to full year net revenue growth and an approximately 0.5 point headwind to non-GAAP operating expense and EPS growth. FX is expected to have an approximately 0.5 point drag to net revenues growth and approximately 1 point benefit to non-GAAP operating expense growth and a minimal drag to non-GAAP EPS growth. Non-GAAP non-operating income is expected to be between $350 million and $400 million, with nearly half in Q2 due to the resolution of some non-U.S. tax matters. Putting it all together, adjusted net revenues growth is unchanged at low-double-digits, adjusted operating expense growth is updated to low double digits, and adjusted EPS growth is unchanged at low-teens. For the second quarter, similar to the full-year, Pismo is expected to have a minimal benefit to net revenues growth and an approximately 0.5 point headwind to non-GAAP operating expense and EPS growth. FX is expected to have minimal drag to net revenues growth and an approximately 0.5 point benefit to non-GAAP operating expense growth and minimal benefit to non-GAAP EPS growth. We expect adjusted net revenues growth in the upper mid to high-single-digits and adjusted operating expense growth in the low-double-digits, north of 10%. Nonoperating income is expected to be highest in Q2 due to the resolution of some tax matters, as I noted earlier. As such, the tax rate is expected to be between 16% and 16.5% in Q2 with the full-year unchanged. This puts second quarter adjusted EPS growth in the high-teens. In summary, we're off to a solid start in the first quarter. The fundamental drivers remain relatively stable, and with no material changes to our full year guidance, we remain focused on the execution of our growth strategy for the rest of 2024. As always, if the environment changes and there's an event that impacts our business, we will, of course, adjust our spending plans. We remain thoughtful on balancing between short- and long-term considerations. And now Jennifer, let's go to Q&A."
},
{
"speaker": "Jennifer Como",
"content": "Thanks, Chris, and with that, we're ready to take questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Our first question comes from Tien-Tsin Huang with JPMorgan. Your line is open."
},
{
"speaker": "Tien-Tsin Huang",
"content": "Hey, thanks so much. Just want a clarification and a bigger question here. Just on the clarification, the new flows up low single digits versus mid-teens last quarter. How did that come in versus plan? Were there some onetime issues? Because it sounds like the other metrics were in line. And then my question was just on U.S. volume running in the mid-single-digits here, it's pretty tight to PCE. I know there are a lot of factors like gas and e-com and Reg II, but just can you clarify your view on U.S. volume here in relation to PCE growth in the short to mid-term? Thank you."
},
{
"speaker": "Ryan McInerney",
"content": "Tien-Tsin, it's Ryan. Why don't I start on the second part of your question and then Chris can answer the first part and add or correct any on the second part. I think let's back way up for a second in the U.S. U.S. remains a significant opportunity for us in consumer payments. I mean, there's still a lot of cash, a lot of checks, a lot of ACH. We're having great work with fintechs and banks to bring more people in on the carded front. We're doing work to expand acceptance, the service industry, whether it's plumbers or contractors, charities, vending, parking, tap to pay. I mean, we continue to be very, very excited about the U.S. market. I think as you said, and Chris can add some detail, in the quarter, there's some Visa-specific factors on the growth rate in the U.S. as it relates to PCE, like you were talking about. But as we look forward, it continues to be a big opportunity for us. We continue to be excited about it. Chris, do you want to take the first part of Tien-Tsin's question and add anything on the second?"
},
{
"speaker": "Chris Suh",
"content": "Sure. Yes, in new flows, so the underlying fundamentals of our commercial business remain sound. Commercial payment volumes grew 8% and Visa Direct transactions grew 20%. And importantly, the new flows business continues to be a growth engine for Visa. We do expect the full-year revenue growth to exceed consumer revenue growth. Now specific to your question around the first quarter, it was impacted by a couple of factors: first, the mix of business, with cross-border volume growth slowing in Q1 as travel continued to normalize; and second, the growth was also impacted by a few onetime items that happened to be larger than we might typically see in any given quarter. But all in all, we feel great about the business and the long-term growth trajectory ahead."
},
{
"speaker": "Tien-Tsin Huang",
"content": "Cool, that's helpful. Thank you both."
},
{
"speaker": "Jennifer Como",
"content": "Next question, Jordan."
},
{
"speaker": "Operator",
"content": "Our next question comes from Dan Perlin with RBC Capital Markets. Your line is open."
},
{
"speaker": "Dan Perlin",
"content": "Thanks. I just wanted to ask a question around the new partnerships within value-added services. Ryan, it sounds like, as part of the priorities, you want to get value-added services on all the networks. And I think you were alluding to the fact that this is going to be maybe a bigger shared responsibility with this partnership growth, and ServiceNow is obviously a great example. But I'm just trying to reconcile kind of how we should be thinking about Visa maybe opening up those opportunities with these two partnerships and what that may do at some point to the financial picture of the company? Thanks."
},
{
"speaker": "Ryan McInerney",
"content": "Yes. Again, if I back up before I answer to the specific question about ServiceNow and partners, we're very excited about the progress that we've made on our value-added services strategy. We're excited about the momentum that we're seeing kind of in the market. We're excited to see our sales efforts really driving success and performance across issuing, acceptance, risk and identity, advisory and open banking. And it's exactly as you were saying with partners like ServiceNow. What we're finding is we can have great efforts selling to our partners directly around the world. But we're also getting a lot of demand from various different platforms that already have relationship with thousands or tens of thousands or, in some cases, more customers in any one country or region. And they're very excited to sell through our value-added services as a way of differentiating their platform and deepening relationships with their users and their customers. And so in the example of ServiceNow, they had been talking to their bank clients, and their bank clients had asked for and been interested in some of the dispute services that we provide. And so we're going to market first, as I said in my prepared remarks, with our dispute services via ServiceNow. We've got a pipeline of other products and services that we're working with them on. And we're deep in discussions with other platforms around the world about bringing our money movement solutions and our value-added services solutions as a way to differentiate their platform and add value to their users."
},
{
"speaker": "Jennifer Como",
"content": "Next question, Jordan."
},
{
"speaker": "Operator",
"content": "Our next question comes from Craig Maurer with FT Partners. Your line is open."
},
{
"speaker": "Jennifer Como",
"content": "Craig, are you there?"
},
{
"speaker": "Craig Maurer",
"content": "Yes. Sorry, can you hear me?"
},
{
"speaker": "Jennifer Como",
"content": "We sure can."
},
{
"speaker": "Craig Maurer",
"content": "Okay. Great. I wanted to ask if you can be a little bit more detailed in the comments around Reg II and how you're seeing volume move perhaps off your network. And second, if you can just add some detail around the onetime items that impacted Visa in the U.S. in the quarter, I'd appreciate it."
},
{
"speaker": "Ryan McInerney",
"content": "So let me talk a little bit about the business aspect of Reg II, and then Chris, you can hit both of those specific questions, the Reg II and the onetime items. I think it's important at this point to just observe. We're 6 months in now since Reg II in the U.S. And we've had a chance to really engage with our clients and partners on the merchant side of what we do. And we're having really good discussions, really good dialogues. It's been a great opportunity for us to highlight our products, our services and especially the various different things that differentiate a Visa debit transaction from other alternatives. And to be honest, we're getting the chance to have conversations at more senior levels in the organization about the details of our products than we've ever had before, which is great. And so far, we're having great success. The sales conversations have been positive. The results client by client that we're finding as we're able to talk to them about the features and benefits of Visa Direct are great so far and feel really good about our results 6 months into this so far. So Chris, you want to hit the two pieces specifically?"
},
{
"speaker": "Chris Suh",
"content": "Yes, will do. So yes, on Reg II, so as we indicated, we did see some modest impact in the U.S. Payment volumes growth in the U.S. was down about 80 basis points from Q4 to Q1. And that slowdown was primarily due to a couple of things. One is the mix of spend days, but also there were a few smaller things, a softer October and the modest impact from Reg II that we're talking about. So a couple of things. It's important to note, we've actually not seen any meaningful changes to volumes being routed away since October. So all in all, the impact is modest, really hasn't changed over the past quarter, and that's actually what we have assumed and we shared for the rest of the year. Now to your second part of your question about one-time items, I talked a little bit about the things in the U.S., Reg II and the slow October. The other place where I talked about onetime items was in the new flows business. As I said, the revenue growth was impacted by a couple of things. One, I talked about the cross-border normalization as on travel. And then secondly, there were these one-time items, and I'll give you an example of one. In the normal course of our business, we regularly true up or true down our incentive and rebates with our clients based on their reported metrics. And in the first quarter, the net impact of these adjustments ended up being larger than we might typically see in a quarter. But all in all, it's not something that gives us concern. The underlying business fundamentals remain healthy. It doesn't change our expectations for full year growth for new flows revenue, which will continue to outpace consumer revenue."
},
{
"speaker": "Jennifer Como",
"content": "Next question, Jordan."
},
{
"speaker": "Operator",
"content": "Our next question comes from Sanjay Sakhrani with KBW. Your line is open."
},
{
"speaker": "Sanjay Sakhrani",
"content": "Thanks, good evening. I guess just a question on the slower volumes year-to-date, on the severe weather. I'm just curious if there's been any softness beyond that. And then maybe, do you expect that spending to sort of reaccelerate because the weather has gotten better? Or maybe you can just speak about that a little bit."
},
{
"speaker": "Chris Suh",
"content": "Yes. Thanks, Sanjay. Yes, we did see that growth slowdown in the first week of January. And we've looked really closely at it, and it's directly correlated to the extreme cold weather that's hit in many parts of the U.S. I'll give you a few examples. For anyone in Kansas City, they know this. We went from 45 degrees in the last week of December to negative 10 in the first few weeks of January. And so no one was out and about, and we saw growth in Kansas City go from mid-single digits growing to declining mid-single digits. To take another example, in San Diego, those that are lucky enough to be there, 60 degrees, and we've seen stable mid-single-digit volume growth into January. And maybe a third example that highlights the swings that we saw, in Dallas, it was nearly 60 in the first two weeks of January and then dropped to below 20 degrees in the third week, and we saw the exact same pattern following with our card-present volumes in that third week. And so to the second part of your question, the good news is we've seen these type of weather-related patterns before. They tend to be short blips, and over the course of the quarter, tend to get smoothed back out."
},
{
"speaker": "Jennifer Como",
"content": "Next question, Jordan."
},
{
"speaker": "Operator",
"content": "Our next question comes from Ken Suchoski with Autonomous Research. Your line is open."
},
{
"speaker": "Ken Suchoski",
"content": "Hi, good afternoon. Thanks for taking the question. I wanted to ask about the EPS growth outlook. It looks like you're guiding to high-teens EPS growth in fiscal 2Q, which I think implies a mid-single-digit decline in the share count quarter-over-quarter. But I'm just trying to figure out why that doesn't flow through to the full year EPS growth figure where you're guiding it to low-teens growth. So if you can help us reconcile that, that would be great. Maybe there's some tax, certain OpEx impacts in the back half of the year that we're not accounting for."
},
{
"speaker": "Chris Suh",
"content": "Yes. It is specific to Q2. I think I mentioned on the call, there were some tax matters that were resolved outside of the U.S. that brought our tax rate down in Q2 into the 16% range. That same matter also had some benefit that hit the NOI line, which also then helped the high-teens growth rate on EPS in Q2 specifically. For the full-year, it doesn't change the tax rate. It doesn't change our prior outlook for EPS growth."
},
{
"speaker": "Jennifer Como",
"content": "Next question, Jordan."
},
{
"speaker": "Operator",
"content": "Our next question comes from Harshita Rawat with Bernstein. Your line is open."
},
{
"speaker": "Harshita Rawat",
"content": "Good afternoon. I want to follow-up on services. Given how increasingly important these are to your revenue growth, can you give us some insights, quantification on the composition of your value-added services, DPS, CyberSource, risk, et cetera? And maybe also expand about the growth drivers here with regards to attach rates, processing penetration, geo expansion. They're growing almost 2 times faster than your card volumes' overall services, so we are trying to just have a clear guidance here."
},
{
"speaker": "Ryan McInerney",
"content": "Yes, thank you. As I was saying earlier, I think the strategy is really firing on all cylinders. Our execution is firing on all cylinders. The client demand remains strong. The TAMs are large, as you were saying. Last year, we generated about $7 billion in revenue in the value-added services business. I think we said in the quarter, it was a little more than $2 billion and up 20% in constant dollars. Those are great results. To get in a little bit into the details of your question, I mean, we run these businesses segment by segment. In issuing solutions, we're having great success with our network products around the world. DPS continues to have great success with clients in the U.S. I mentioned in my prepared remarks that we had renewed with Bank of America. That's one of our, as you might expect, largest clients in DPS, a fantastic partner, as well as a number of the other value-added services I mentioned. In the acceptance solutions business, CyberSource continues to have great success around the world, both with their omnichannel services as well as some of the value-added services they have, like token management service and the like. Our disputes business beyond just what I mentioned earlier around ServiceNow is having great success. Verifi is really firing on all cylinders, especially as it expands outside the U.S. Our risk and identity solutions business is really proving to be very resilient and high growth, both our Advanced Authorization Platform, Visa Risk Manager, Visa Secure, all the various different products that we've been bringing to market. And then our advisory services continue to do well. I mentioned in a few of the client wins in my prepared remarks, the success we've had with our managed services platforms where we're embedding teams of Visa employees in our clients, working shoulder to shoulder with our client partners day in and day out, week in and week out, month in and month out, helping them drive their business forward. I mean, that drives revenue growth. That diversifies our revenue. But more importantly than any of that, that embeds us in the building with our clients, helping them grow their businesses, makes our core business even more sticky. So yes, it's execution, it's product pipeline, it's delivery, and we feel really good about the results. Thanks for the question."
},
{
"speaker": "Jennifer Como",
"content": "Next question, Jordan."
},
{
"speaker": "Operator",
"content": "Our next question comes from Bryan Keane with Deutsche Bank. Your line is open."
},
{
"speaker": "Bryan Keane",
"content": "Hi, guys. Just wanted to get a couple of clarifications. I think last quarter, Chris, you talked about growth would be at a low point in the first quarter, and then you would see that trough accelerate going forward. Just a nuance of the guide is mid to high single digits, so just trying to make sure if there was anything else new to report on Q2 versus Q1 being the trough. And then secondly, just a slightly higher operating expense in constant currency from, I think, it was high single to low double, just the low double now. Was there anything to factor in for that?"
},
{
"speaker": "Chris Suh",
"content": "Yes. Thanks, Bryan. Yes, so just backing up to your point, going into Q1, you outlined the guidance that I gave. We set an expectation at that time, similar language, high to mid-single digits to high -- sorry, mid- to high single digits, and we did come in at the high end of that range, which was, again, largely benefiting from timing of incentive performance. We have a similar expectation in terms of the range of growth in Q2, but many of the variables that I talked about in terms of the half one versus half two a quarter ago, which was lapping high volatility, lapping high cross-border performance from a year ago and lapping lower incentive growth from a year ago, those, we continue to believe, hold true. And we do anticipate that growth will accelerate into the second half of the year. In terms of your question on OpEx, yes, the changes that you picked up in terms of the full year guide primarily have to do with two things. One is we're now including the impact of the acquisition of Pismo into the guide for OpEx, and there's been some slight updates based on FX, the current FX rates."
},
{
"speaker": "Jennifer Como",
"content": "Next question, Jordan."
},
{
"speaker": "Operator",
"content": "Our next question comes from Andrew Jeffrey with Truist Securities. Your line is open."
},
{
"speaker": "Andrew Jeffrey",
"content": "Thanks. I appreciate you taking the question. Ryan, I wanted to dig in a little bit on the impressive 17% merchant acceptance growth. It sounds like that really highlights the possibility or the opportunity for continued volume growth even in markets maybe where the secular growth rate is slowing a little bit. Is that sustainable? Should we continue to think about that kind of mid-teens acceptance growth as being a key driver of overall volume expansion?"
},
{
"speaker": "Ryan McInerney",
"content": "Listen, when I'm talking to our sales teams around the world, I'm pushing them for as much as possible and more. I mean, if you travel around the world, there are still hundreds of millions of small businesses that aren't on our network. And then you add to that, Andrew, you add to that kind of the creator economy and what's happening there. You literally can think about the acceptance opportunity in billions. So our sales teams around the world are out there working hard, getting creative, figuring out different ways around the world that we can serve those 100-plus million small and micro businesses and ultimately, 1 billion, 2 billion, 3-plus billion individuals around the world that all ultimately could become acceptors of our products as you think about things like Tap to Phone rolling out at scale. I mean, you can imagine a world where every handheld device becomes a tap acceptor, and every device is a tap to pay opportunity where we can not only penetrate further into the C2B space but the P2P space and others. So we felt really good, as you were alluding to, for the last -- I think the last several quarters, we've been 17%, 18%, 19% growth in acceptance locations. I tried, in my prepared remarks, just to give you a little bit of color of the type of things that we're out there doing with players like bKash and Caixa. And we'll be pushing hard to continue to light up all those other opportunities in emerging markets and developed markets around the world."
},
{
"speaker": "Jennifer Como",
"content": "Next question, Jordan."
},
{
"speaker": "Operator",
"content": "Our next question comes from James Faucette with Morgan Stanley. Your line is open."
},
{
"speaker": "James Faucette",
"content": "Thank you. I wanted to touch on the cross-border travel volume growth. It looks like it slowed from roughly 25% to maybe 16% to 17% in January. And back when you're kind of outlining your assumptions for fiscal '24, you thought it would be in the low-20%, and we see a 4 to 5 percentage point improvement compared to 2019. Just wondering how we should think about that as an assumption going forward. Do you think we'll bounce back to that low 20s? Or do you think something closer to where you've seen in January makes more sense? Now this is an area that sometimes you have at least some forward visibility, so trying to get a sense of where we should be thinking about that component?"
},
{
"speaker": "Chris Suh",
"content": "Yes. Great. Thanks, James. We had a really good quarter in Q1 to start the year on our cross-border business. Cross-border volumes, as you said, was up 16%. We feel great about that; and as you click into those, e-com growth in the low teens and 19% growth in travel, with the index going from 139% to 142%. And I'll just clarify one thing you said in terms of the guidance that we had provided into the low 20s, that was related to the travel portion of that, which came in at 19% or almost 20%. I do think when understanding the composition by region of our performance, and some of this is a little repetitious but I think important to go through, looking at it region by region is helpful. In LAC, CEMEA, Europe and U.S. outbound, strong results, indexing between 145% to 170% relative to the 2019 levels; second, U.S. inbound, which up until Q4 had lagged 2019, also continued to improve in Q1 and in line with our expectations; in AP, we did see continued expansion in and out of AP but a little bit slower than we saw in Q4, and that was specific to Australia and Japan. And it's probably also worth mentioning, well, not necessarily a large number, the war in the Middle East did have some impact on the cross-border numbers as well. But again, stepping back, we feel really good about our cross-border business in total. The Q1 results were strong, 16% growth; healthy growth for both travel and e-com. And we feel good about the outlook for the rest of the year."
},
{
"speaker": "Jennifer Como",
"content": "Next question, Jordan."
},
{
"speaker": "Operator",
"content": "Our next question comes from Ashwin Shirvaikar with Citi. Your line is open."
},
{
"speaker": "Ashwin Shirvaikar",
"content": "Hey, Ryan. Chris, Jen, how are you? I just want to drill down into sort of expectations or implied expectations for second half of fiscal '24 given Q1 results, upper single digits; Q2 expectations around growth, mid- to high single digits, so there's an acceleration that's implied. And the question is, what drives it?"
},
{
"speaker": "Chris Suh",
"content": "Yes. Thanks. I'm going to break that down into two questions because, one, you said how do we feel about the revenue guide and then I think the second question implied there was on drivers. And so let me talk to those because they are a little bit different. And maybe I'll even start with the second part first, which is with drivers. We're 1 quarter into the fiscal year. It was a solid quarter, stable trends from Q4. And importantly, the consumer has remained resilient. As we look into the rest of the year, we do anticipate drivers to continue to tick up slightly in the second half of the year for two reasons: one, average ticket sizes should improve, in particular, as we lap lower ticket sizes in the second half of last year in the U.S. and we see continued inflation in certain international regions; and second, we're continuing to execute against our growth initiatives in our global markets, for example, the processing wins that we've seen in LAC that we've shared progress about previously. So that's sort of the underlying drivers. And then your first question actually was on revenue. We had a solid start for the year, a really good Q1, stable Q4 trends. Today, we've reaffirmed our full year guide on net revenue in constant dollars, and that includes the modest impact of Reg II that we talked about. So we feel good about Q1. We feel good about the outlook for the rest of the year, and we'll continue to focus on execution."
},
{
"speaker": "Jennifer Como",
"content": "Next question Jordan."
},
{
"speaker": "Operator",
"content": "Our next question comes from Timothy Chiodo with UBS. Your line is open."
},
{
"speaker": "Timothy Chiodo",
"content": "Great. Thanks for taking the question. I wanted to dig into Pismo a little bit. The website talks about large banks, marketplaces and fintechs. And you mentioned earlier the movement away from the legacy systems into more modern cores. I want to talk a little bit about the ambitions and the potential in terms of the bank sizing. And also, these core conversions, are they for new product and sort of sidecar cores, if you will? Or are we talking about the potential for your core kind of issuing clients in the U.S., midsized banks, to be moving their legacy core potentially over to something offered by Pismo in the future?"
},
{
"speaker": "Ryan McInerney",
"content": "So let me step back and talk a bit about how we found Pismo and then answer your question directly, Timothy. I mentioned in my prepared remarks these narratives and these priorities that we've been hearing from CEOs of banks all over the world, in the U.S. and all over the world, medium-sized, big-sized banks, which is, one, they're trying to make this transition from their legacy tech stacks to the cloud; and the second is they want to expand, especially in emerging markets where they don't have enough options of issuer processors to help them. That led us, hearing that over and over and over again, to go search the world for what we thought was the best cloud-based processor and core bank provider that we could find. And that led us to Pismo. And so while Pismo is based down in Brazil, their platform is global. Their clients today are a mix of some of the biggest and most sophisticated banks in the world as well as medium-sized banks and fintechs. So they already today have a mix of different client types. And our ambitions, our ambitions are what I said in my prepared remarks, which is we want this to be the preferred provider of banks around the world. You asked specifically about midsized banks in the U.S. for their core banking platform, the short answer is absolutely. As you think about large banks and their issuer processing capabilities not just for debit, which we have today in the U.S., but for debit, credit, prepaid, commercial, not just in the U.S. but globally, we think Pismo is absolutely a solution that our issuers could be using around the world. So yes, it is a global platform. We have global ambitions. Given the relationships that we have, the privileged relationships that we have with banks, big and small, in the U.S. and around the world, we feel good about our ability to distribute the product to them."
},
{
"speaker": "Jennifer Como",
"content": "Last question, Jordan."
},
{
"speaker": "Operator",
"content": "Our final question comes from Jason Kupferberg with Bank of America. Your line is open."
},
{
"speaker": "Jason Kupferberg",
"content": "Thank you. Just wanted to ask if we're still comfortable with low double-digit process volume and transaction growth for this year. I know both of those started off kind of in the high-single-digit range, ticked down a little bit in January. And also, any change in your thoughts around fiscal '24 incentive guidance? I think we were looking for modestly less dollar growth than in F '23, but you did a little better than expected in Q1. Thanks."
},
{
"speaker": "Chris Suh",
"content": "Yes. Thanks, Jason. I think I answered some of the driver questions, but I'll just recap very quickly at a summary level. We're reaffirming the outlook for the full-year on drivers, second half benefiting from average ticket sizes in the U.S. and inflation in certain international regions and continuing to executing a number of our growth initiatives in global markets. Processing wins in LAC is the example that I used a minute ago. And so yes to your first question about reaffirming the guide on drivers. And then sorry, repeat your second question for me."
},
{
"speaker": "Jason Kupferberg",
"content": "Just on the incentive guide."
},
{
"speaker": "Chris Suh",
"content": "Incentives, yes. On incentives, yes, also no change in outlook for the full year. As you know, we manage the business to net revenue growth. That's where we're focused. We've updated our guidance for the full-year and Q2 on that. And we'll continue to, like I said, focus on execution."
},
{
"speaker": "Jennifer Como",
"content": "Great. And with that, we'd like to thank you for joining us today. If you have additional questions, please feel free to call or e-mail our Investor Relations team. Thanks again, and have a great day."
},
{
"speaker": "Operator",
"content": "Thank you for your participation in today's conference. You may disconnect at this time."
}
] |
vici | 2,024 | 4 | [
{
"speaker": "Operator",
"content": "Good day, ladies and gentlemen. Thank you for standing by. Welcome to the VICI Properties Fourth Quarter and Full Year 2024 Earnings Conference Call. At this time, all participants are in a listen-only mode. Please note that this conference call is being recorded today, February 21, 2025. I'll now turn the call over to Samantha Gallagher, General Counsel with VICI Properties."
},
{
"speaker": "Samantha Gallagher",
"content": "Thank you, Operator, and good morning. Everyone should have access to the company's fourth quarter and full year 2024 earnings release and supplemental information. The release and supplemental information can be found in the investor section of the VICI Properties website, viciproperties.com. Some of our comments today will be forward-looking statements within the meaning of the federal securities laws. Forward-looking statements are usually identified by the use of words such as will, believe, expect, should, guidance, intends, outlook, projects, or other similar phrases and are subject to numerous risks and uncertainties that could cause actual results to differ materially from what we expect. Therefore, you should exercise caution in interpreting and relying on them. I refer you to the company's SEC filings for a more detailed discussion of the risks that could impact future operating results and financial condition. During the call, we will discuss certain non-GAAP measures, which we believe can be useful in evaluating the company's operating performance. These measures should not be considered in isolation or as a substitute for our financial results prepared in accordance with GAAP. Reconciliation of these measures to the most directly comparable GAAP measure is available on our website, our fourth quarter and full year 2024 earnings release, our supplemental information, and our other filings with the SEC. For additional information with respect to non-GAAP measures of certain tenants and/or counterparties discussed on this call, please refer to the respective company's public filings with the SEC. Hosting the call today, we have Ed Pitoniak, Chief Executive Officer; John Payne, President and Chief Operating Officer; David Kieske, Chief Financial Officer; Gabe Wasserman, Chief Accounting Officer; and William McCluskey, Senior Vice President of Capital Markets. Ed and team will provide some opening remarks, then we will open the call to questions. With that, I'll turn the call over to Ed."
},
{
"speaker": "Ed Pitoniak",
"content": "Thank you, Samantha. Good morning, everyone. Thanks for joining us. Over the course of the next few minutes leading into our Q&A session, you'll hear from John Payne on our growth activities, and you'll hear from David Kieske on our financial results, financing activities, and initial 2025 earnings guidance. I'll start the call with a few words about the announcement we made Wednesday morning, initiating a new VICI strategic and financial relationship with Cain International and Eldridge Industries through an initial investment in the financing of the One Beverly Hills development. Like most of VICI's growth activities, this VICI investment is a result of our growing and new relationship. This relationship began last May when on a trip to London, I spent time with Jonathan Goldstein, the founding CEO of Cain International, a diversified global real estate development and investment company. By the end of our hour, Jonathan and I agreed that we should find ways to work together. Our urge to work together grew out of the recognition that we share convictions, and we share values. We share conviction in the secular strength for years to come, of experiences. We share cultural and ethical values around partnership. Put another way, the meeting of Cain and VICI is a meeting of minds, and a meeting of ambitions, particularly the shared ambition to invest in differentiated place-based experiences, whether those experiences are entertainment, hospitality, wellness, or sport-based. Excuse me. For those of you not familiar with Cain, which as of year-end 2024 had nearly $18 billion in assets under management, it was founded in 2014 by Jonathan and his partner, Todd Boehly, and it's affiliated with Eldridge Industries, an investment company founded and led by Todd Boehly. Cain and Eldridge have made investments in iconic experiential brands that include Aman, Delano, St. James Sports Clubs, Cirque du Soleil, and Flexjet. Todd is an owner of the Los Angeles Dodgers and the Los Angeles Lakers, and both Todd and Jonathan are owners of Chelsea FC in the English Premier League. As 2024 went by, Jonathan asked if the development at One Beverly Hills might be our first opportunity to work together. These discussions enabled Cain, Eldridge, and VICI to get to know each other better, and over the last few months, we all came to believe that our shared conviction around place-based experiences could yield as many compelling opportunities to work together in the years to come. And that's why, as well as announcing our One Beverly Hills investment on Wednesday, Cain, Eldridge, and VICI also announced our joint signing of a letter of intent expressing our intention to work collaboratively to identify and pursue experiential investment opportunities that meet our respective investment objectives. As you would have seen if you reviewed the investment deck we posted to our website, One Beverly Hills stands to rank among the most compelling American luxury hospitality, retail, and residential developments in recent history. The development is currently rising out of over 17.5 of the best-located acres in Beverly Hills, a triangle bordered by Wilshire Boulevard, Santa Monica Boulevard, and the LA Country Club. This development is centered on the Aman brand, among the world's most venerated luxury hospitality brands. One Beverly Hills will be the largest realization of Aman-branded hospitality, wellness, and living to date with an Aman hotel, an Aman wellness spa, an Aman Club, and two Aman residential towers. The development will also include a full renovation of the legendary Beverly Hilton, longtime host site of the Golden Globes and the Milken Conference, as well as ten acres of botanical gardens and open space with high-end retail and dining offerings. Capital is a key fuel for ambitious placemakers and experience creators. Cain stands among the most ambitious placemakers we have come to know, and yet Cain balances that ambition with what we've seen to be strong capability in development risk management. We believe multi-generational, multinational demand for the differentiated experience within the differentiated place will create abundant opportunities for Cain and Eldridge in the coming decades, and we're excited about the prospect of becoming a long-term partner in their growth. This announcement of our new partnership with Cain and Eldridge represents our first new venture in what we hope will be a year of new investment ventures in both gaming and non-gaming. For more on that, I'll now turn the call over to John."
},
{
"speaker": "John Payne",
"content": "Thanks, Ed, and good morning to everyone. I'll start by reiterating Ed's enthusiasm around the new strategic relationship we formed with Cain and Eldridge. As we said time and time again, deep relationships are at the core of VICI's investment strategy. Through the development of a new relationship with Homefield Kansas City and the strength of existing relationships with Great Wolf and the team from Venetian, we were able to commit approximately $1.1 billion of capital in 2024 at an initial yield of 8.1%. The quality and scale of our existing portfolio also accrues to the value of our platform. Since our last earnings call in early November, the VICI team attended the NAREIT conference in Las Vegas. The conference provided a great opportunity to physically showcase our Las Vegas Strip assets and convey the incredible scale of operation happening at these properties every single day. For example, the Venetian, to which we committed up to $700 million in 2024 through our partner property growth fund strategy, sprawls over 17 million square feet. It is being proactively reimagined across several business verticals, including convention, food and beverage, hotel rooms, gaming floor optimization, entertainment, and more to drive the continued growth of the operating business, as well as capitalize on the Sphere, which sits behind the Venetian. In R.J. Milligan's NAREIT recap note, he observed that, I quote, \"With all the events in and around Las Vegas, it was hard to ignore the quality of VICI's real estate, which we don't think the market is giving them enough credit for. It's just so hard to comprehend that VICI was able to purchase the Venetian at the same cap rate as a well-located Dollar General.\" Well stated, RJ. Las Vegas tourism also continues to hit records. According to the LVCVA, 2024 saw record airline passengers through Harry Reid Airport at 58 million for the year, and visitation to the city increased 2% year-over-year to approximately 42 million. Our operating partners are reinventing experiences at our assets to capitalize on demand. For example, MGM Grand recently announced a $300 million remodel of all of their 4,200 hotel rooms, to be completed in December of 2025, and launched their Palm Tree Beach Club outdoor music and entertainment venue, which will open in May of 2025. Caesars New Orleans just opened following a comprehensive $435 million renovation, and the property hosted many Super Bowl fillers a couple of weeks ago. And in November of last year, Harvey's Lake Tahoe also announced a $100 million all-encompassing transformational project. Just since the fourth quarter, our operators have announced nearly $1 billion of investment in our real estate. That is reflective of our shared conviction around the value of high-quality experiences at high-quality properties. VICI believes that the quality and scale of investment opportunity in our existing properties, as well as our ability to cultivate and maintain deep relationships with our partners, will provide springboards for future growth. Now I will turn the call over to David, who will discuss our financial results and guidance."
},
{
"speaker": "David Kieske",
"content": "Thanks, John. Let's start with our balance sheet. As we begin 2025, seven years after our IPO in 2018, I want to highlight 2024 and reflect on how far our balance sheet has come since going way back to our pre-emergence in the summer of 2017. VICI had total leverage of roughly 10.5 times debt to EBITDA. We were born with a very unnatural balance sheet early on, with short tenure, secured debt, second lien debt, and a $1.6 billion CMBS loan that matured in 2022, all instruments that we knew were not consistent with becoming the blue chip we knew we should and could become. After we emerged in October of 2017, we got to work on fixing our balance sheet. We started to chip away at the second lien notes with our IPO and retired the remaining $498 million in February 2020. In connection with the Eldorado Caesars merger, we retired the CMBS debt. With our acquisition of MGP, we were able to retire all of our remaining secured debt and received an investment-grade credit rating from S&P and Fitch in April of 2022. We were once regular at that time with Moody's. Through the leadership of Aaron Ferri and our team, we put our heads down and worked with Moody's over the next two years to educate them on American gaming, the resiliency of our tenants' business, and the quality of our balance sheet. That work paid off with the Moody's upgrade we received on November 18, 2024, giving us an investment-grade credit rating across all three agencies. The ratings upgrade should accrue to our benefit with improved access to and cost of capital over time. We believe our balance sheet and unsecured debt complex is one of the more liquid debt complexes across the REIT landscape, with total debt of $17.1 billion, of which we have unsecured debt of $14.1 billion. This creates liquidity in our unsecured notes. We saw this in our December refinancing, where we had several new institutional credit investors coming to our offering. The quality of our balance sheet was also highlighted during our recent recast of our unsecured revolving credit facility, which we closed subsequent to quarter-end with a new $2.5 billion facility. We had strong sponsorship from our bank group and want to thank each and every institution that committed to that facility and the conviction they all have in our balance sheet and business. We have approximately $3.3 billion in total liquidity, comprised of approximately $525 million in cash, $176 million of estimated proceeds available under our outstanding forwards, and $2.4 billion of availability under our revolving credit facility. Our net debt to annualized fourth quarter adjusted EBITDA, excluding the impact of unsettled forward equity, is approximately 5.3 times, within our target leverage range of 5 to 5.5 times. We have a weighted average interest rate of 4.41%, taking into account our hedge portfolio, and a weighted average of 6.4 years to maturity. Again, thank you to Aaron and the entire team for the work that has been completed. But know that we are not done, with a continual focus on improving our balance sheet. Touching on the income statement, AFFO per share was $0.57 for the quarter, an increase of 3.6% compared to $0.55 for the quarter ended December 31, 2023. For the full year 2024, AFFO per share was $2.26, an increase of 5.1% compared to $2.15 for the full year 2023. Our results highlight our highly efficient triple net model, given the increase in adjusted EBITDA as a proportion of the corresponding increase in revenue. Our margins continue to run strong in the high 90% range when eliminating non-cash items. Our G&A was $20.7 million for the quarter, and as a percentage of total revenues, was only 2.1%, which continues to be one of the lowest ratios in not only the triple net sector but across all REITs. Turning to guidance, we are initiating AFFO guidance for 2025 in both absolute dollars as well as on a per-share basis. AFFO for the year ending December 31, 2025, is expected to be between $2.485 billion and $2.555 billion, or between $2.32 and $2.35 per diluted common share. With 2025 guidance, VICI expects to deliver year-over-year AFFO per share growth of 3.3%, a very solid starting point as we begin 2025. As a reminder, our guidance does not include the impact of operating results from any transactions that have not closed, interest income from any loans that do not yet have final draw structures, possible future acquisitions or dispositions, capital markets activity, or other non-recurring transactions or items. With that, operator, please open the line for questions."
},
{
"speaker": "Operator",
"content": "Thank you. As a reminder, if you'd like to ask a question, please press star followed by one on the telephone keypad. Our first question for today comes from Anthony Paolone from JPMorgan. Your line is now open. Please go ahead."
},
{
"speaker": "Anthony Paolone",
"content": "Yeah. Thanks, and good morning. I guess my first question is, from our side, we obviously just see the things that you close. But just wondering if you could talk about kinda what deal flow looked like in 2024 and what it looks like currently in contrast to maybe in prior years, you know, whether you're seeing a lot of stuff and it's just not making it past the finish line or you're not seeing as much as you'd like in terms of the outright property purchases. And so any color there would be great."
},
{
"speaker": "Ed Pitoniak",
"content": "Yeah. I'll start, Tony, and then I'll turn it over to John. You know, 2024 for us was a year in which we did not see anything resembling a plentiful flow of compelling high-quality real estate acquisition opportunities. We did see a very compelling opportunity to further invest in one of our marquee properties, the Venetian. And what we also saw is that while high-quality existing assets don't appear to be widely for sale, or at least didn't in 2024, highly compelling high-quality developments were there. And a lot of the work we've done, you know, whether with HomeField at the very beginning of the year, whether our ongoing work with Great Wolf, our ongoing work with Canyon Ranch and Cabot, and now our new work with Cain and Eldridge is about identifying and providing capital to great experiential placemakers and getting very, very good yields on it, especially when comparing those yields to the incredibly high quality of the developments we're helping to fund. And beyond that, I'll turn it over to John. He can give you further color on what we saw in 2024, but maybe more importantly, what we believe we will see in 2025. John?"
},
{
"speaker": "John Payne",
"content": "Yes. A little bit, Ed. Tony, good to talk to you this morning. One of the parts of your question was how does it compare to years before. Remember when you started the company, David walked through some of that history. We were simply a casino triple net lease REIT. Today, with Ed's announcement and our announcement the other day, you can see we continue to diversify our portfolio. So the funnel continues to get wider of things that we look at. And I would say the beginning of 2025, I moved as busier than I've been in a very long time. And we continue to be very thoughtful with where we put our capital to work, the type of partners that we want to do business with, the type of growth potential. So that's a long way of saying we're quite busy. The funnel's wide. We're looking at a variety of things in the experiential and the casino gaming space."
},
{
"speaker": "Anthony Paolone",
"content": "Okay. Thanks. And then just a follow-up. Any comments on where you think cash yields would be right now for some of the various buckets that you're looking at, whether it would be, you know, where a high-quality asset on the strip might be versus regional versus some of the other categories?"
},
{
"speaker": "Ed Pitoniak",
"content": "Yeah. Not a lot of visibility into that, Tony, on the strip. We haven't seen any meaningful trades recently on the strip. And I think with the volatility that we've seen in the ten-year over, well, what are we now? The last three years, and this year has not really represented a meaningful change from that volatility. I think it's really a little bit hard to get pricing certainty on permanent assets. Whether on the strip. Regional, I think there's been more trading activity, John. So there's probably somewhat more clarity there. Though, again, quality for us is a key consideration."
},
{
"speaker": "John Payne",
"content": "And remember on the strip, Tony, the world's pretty good out there. I'm not sure there's a market that had such great success again in 2024 after following a record of 2023. So operators looking to sell those assets on the strip is not likely at this time because the business continues to be strong across many of the different segments in Las Vegas."
},
{
"speaker": "Anthony Paolone",
"content": "Okay. Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Caitlin Burrows of Goldman Sachs. Your line is now open. Please go ahead."
},
{
"speaker": "Caitlin Burrows",
"content": "Hi. Good morning, everyone. Maybe just following up on the development funding talk. Ed, I know you mentioned that when you looked through the opportunities of 2024, it seems like that's what made sense at the time. I guess how do you think of that development funding that eventually gets paid back versus acquisitions and what that means for the future of the portfolio and, like, the recurring nature of income?"
},
{
"speaker": "Ed Pitoniak",
"content": "Yeah. No. It's a very good question, Caitlin, and it's one we talk about a lot at the management table at VICI. We, as a starting point, in this particular case with Cain and Eldridge, much has been the case with Great Wolf. We are not overly concerned about the money coming back because of the depth and time extent of the pipeline we believe we could have with Cain. And in this particular case, I obviously need to be careful here, but I do want to say that in the particular case of One Beverly Hills, we are working, we continue to work. Okay. And I should note the money for One Beverly Hills, that $300 million is already going out the door, but we continue to work with Cain as potentially participating in a larger and longer way with One Beverly Hills. But beyond that, to really get to the heart of your question, we see a pipeline of opportunities with Cain across their various verticals. They could enable us to continue to roll our capital into new Cain ventures. When they talk, for example, about the growth opportunity for Aman globally, especially across Europe in the coming decade, we see an opportunity to continue to be a funding partner in that particular example, much in the way David and the team have been now a steady partner to Great Wolf for how long, David?"
},
{
"speaker": "David Kieske",
"content": "Five years? Yeah. About five years."
},
{
"speaker": "Ed Pitoniak",
"content": "Right. So we obviously are mindful of the fact that this money will come back to us at some point or could come back to us at some point, Caitlin. But we really do focus on relationships that we think could enable us to continue to basically roll that capital into new manifestations of a given partnership."
},
{
"speaker": "Caitlin Burrows",
"content": "Got it. Okay. Yeah. That makes sense. And then maybe more like a nerdy question. But on the share count, you guys have a lot of forward equity. So can you go through over what time period you're required to settle those shares? Under what condition? Share price are assumed in guidance?"
},
{
"speaker": "David Kieske",
"content": "Yeah. Caitlin, as we've done for many years now, we have outstanding forward equity on a quarter-by-quarter and an annual basis. And those contracts are typically one-year contracts, but they are extended and amended to go beyond that initial period of time, and that is very commonplace with banks and with the counterparties. And then in our guidance, in our share count, we use the treasury stock solution method in our making some estimates around reasonable projections around future stock prices and incorporating a level of dilution into our guidance range, but do not obviously take into consideration the entirety of those outstanding forwards because we use those to match funds, potential acquisitions, which are not in our guidance. So this is, you know, very common across the REIT land, and we've been doing it. I know a lot of other triple nets have done it for years."
},
{
"speaker": "Ed Pitoniak",
"content": "And maybe I'll just add to what David said, Caitlin, by emphasizing that the way we did it for 2025 guidance is the way we have always done. Okay. There's been no change in the methodology."
},
{
"speaker": "Caitlin Burrows",
"content": "Got it. Okay. Thanks."
},
{
"speaker": "David Kieske",
"content": "Thanks, Caitlin."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Barry Jonas of Truist Securities. Line is now open. Please go ahead."
},
{
"speaker": "Barry Jonas",
"content": "Hey, guys. Good morning. In September, you'll have the right to call the Caesars Forum Center at the same cap rate you had on the Indiana properties. Any thoughts you can offer on the puts and takes to exercising that option?"
},
{
"speaker": "John Payne",
"content": "Barry, good to talk to you. It's definitely an asset that you're well aware of. They built a great facility there. It anchors the empty acreage that we have in Las Vegas. So we'll continue to see how it's performing when that time comes up. Obviously, it also connects to one of our assets in the Harrah's facility that we own the real estate in the building and then lease it back to Caesars. So definitely on our radar. It's definitely something that we've been looking at over the years, and you're all aware of this opportunity that we could have, and we'll continue to study it in time period as it approaches."
},
{
"speaker": "Barry Jonas",
"content": "Understood. Understood. And then just as a follow-up, you know, I'm not sure you've talked about this before, but, you know, you've obviously operated golf courses. But is there a scenario where you would consider operating casinos or other assets in a TRS?"
},
{
"speaker": "Ed Pitoniak",
"content": "Thanks. Well, as the starting point, any casino and Samantha and David helped me out here. Any casino that went into a TRS would have to be a casino with zero, repeat zero, hotel rooms. There is an intricacy or nuance of REIT legislation that would forbid the inclusion of a casino with hotel rooms in a TRS. Beyond that, I would say we don't see that happening. We would not seek to have that happen. I guess it's always a possibility that you we would be silly to rule out a priori with a hundred percent certainty, but not in our plans."
},
{
"speaker": "Barry Jonas",
"content": "Understood. Alright. Thanks, guys."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Greg McGinnis of Scotiabank. The line is now open. Please go ahead."
},
{
"speaker": "Greg McGinnis",
"content": "Hey. Good morning. Given the nonbinding letter of intent on the new partnership with Cain and Eldridge, how would you describe your competitive positioning relative to other capital providers, especially as they consider more permanent financing options upon completion of that development?"
},
{
"speaker": "Ed Pitoniak",
"content": "Yeah. It's a very good question to ask, Greg. I would say that in the case of One Beverly Hills, so, again, we shouldn't rule out anything ever a priori. We do not expect to become a permanent real estate owner of the assets at One Beverly Hills. But having said that, based on the discussions we've already been in with Jonathan Goldstein and with Todd Boehly, we see opportunities to work across a portfolio. For example, in the Cain and Eldridge portfolio, you will see that one of the investments they have is St. James Clubs. And, again, I really emphasize looking at that slide and the wonderful deck that Hayes put together. And St. James Clubs can represent an example of us to further capitalize on the knowledge we've gained through our investment in Chelsea Piers into these kinds of sports and recreation complexes. And absolutely, they will always have the ability to seek other forms, other sources of capital. But I will emphasize that there is a cultural union between or among Cain, Eldridge, and VICI that gives us a lot of confidence that we will always have a chance to be a partner of choice to them as they seek to capitalize the really compelling experiential investments they are making. And I will say, to that regard, Greg. So, Greg, I'll just say to that regard, it was Todd Boehly who proposed, hey, let's do an LOI. I mean, Samantha can explain why in a case like that, you kinda have to make it nonbinding. But it was a sign of Todd's commitment to the partnership."
},
{
"speaker": "Greg McGinnis",
"content": "Okay. Good to hear. I guess thinking about, you know, investing in the assets that you already have. One, curious, you know, is Venetian kind of looking for more of the capital you've potentially committed? And then, you know, MGM guided slightly lower growth CapEx funding for this year. So it does appear they're allocating some funding to MGM Grand. What's your kind of general sense for how CapEx budgets are trending for casinos compared to the last few years, and what might that mean for your investment opportunities with them in Las Vegas and regionally? And then also, how does that compare to the contractually obligated CapEx?"
},
{
"speaker": "John Payne",
"content": "Yeah. Very good question. I'll start in Las Vegas. One of the advantages of our portfolio and having such a big presence in that market is the assets are absolutely incredible. Like, in my opening remarks, I talked about Venetian, and I said that it's over 17 million square feet. That's bigger than some companies' whole portfolio, and it's one of our assets in one market. Why I bring that up is that it provides opportunity for us to brainstorm with the operator about how to use our capital to continue to have them grow. And obviously, this past year, we announced the amount of money up to $700 million we've been putting in with the Apollo team into the Venetian. We have those same conversations with our other partners and operators. Obviously, Las Vegas has bigger boxes than the regionals, but we do have conversations with our regional partners about all their opportunities to build hotels, other opportunities to bring casinos that happen to be on riverboats on the land. So you continue to have those discussions. I think there continues to be an excitement about putting new capital into Las Vegas. In fact, there was an article I saw this morning about the Caesars Organization putting over a billion dollars in Las Vegas over the past couple of years. So that should get you and our investors excited about the opportunities that could be presented in that market. But I think 2025 is very similar to what we saw in 2024 and even 2023, that operators continue to reinvent themselves, and they need capital to create new experiences."
},
{
"speaker": "Greg McGinnis",
"content": "Great. Thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from Rich Hightower of Barclays. Line is now open. Please go ahead."
},
{
"speaker": "Rich Hightower",
"content": "Hey. Good morning, everybody. And congrats again on the new partnership with Cain and Eldridge. Morning, Ed. Let me go back to the guidance really quickly, if you don't mind. David, I think you mentioned in the prepared comments that certain loan fundings are not included in the AFFO number as presented last night. Can you walk us through what precisely, you know, is included, dollars, cadence, timing, etcetera, just so we have a kind of a clear understanding of funding throughout the year as is currently contemplated?"
},
{
"speaker": "David Kieske",
"content": "Yeah. Rich, you mean, like, comments or the specific comment was we do not include in guidance any funding or development funding that does not have an identified draw schedule. As we sit here today, you know, we're continuing to fund Great Wolf, we're funding Canyon Ranch Austin, and Cabot Citrus Farms, and it's fifteen, twenty million dollars a month or so of that. You know, with Great Wolf Northeast, we're complete in May of 2025. Canyon Ranch is sometime in 2026. Citrus Farms is working through, you know, later this year, early next year. So there's not a specific number per month because it's all based on the timing of the draws and the amount of draws and then obviously, the installments are completed. You know, we have a construction loan full from the construction loan that's outstanding."
},
{
"speaker": "Rich Hightower",
"content": "Okay. That's actually helpful. And just to be clear, Venetian, you know, PPG funding is kind of separate from that. Is that what's the timing on that one as well? If I have that correct."
},
{
"speaker": "David Kieske",
"content": "Yeah. So we announced that the total commitment of $700 million. They drew $400 million in 2024. And that is all converted to rent and embedded in the lease. Now they have the option, but not the obligation, to draw an incremental $300 million of that significant over time. And they're both in the budgets right now and their plans, and as John talked about putting a lot of new, you may have seen a lot of new restaurants and a lot of new experiences in the Venetian. And so they're working through and when they would draw that incremental $300 million."
},
{
"speaker": "Ed Pitoniak",
"content": "And needless to say, Rich, given that they have not firmly committed to using any of that, none of that."
},
{
"speaker": "Rich Hightower",
"content": "Okay. That's very helpful. And then one last kind of small one, and I think you guys have addressed this on prior calls, but just so you know, we all have it clear. You know, you do see some pretty big swings in, I guess, the change in allowance for credit losses on the income statement. Obviously, a non-cash number, you know, most of the time. We hope there aren't any actual credit losses. But just, David, help us understand the drivers of that quarter-to-quarter swing?"
},
{
"speaker": "Gabe Wasserman",
"content": "Yeah. Hey. Gabe Wasserman here. I can take that. So in the fourth quarter, most of the allowance is really driven by Moody's, which is the service provider that we use to help us model out and project future losses. The fourth quarter, their economic scenario, which is a scenario condition and a requirement of the model and the bank are using similar forward projections. They were kind of forecasting, you know, higher for longer interest rates, potential tariffs, and some headwinds economically, and that was going through our projections. That was really the driver of the increase in the allowance in the fourth quarter."
},
{
"speaker": "Ed Pitoniak",
"content": "Which, Gabe, would be another way of saying it is it was more general than specific to any senior credit, more macro as opposed to micro to any of those specific."
},
{
"speaker": "Rich Hightower",
"content": "Perfect. Very helpful. Thank you, guys."
},
{
"speaker": "Ed Pitoniak",
"content": "And, Rich, you get an award, Rich, for asking about CECL."
},
{
"speaker": "Rich Hightower",
"content": "I knew we had addressed CECL on prior calls, but I just think it's been a little while. So, again, appreciate the call. Thanks."
},
{
"speaker": "Ed Pitoniak",
"content": "Hey. Yeah. It has. There you go."
},
{
"speaker": "Operator",
"content": "Next question comes from Jim Kammert of Evercore. Line is now open. Please go ahead."
},
{
"speaker": "Jim Kammert",
"content": "Thank you. Good morning. I know, David, obviously, guidance excludes new capital markets activities, but given the $1.3 billion that's rolling or maturing, I should say, of notes in Q2, how is VICI leaning right now? Repay a part of that or refund? And where what would the cost be?"
},
{
"speaker": "David Kieske",
"content": "I think I answered just your question to break it up a little bit. Yeah. We've got a May maturity and June maturity, and we only get in some guidance on those refi's, but we're seeing on a ten-year kinda one twenty, one twenty-five. So spread over the ten-year, which I know it was a four four eight a few, you know, early this morning, but obviously bounces around. So look at mid Yeah. Mid five five and a half to five seven five. Area for a ten-year refinance."
},
{
"speaker": "Jim Kammert",
"content": "Great. Thank you. And then, obviously, early innings with the new relationship, how has his relationship or ownership of Chelsea helped give you a little insight into the tent kind of view as to how those owners and consortiums think about tracking additional capital and opportunity for VICI?"
},
{
"speaker": "Ed Pitoniak",
"content": "Well, certainly, you know, in the specific case of Chelsea, one, as is true with so many of the Premier League teams, they're very focused on making sure that they are doing everything they can to maximize game day revenue. And, obviously, maximizing game day revenue involves making sure you have the optimal stadium and to a great degree now increasingly, the right surroundings around the stadium. We've had, I would say, Samantha, very preliminary chats with Todd around their vision for what Chelsea FC can become in terms of its placement in London, but not much more than that."
},
{
"speaker": "Jim Kammert",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from Smedes Rose of Citi. Your line is now open. Please go ahead."
},
{
"speaker": "Smedes Rose",
"content": "Hi. Thank you. I just wanted to ask you if maybe you provide any sort of update on the licensing process that seems to be kind of lurching forward in New York for, you know, full-on casinos. And just kind of as part of that, if your MGM property were not selected for a license, does it just remain as a essentially, a slot-only facility, or is there some other change that would take place?"
},
{
"speaker": "John Payne",
"content": "Smedes, it's John. I probably should be asking you what you think about the New York process. Look, I think there's news almost every day. We're sitting here in New York altogether. I read an article yesterday about one of the groups that is potentially bidding on the license. It does seem like there's progress being made on all the different steps it takes to win one of the three licenses. It does still seem like they're shooting for a decision at the end of this year, but your guess is as good as mine. Same with the last part of your question you asked about the MGM property at Empire City. We're excited about that group has put together a very, very healthy bid for the full license. I don't know the exact answer to your question. Should they not receive one of the three licenses, how that ultimately plays out with the slot facility, but I think in this whole process plays out with the gaming commissions, how they make their decisions. We'll continue to learn more, but it does seem like there's more progress in Q1 2025 than there has been in a while, but it's hard to determine ultimately when the final stage is."
},
{
"speaker": "Smedes Rose",
"content": "Okay. And then in terms of the ones that really Hills, and maybe this can make any difference in terms of your loan to them. But I just wanted to ask you. I mean, Los Angeles has a lot of luxury retail readily available. It has a lot of housing, and it has a lot of luxury hotels. I guess, you know, from their perspective, you know, what I guess, is giving them confidence that there's incremental demand for, you know, more multimillion-dollar condominiums and more, you know, Chanels and whatnot and just don't know. Maybe that's sort of a dumb question, but I'm just kind of wondering how they're thinking about the demand in fact there."
},
{
"speaker": "Ed Pitoniak",
"content": "Yeah. I think and I'm priming so Samantha. She's gonna need to speak here in a moment because she actually has experience with Aman. I think Smedes, to answer your question, we really have to do all we can to help everyone understand the brand power of Aman. Aman, obviously, is not a public company. There are no Amans within hotel REIT portfolios. But if I were you, I would just do a price check on the rates that Aman gets location by location around the world, because Aman is in a league of its own. Correct, Samantha?"
},
{
"speaker": "Samantha Gallagher",
"content": "Yeah. I think just to add to Ed's point, you're talking ultra-high-end luxury. It truly is above and beyond really what you see almost anywhere else in the world, and they've been able to do it in cities throughout the world. And I think that's what they'll bring to Beverly Hills, which I don't think they have up here."
},
{
"speaker": "Ed Pitoniak",
"content": "Yeah. And, you know, it's so much to the credit of the Cain team. They were able to get entitlements and permitting for that 17.5 incomparable acres for incremental hotel supply in Beverly Hills, and some of you may have seen over the course of 2024, that LVMH was unable to get entitlements and permitting for a Cheval Blanc on Rodeo Drive. There is supply there. To your point, Smedes. But, again, I would we will do all we can to help everyone understand the very, very differentiated position of Aman in every market in the world that it operates in."
},
{
"speaker": "Smedes Rose",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from David Katz of Jefferies. The line is now open. Please go ahead."
},
{
"speaker": "David Katz",
"content": "Thank you. Good morning, everybody. I wanted to ask a little bigger picture question. You know, first, congratulations on your announcement of the new partnership. But in that putting it all in context, the discussion we have, you know, with investors frequently is around, you know, thinking about underwriting the various aspects of your TAM. And, obviously, a deal like this adds to your TAM in some ways. Right. But to an earlier question about the duration of the capital you have out now and how we sort of think about that strategically. Then the, you know, potential expansions embedded in your current portfolio and how we think about underwriting those versus, you know, a new casino partner, you know, to be named later. So to speak. Right. They're across the spectrum, and I'd love to add your just your thoughts and comments around how we, you know, underwrite those or whether it's straight math."
},
{
"speaker": "Ed Pitoniak",
"content": "Yeah. It's a great question, David. And one of the ways in which I'll answer it is that when we think about TAM, we really also think about the I'm trying to come up with an acronym on the spot, and I'm not gonna do it, David. I was gonna say, like, the tar, the total amount of the relationship. That's not very good, is it?"
},
{
"speaker": "David Katz",
"content": "Exactly. What I'm getting at is on the quad."
},
{
"speaker": "Ed Pitoniak",
"content": "Yeah. There you go. Thank you, David."
},
{
"speaker": "David Katz",
"content": "Yeah. On the fly."
},
{
"speaker": "Ed Pitoniak",
"content": "I'll do better next time. I promise. When we as we began to get to know Cain and Eldridge, we very quickly developed very high conviction that this has the potential to be a multibillion-dollar relationship over time. We do believe there can be opportunities within that relationship for us to ultimately own permanent real estate. But also the opportunity to continue as a, as my answer to Caitlin indicated, the opportunity to have numerous funding opportunities and thus opportunities to continue to roll our capital behind their initiatives. And so we are very, very focused on widening our TAM without diluting our quality. Our quality of relationship and our quality of investment. And, again, at a time like this, when the gaming deal flow is what it is, we believe we serve our stockholders very well by developing these kinds of relationships to give our stockholders participation in what we think is some of the most compelling placemaking taking place right now."
},
{
"speaker": "David Katz",
"content": "Okay. Thank you. Appreciate it."
},
{
"speaker": "Operator",
"content": "Thank you, David. Our next question comes from John Kilichowski of Wells Fargo. Your line is now open. Please go ahead."
},
{
"speaker": "John Kilichowski",
"content": "Thank you. Good morning. Maybe if I could just circle back on that last comment, Ed. You said that, you know, eventually owning some of the real estate in these deals with Cain and Eldridge could you specify specifically maybe what types of real estate you'd be looking to own here? Obviously, in this project, it's multi-use. We have the hotel, the residences, the retail, the food, and beverage. Just curious what you would be owning versus not owning."
},
{
"speaker": "Ed Pitoniak",
"content": "Yeah. And just to be clear, and as I indicated earlier in my remarks, we are not optimistic that we would eventually own any real estate within One Beverly Hills. This is real estate that if it if and when it trades, it will trade at stratospheric values. And, also, is real estate of a nature that doesn't exactly fit our investment criteria, which obviously mainly involves net lease. But beyond that, as you look across the Eldridge Cain portfolio, I think you will see, again, citing that really good slide in the deck, businesses current businesses within Cain and Eldridge that involve real estate. It's very, very much resembles real estate that we already own, and I would cite the example of Chelsea Piers as the type of real estate we already own and are very excited to continue to invest in."
},
{
"speaker": "John Payne",
"content": "I have one thing to add to that as well. Creating partnerships like we have with Cain and Eldridge also opens other potential partners that are around the world that are seeing what we are doing with our capital to help other experiential companies grow. I mean, we've just made this announcement, and there are folks that are reaching out saying, hey, very interesting way that you are getting involved with that project. We'd like to talk to you about x, y, and z. So don't underestimate that as we continue to build these world-class developers and partners that it also opens new ones for us and doesn't keep us as, hey, you're just that gaming REIT, which we love casino gaming, but it really is open to funnel for conversations about other opportunities for us around the world."
},
{
"speaker": "Ed Pitoniak",
"content": "Yeah. And I just want to build on what John is saying too that there's actually another dimension of partnership in what we've just announced. And though it may not have been visible in our releases, this marks the fourth time in which we will have partnered with JPMorgan in participating working together on a capital structure for a very compelling development. And, you know, as you all know, we are a very small team. We have over 25% of the company sitting at this table, and that's seven people. And so we are always very focused on opportunities to force multiply what we are able to achieve at VICI. And we're really, really appreciative of the partnership that David and his team have formed with Brian Baker and his team at JPMorgan when it comes to identifying opportunities to work together and put our capital to work in opportunities that might not have otherwise been available to us."
},
{
"speaker": "John Kilichowski",
"content": "Got it. I appreciate that. And then, you know, maybe jumping back to one of the first comments you made today was just on the pipeline really picking up. And I'm curious on the other side of that equation, how has the competitive landscape changed? I feel like across most of our earnings discussions this quarter, we've heard competition has certainly spiked on the private side. I'm curious if you're seeing the same."
},
{
"speaker": "John Payne",
"content": "It's been the same since we started the company. You know? This is a space, particularly the casino space, where there's a lot of interest. There's great operators. There's great real estate. Buildings perform like no other in the experiential sector. So as we look at any opportunity, we go in with our eyes open if there's others that are looking at this, and that's why we pride ourselves on building deep relationships, strengthening the ties, and growing the company in that fashion. So I wouldn't say we'd see an increase in competition. I'd say it's always been there, and we want to continue to be out there as well."
},
{
"speaker": "John Kilichowski",
"content": "Got it. Thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from John DeCree of CBRE. Your line is now open. Please go ahead."
},
{
"speaker": "John DeCree",
"content": "Hey, everyone. Took a lot of ground, but maybe got two more. One on the casino M&A environment. I think we discussed it a little bit earlier, pointing to the volatility in the ten-year, but, you know, Ed or John or David, curious if you have any thoughts as to what else is kind of influencing, like I said, I would say, the lack of M&A in the space, whether it involves real estate or not. It seems like it's, you know, still kinda quiet. So curious if you kinda see any other factors in there that are, you know, maybe causing that."
},
{
"speaker": "John Payne",
"content": "I don't think John's nice to talk to him. You hit on a few. Again, in my remarks earlier while I was answering one question, I just talked about Las Vegas. And if you're an operator in Las Vegas and you're performing the way you're performing, you have to say, well, where else would I like to operate? And you land on, I'd rather own this asset. I can continue to invest in it. There are new customers coming through my door every day. And I'm gonna just make this a better place. I mean, the results that you saw out of Las Vegas, I mean, Wynn's results were incredible. We saw there's incredible results coming out of the buildings that we own. So, John, I don't see a lot of trading in Las Vegas at the time. It comes to the regionals, I think it's just a matter of they like operating those businesses right now. There could be some trades over time. And if so, we will see if there's an opportunity for us."
},
{
"speaker": "Ed Pitoniak",
"content": "And, John, I'll just add to that, because I think when it comes to regional gaming, you know, we're in a period where investing in regional gaming has to be done with precision, market by market, asset by asset. We're obviously seeing supply growth across much of the US regional landscape. And I think if you're going to invest incremental capital in regional gaming, you want to be highly aware of new competition and new supply and what that would mean for same-store sales and existing assets. So, again, it's not solely a case of, well, what's available. It's also a case of, well, what do you really want to own? Again, we are very much in this for the long term. And thus, we are going to be, by nature, selective."
},
{
"speaker": "John DeCree",
"content": "Thanks, John. That's helpful. Maybe one more on the discussion of Aman hotels as a good example. You know, a lot of those ultra-high-end international hotels. I'm curious your thoughts on how you think about expanding a bit more internationally. Obviously, there's some in Canada, but, you know, would you go overseas? Kind of in an investment or lending capacity, like, you've done in California recently. So opportunities where maybe not real estate ownership, but, you know, M&A or however else you would structure it in some international markets or something like that on the table. How kinda far have you explored those kinds of lending in international market opportunities?"
},
{
"speaker": "Samantha Gallagher",
"content": "Yeah. So we definitely would, and we actually do have some lending activity in the UK, in Scotland, right now, with Cabot. And we've done our internal team has done a lot of work around really mapping the world and where we can invest both from a lending perspective as well as an acquisition perspective, understanding any tax leakage and really looking at what jurisdictions would be most compelling for us so that when we look at our TAM, we're really knowledgeable about it. So the answer to that question is yes. We absolutely can and would have."
},
{
"speaker": "John DeCree",
"content": "Thank you very much."
},
{
"speaker": "Operator",
"content": "Thanks, John. Our next question comes from Chris Darling of Green Street. Line's now open. Please go ahead."
},
{
"speaker": "Chris Darling",
"content": "Thanks. Good morning. Question on the gaming side. Seems like there's been a lot more capital flowing into the historic horse racing segment of the market. A couple of projects, I think, have been announced in New Hampshire. Is this a segment of the market that's interesting to you, and how would you think about sort of the opportunities and risks involved?"
},
{
"speaker": "John Payne",
"content": "Chris, nice to speak to you. Yes. If you're asking, would we make an investment into a racetrack, particularly, most of these investments are adding some form of new gambling to that investment. So whether it's historical racing machines that are being added in certain markets, other markets are adding just simple class three slot machines and some, as we heard today, talking about Empire City, the ability to turn a casino into a full-fledged casino. So to answer your question, they're all areas that we would have interest in placing investments if we have the right partners, if we have the right structure along the way. So we continue to study the markets that you mentioned, and other markets that could, as Ed mentioned, there could be some new markets that open up over time, and we'd be interested in those as well."
},
{
"speaker": "Chris Darling",
"content": "Alright. Fair enough. And then just one more quickly for me. Curious if you could walk through the rationales from a pure gaming standpoint to sell the Canadian operations to IGP. And then I think it'd be helpful as well to understand a little bit more about who IGP is, kinda their scale, where they own, future ambitions, anything that you could add."
},
{
"speaker": "John Payne",
"content": "Yeah. We were very excited. We had a great relationship with the management team and the owners of Pure. But we are excited to form our new relationship with a few tribes that have come together to form this group. We're learning more about their interest, their capacity to grow their business. That was one of the things that we were excited about, not only them acquiring the operations of the assets we own in Canada, but also our ability to continue to partner not only in Canada, but there could be opportunities all over the world. So the more we learn about each other, this is our first opportunity to work together, the more I think you'll see us grow with them over time should the right opportunities come about."
},
{
"speaker": "Ed Pitoniak",
"content": "And, Chris, just to make sure I understood your question clearly, I want to clarify that we didn't sell anything. The prior owner of Pure, Onex, a Toronto-based PE firm, sold the OpCo to IGP. And not only are we excited about IGP being our new partner on the Alberta assets, it also signifies that OpCos are marketable. That there are buyers for OpCos, which I think there has been some questioning around, but this is a clear example of gaming OpCos and OpCos having value."
},
{
"speaker": "Chris Darling",
"content": "Got it. And yeah, that point was understood, Ed, but I appreciate the clarification. That's all for me. So thanks for the time."
},
{
"speaker": "Operator",
"content": "Thank you, Chris. At this time, I'll turn the call back to Ed Pitoniak for any further remarks."
},
{
"speaker": "Ed Pitoniak",
"content": "Thanks, Alex. And thanks to all of you. We know many of you have another call coming up here just momentarily. So wish you the best and thanks again for attending this morning. Bye for now."
},
{
"speaker": "Operator",
"content": "Thank you all for joining. You may now disconnect your lines."
}
] |
vici | 2,024 | 3 | [
{
"speaker": "Operator",
"content": "Good day ladies and gentlemen, thank you for standing by. Welcome to the VICI Properties Third Quarter 2024 Earnings Conference Call. At this time, all participants are in listen-only mode. Please note that this conference call is being recorded today, November 1, 2024. I will now turn the call over to Samantha Gallagher, General Counsel with VICI Properties."
},
{
"speaker": "Samantha Gallagher",
"content": "Thank you, operator, and good morning. Everyone should have access to the company's third quarter 2024 earnings release and supplemental information. The release and supplemental information can be found in the investor section of the VICI Properties website at www.viciproperties.com. Some of our comments today will be forward-looking statements within the meaning of the federal securities laws. Forward-looking statements which are usually identified by the use of words such as will, believe, expect, should, guidance, intend, outlook, project, or other similar phrases are subject to numerous risks and uncertainties that could cause actual results to differ materially from what we expect. Therefore, you should exercise caution in interpreting and relying on them. I refer you to the company's SEC filings for more detailed discussion of the risks that could impact future operating results and financial conditions. During the call we will discuss certain non-GAAP measures which we believe can be useful in evaluating the company's operating performance. These measures should not be considered in isolation or as a substitute for our financial results prepared in accordance with GAAP. A reconciliation of these measures to the most directly comparable GAAP measure is available on our website in our third quarter 2024 earnings release, our supplemental information, and our filings with the SEC. For additional information with respect to non-GAAP measures of certain tenants and/or counterparties discussed on this call, please refer to the respective company's public filings with the SEC. Hosting the call today, we have Ed Pitoniak, Chief Executive Officer, John Payne, President and Chief Operating Officer, David Kieske, Chief Financial Officer, Gabe Wasserman, Chief Accounting Officer, and Moira McCluskey, Senior Vice President of Capital Markets. Ed and team will provide some opening remarks and then we'll open the call to questions. With that, I'll turn the call over to Ed."
},
{
"speaker": "Ed Pitoniak",
"content": "Thank you, Samantha, and good morning, everyone. It's an interesting world we're currently living in, isn't it? I wish this was a video call so that I could ask for a show of hands on how many of you predicted that the Fed would lower the Fed funds rate 50 bps in mid-September and over the next six weeks, the U.S. 10-year yield would rise 70 bps. If you work at a hedge fund and bet that prediction, let me know if you need help spending all the money you just made. At VICI, we never tire of trying to make sense of the times we are living through so that we can be situationally ready for the future that may arise out of the present. To tell you about one of the means we use to make sense of the times we're living through, I need you to please grab that old-fashioned thing called a pen or pencil and that old-fashioned thing called a piece of paper. Draw a horizontal or latitude line on the paper. This axis will represent consumer economic conditions. At the left end of the latitude line, put lousy, and at the right end of the line, put great. Now, through the middle of the horizontal line, draw a vertical or longitude line. This axis will represent REIT capital market condition. At the top end of the latitude line, put great, and at the bottom end of the line, put lousy. You now have one of the key maps we use at VICI to determine at any given time where we are located latitudinally and longitudinally in relation to consumer economic conditions and REIT capital market conditions and where we might be headed. Over VICI's seven years of existence, we have operated in every quadrant on this grid, and we have successfully generated earnings growth and dividend growth during our journey through all these quadrants. Given 2024's volatility, we have operated in or verged on almost all of these quadrants year-to-date. We like where we currently are, in a good position to fund the opportunities we are working on, but as always at VICI, we remain situationally ready for whatever lat-long position we may be in or headed toward. We've worked hard to develop a philosophy, strategy, and practice of capital allocation that enables VICI to allocate capital no matter which quadrant we find ourselves in at any given time. We achieve the sustained and sustainable capital allocation through two key means, internal funding capability through all cycles and investments that fund over time. When access to or cost of capital is in a negative quadrant, we want to be capable of what we've come to call capital markets independence, meaning that we have internal capital resources available to us that we can use to generate accretive external growth. At VICI, capital markets independence is funded through both retained cash flow and what we call regained cash flow, meaning repayments of loans we've made through VICI experiential credit solutions. Depending on the loan repayments received in a given year, our annual internal cash resources available for allocation can be anywhere from $350 million to $500 million. When levered with debt, this can give us $500 million to nearly $1 billion of investing power, even when, again, overall capital market conditions are not positive. VICI's ability to fund external growth no matter what quadrant we're in builds off our foundation of same-store NOI growth that, thanks to our leases, rent escalation rates, and 100% occupancy is far superior to conventional net lease REITs as documented by Green Street. We capitalize on this sustained funding capability by developing investment opportunities that enable us to put capital out the door in a regular sustained cadence, with Q3 2024 being an example of a quarter in which we announced no new transactions but nonetheless put nearly $250 million of incremental capital to work through our property partner growth fund and lending initiatives. Sustainable capital allocation is integral to a subject that we are religious about. At VICI, we are religious about the power of compounding, the compounding of earnings growth, the compounding of dividend growth, the compounding of total return. One of the keys of compounding is not go backwards, not in earnings, not in dividends, not in total return. A key to sustained forward momentum is the ability to generate earnings and value growth through all cycles in all quadrants of our BG conditions map. We don't know what the coming quarters will bring in REIT capital market conditions or consumer economic conditions, but we work every day to be ready for what may come. With that, I'll now turn the call over to John and David, who will talk about our growth outlook and current performance. John?"
},
{
"speaker": "John Payne",
"content": "Thanks, Ed. Good morning to all of you on the call today. We're often asked where we spend most of our time and energy, and while we've built a team that can assess the wide range of opportunities across experiential sectors and various geographies in tandem, I have said many times that casino gaming will continue to be a major driver of our growth. The size and scale of gaming assets is one element contributing to this focus, and we also like gaming because of how experiences at these assets continue to evolve, specifically in Las Vegas. We believe the tailwinds around gaming in Las Vegas will continue to create investment opportunities for VICI, similar to the Venetian Partner Property Growth Fund investment we announced during the second quarter. A recent Financial Times article exemplifies our view of the future opportunities in Las Vegas. In the article, Barry Dillard, the Chairman of IAC, shared his thoughts on his company's stake in MGM Resorts. He said, you can't disintermediate a physical experience, which is why we are betting on Las Vegas. He then goes on to say, the amount of entertainment, sports, live performances, and every possible variety and combination in Las Vegas is unequaled anywhere in the world. This quote underlies the merits of VICI's experiential real estate strategy, as well as our significant ownership of Las Vegas real estate. VICI is positioned to be a prime partner of our operators as they seek to invest further in this one-of-a-kind city. An example we have often cited is the opportunity presented by the Sports Triangle at the south end of the Las Vegas Strip, with our ownership of all six MGM assets contained within and alongside Allegiant Stadium, T-Mobile Arena, and the potential A's Stadium on the former Tropicana site. Given the increased densification and foot traffic in the area, our partners at MGM may seek to reinvest in those assets over the coming years. The scale of investment opportunity within assets VICI already owns provides us with a very unique advantage. We have also utilized our partner property growth fund with regional tenants, including Century, who this week is hosting the grand opening of their land-based casino in Caruthersville, Missouri. In 2022, VICI announced an investment of $52 million to fund development of this new casino resort at Century Caruthersville to replace the last remaining Riverboat casino on Open Water in Missouri. We have taken great care in the selection of our partners and investments to ensure not only a best-in-class portfolio with quality income, but a portfolio of investments and partners we can grow with. This ethos is foundational to our capital allocation strategy and sets VICI up well for future pipeline opportunities and consistent capital deployment. In the third quarter, we deployed $230 million of capital through various loans and partner property growth fund agreements. This has been our 13th quarter of consecutive capital deployment. VICI has built a legacy of getting better as we grow bigger, and we believe our disciplined strategy will allow us to be situationally ready to continue to deliver consistent and sustainable growth. Now I'll turn the call over to David, who will discuss our financial results and guidance. David?"
},
{
"speaker": "David Kieske",
"content": "Great. Thanks, John. Thanks, everybody, for joining us. I'll touch on our balance sheet, liquidity, results, and our updated full-year guidance. Subsequent to quarter-end, we settled 7 million shares and received approximately $201 million under our forward sale agreements. These proceeds contributed to funding the Venetian Capital investment we announced in Q2. We currently have approximately $2.9 billion in total liquidity comprised of approximately $160 million in cash and cash equivalents, $430 million of estimated proceeds available under our outstanding forwards, and $2.3 billion of availability under our revolving credit facility. In addition, our revolving credit facility has an accordion option, allowing us to request additional lender commitments of up to $1 billion. In terms of leverage, our total debt is currently $17.1 billion. Our net debt to annualized third quarter adjusted EBITDA, excluding the impact of unsettled forward equity, is approximately 5.4x, within our target leverage range of 5x to 5.5x. We have a weighted average interest rate of 4.36% taking into account our hedge portfolio and a weighted average 6.3 years to maturity. Touching on the income statement, AFFO per share was $0.57 for the quarter, an increase of 4.9% compared to $0.54 for the quarter ended September 30, 2023. Our results once again highlight our highly efficient triple net model, given the increase in adjusted EBITDA as a proportion of the corresponding increase in revenue. Our margins continue to run strong in the high 90% range when eliminating non-cash items. Our G&A was $16.5 million for the quarter, and as a percentage of total revenues was only 1.7%, which continues to be one of the lowest ratios in not only the triple net sector, but across all REITs. Turning to guidance, we are updating our AFFO guidance for 2024 in both absolute dollars as well as on a per share basis. AFFO for the year ending December 31, 2024 is expected to now be between $2.36 billion and $2.37 billion, or between $2.25 and $2.26 per diluted common share. And just as a reminder, our guidance does not include the impact on operating results from any transactions that have not closed, interest income from any loans that do not yet have final draw structures, possible future acquisitions or dispositions, capital markets activity, or other non-recurring transactions or items. With that, Adam, please open the line for questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] And our first question comes from Barry Jonas from Truist Securities. Barry, your line is open. Please go ahead."
},
{
"speaker": "Barry Jonas",
"content": "Wanted to start with Tribal Gaming, see if you had any updated views there. Maybe you could spell out any parameters you would look for to execute any loans or sale leasebacks. Thank you."
},
{
"speaker": "Ed Pitoniak",
"content": "Yes, good morning, Barry. I think the starting point for us, VICI, is that over our seven years, led by John and the team, we have developed very positive, powerful relationships with American tribal nations. We currently have four tribal relationships. As you know, Barry, they all obviously involve partnering with tribes in commercial gaming opportunities off of tribal land. And when it comes, again, to doing business with tribes, we love doing business with them. They're commercial, they're collaborative and great to do business with. When it comes to doing business on tribal land, it is, again, not about tribes being idiosyncratic. It's about the structure that applies to tribal gaming on tribal land that is idiosyncratic. And when you have an idiosyncratic situation, it's sometimes useful to create a counterfactual that enables you to better understand the idiosyncrasy, the risks associated with the idiosyncrasy, and perhaps a better understanding of how to price the risk of that idiosyncrasy. So to create a counterfactual, I'm going to ask you, Barry, to imagine a scenario in which we announce that we've done a deal with a commercial gaming operator on freehold commercial land. But in that deal, we tell you that that commercial gaming operator is the only party in the world entitled to operate the gaming floor at the center of the asset and likely the economic engine of the asset. And moreover, that same operator owns the land underneath everything and thus would be the ground less sore to us as the ground less sea. So that is by definition a sandwich lease. And from everything we've been able to learn, that is what applies to the transaction you're implicitly referring to that got announced last week by our peers and colleagues at GLPI. We give full credit to GLPI for announcing this, for doing the work that went behind it. But I would say we are still coming up the learning curve when it comes to understanding the risks associated with that structure and how to best price the risk. At VICI, we spend a lot of time focusing on tail risk. And in fact, there may be moments when some people feel both externally and internally, maybe we spend a little too much time focused on tail risk. But in this particular case, the tail risk, again, is so idiosyncratic and so unique to this situation that we're not at a point where we can say with any confidence, okay, the code has been cracked and the idiosyncratic risks that have always applied here have either been eliminated or have been minimized to a degree where we can confidently price the risk."
},
{
"speaker": "Barry Jonas",
"content": "Great. I really appreciate that. Maybe just for a follow up, I wanted to touch on Vegas. I'm curious if you looked at Caesars sale of the LINQ, I believe, correct me if I'm wrong, you had a roofer there. And then with that sale, wondering if we could see anything happen with those 26 adjacent acres that VICI owns. Thank you."
},
{
"speaker": "Ed Pitoniak",
"content": "Yes, just to be clear, Barry, we did not have a roofer on the LINQ promenade. The assets, we have a roofer on our casino assets and not the promenade, which is a distinct property unto itself. There is an idiosyncrasy. Well, I shouldn't call it an idiosyncrasy. The LINQ promenade is not technically a net lease property. But we're very glad to see TPG and especially [indiscernible] at Acadia led by Ken Bernstein go in there. I think there's a lot of potential to continue to make that a corridor that exactly to your point can become a very powerful corridor to the land that we own in back of the promenade in the area in and around Ceasar's Forum Convention Center."
},
{
"speaker": "Operator",
"content": "The next question comes from Anthony Paolone from JPMorgan. Anthony, your line is open. Please go ahead."
},
{
"speaker": "Anthony Paolone",
"content": "John, you mentioned in your comments, just a lot of opportunities for things like, you know, reinvestment into properties and such. So I mean, can you just talk about just as you look at the pipeline, how much of it is now, really focused on on those types of investments versus, new acquisitions and whether that's changed much in the last quarter or two?"
},
{
"speaker": "John Payne",
"content": "Yes, Tony, good morning. Very good question. I don't think it's changed. What I like about what we've done is created these pillars of growth. We've got opportunities to continue to have real estate acquisitions, as you referred to in my comments, the ability to grow with our property partner growth funds with assets that we already own, particularly in Las Vegas. Although, as I mentioned in my opening remarks, we do have some opportunities in our regional assets because they're large as well. And then we have this opportunity, as Ed mentioned, in his marks with VICI Experiential Credit Solutions, our credit book where it's open doors for us to come in, provide a credit solution and then over time, hopefully flip it into real estate ownership. So Tony, I wouldn't say we're focused more today on the property partner growth funds than the other two. I like the fact that we're spending time and I've got a team now that are spending time on all three of these, which will provide growth for us for the long-term."
},
{
"speaker": "Anthony Paolone",
"content": "Okay. Thanks. And then just the follow up there, maybe for you, John, and also, Ed, you commented about the 70 basis point move in the 10 year over a pretty short period of time. Do you think that's had any effect on just the propensity of your counterparts to want to transact or on just where pricing might need to be?"
},
{
"speaker": "Ed Pitoniak",
"content": "Yes, Tony, I wouldn't say that move over the last over the last month has necessarily by itself been highly impactful, but it's all been part of a period of volatility that has just been frankly, it's been kind of nauseating. And I do think it's led to a level of indecision and inaction that is reflected certainly for us and what we've been able to come forward and tell you about. And needless to say, we very much hope that this period of volatility will soon start to pass, just to dramatize that volatility, Tony. Back in 2018, the number of days in the trading year when the U.S. 10 year moved 10 basis points or more was three. In 2019, it was seven. In 2020, it was 16. In 2021, it was eight. In 2022, it was 46 days. It was 39 days last year. And given the volatility we've seen, crikey, even this week, I think we're in the 20s now. And this is really just an example of how a lot of people have really, a lot of people on both sides of the transaction table have just been trying to figure out where am I today and where the hell am I going to be next week? And, needless to say, we are among those many in both America and globally who hope things really kind of calm down next week. And that the kind of volatility we've especially seen in the move index starts to quiet down because it has definitely led to all kinds of different behaviors by investors. And I saw where NFL ratings are down over the last month and that's attributed to the election. It's like, man, people are just so distracted and stressed out that they can't even summon the time and focus to watch NFL games for crikey's sake."
},
{
"speaker": "Operator",
"content": "The next question comes from Chris Darling from Green Street. Chris, your line is open. Please go ahead."
},
{
"speaker": "Chris Darling",
"content": "Maybe for Ed, can you talk about the potential opportunity to acquire gaming assets in off-strip Vegas locations? And to the extent there's opportunity and interest on your part in pursuing that, it'd be helpful if you could elaborate maybe on what you look for in terms of yield coverage, but also how you think about partnering with the right operator in that sort of scenario."
},
{
"speaker": "Ed Pitoniak",
"content": "And just to be clear, Chris, when you say off-strip, you're referring to the locals and downtown markets in Las Vegas?"
},
{
"speaker": "Chris Darling",
"content": "Yes, exactly."
},
{
"speaker": "Ed Pitoniak",
"content": "Or are you speaking about regional gaming?"
},
{
"speaker": "Chris Darling",
"content": "It could be either, honestly, but I'm more so referring to within the Vegas metro area itself, just off-strip."
},
{
"speaker": "Ed Pitoniak",
"content": "I see. Yes, good. John, John and team are doing a lot of work in that area. John, over to you."
},
{
"speaker": "John Payne",
"content": "Yes. Chris, nice to talk to you this morning. If you've been following us as you have for the past couple of years, you've heard us talk about our love of Las Vegas. And obviously, we've got great assets on the strip, but we've been spending years meeting with operators, not only in the local downtown market, but as you said, in the regional market, where they're just some fabulous assets. And you ask what we do, we obviously spend time to understand the operator's quality, the asset quality, the credit quality, what a structure of a lease could look like, how we could potentially help an operator who has assets in the local, downtown or regional market grow, not only in their current assets, but if they have a plan to grow the number of assets, how our capital could help them grow. So it's definitely been a focus of me and my team, not only recently, but also over the past couple of years. And there really are some neat places that we would love to be partners with great operators there."
},
{
"speaker": "Chris Darling",
"content": "All right, helpful thoughts. And then maybe just one more, and this is more so focused on the regional side, outside of Vegas."
},
{
"speaker": "Ed Pitoniak",
"content": "This was given to me by a guy, some of you know, named Mike Simanovsky, the Founder of Conversant. And it's a book by Edward Chancellor, in which he collects the essays, sorry, not the essays, the investment memos of an asset management shop out of London called Marathon. And one of Marathon's main investment theses is to identify categories that are at lower risk of excess capital being invested in the category and creating excess capacity. And I think one of the things we are mindful of right now in American regional gaming is making sure we understand market by market, the degree to which a given regulatory regime is at risk of authorizing the creation of more capacity than the market really should be able to sustain. And I think there are areas, and I would say in particular, areas like Illinois and Indiana, where I think we all have to be mindful of, okay, when is enough, enough? But in terms of the current tone of the market, regional market, I'll turn it over to John."
},
{
"speaker": "John Payne",
"content": "Yes, Chris, and Ed hit on this very well, just about, as you underwrite regional gaming, you should understand some of the history of it, places like Pennsylvania that added new [licensers] [ph] or Illinois that added BLTs. You start to see new states add historical horse racing machines that now look very similar to slot machines. So to your point, as we look at regional assets, and in our lifetime, we will continue to buy real estate and buildings and regional assets, but we're very thoughtful in understanding the best we can at the time, the competition that is in the market that could impact the asset that we're buying, and then potential new markets that could open up. Because as someone who's been in the business, I don't like to date myself, but I'm almost going on 30 years, I don't think there is belief that states like Nebraska or Virginia or Kentucky, which has HHR machines, would really have gaming at the moment that they do now, the magnitude that they do now. So to answer your question, we are being thoughtful and disciplined in our underwriting as we look at regional assets."
},
{
"speaker": "Operator",
"content": "The next question comes from Smedes Roans from Citi. Your line is now open. Please go ahead."
},
{
"speaker": "Smedes Rose",
"content": "On your last call, you talked a little bit about some of your tenants were seeing weakness, especially on the lower end of the consumer spectrum. I'm wondering if you can [indiscernible] here that kind of feedback, and if you think that might impact their propensity to kind of reinvest or to participate in your funds that you've talked about previously."
},
{
"speaker": "Ed Pitoniak",
"content": "John?"
},
{
"speaker": "John Payne",
"content": "Yes, Smedes, good to talk to you this morning. Probably the first part is a better question for our great operators that have extensive details on their databases and where they're seeing positive growth and where they're seeing some weakness. I think you've seen the earnings that have come out, and some have talked, particularly in the regional markets, that they are seeing a little bit of slowness in the lower segments of their business. But we continue to, this is the beauty of having great partners and having quite a few of them. We continue to meet with them, talk about how they're thinking about growth, and is there a way that our different pillars of capital that I talked about earlier could help them grow, and whether that's with a property partner growth fund, whether they have a credit opportunity, whether they're building, would like to build a new hotel, whether they'd like to build a casino on land instead of on a boat. Those are all type of conversations we'd like to have and are having with our partners, and we hope that leads to growth for us with all different types of our partners."
},
{
"speaker": "Smedes Rose",
"content": "Thanks. And then maybe just kind of bigger picture, I need to think about coming into 2025, would you be giving a reasonable on the external growth side to think about maybe you do more frequent deals with smaller scope, or are you guys still maybe chasing the big deal, maybe in the non-gaming space that will more meaningfully drive their earnings growth next year? I guess I'm so touched about the opportunity set now that you've had more time, I guess, to think about kind of non-gaming and gaming investment opportunities and how it might play out here."
},
{
"speaker": "Ed Pitoniak",
"content": "Yes, I mean, it's something we think about every day. We have set forth goals and strategies at VICI that, like any goals and strategies, have trade-offs, and anyone who thinks their strategy doesn't involve trade-offs either doesn't have a strategy, doesn't understand it, or it is not truly a differentiated strategy. And in our focus on experiential and our dedication to experiential, both gaming and non-gaming, we have to accept the trade-off that it is not a category of real estate transaction that has an endless stream of marketed processes. So we've got to do a lot of work every day, and John and the team and David and the team do work every single day, and Samantha and the team, to identify and chase down opportunities that usually are not marketed, or if they are marketed at all, it's quite quietly. As we look ahead to next year, John and David and Samantha and the teams are working on some very exciting stuff, including bigger assets in gaming, and only time is going to tell if we can bring these to full fruition. We wish, again, there are times when we wish, geez, it'd be nice to have one of these stamping machines where we just stamp out every week a few deals where maybe we bought car washes or dry cleaners or convenience stores or whatever, but that's not what we focus on, that's not what we invest in, and we have to accept the trade-off that our deal flow will be more sporadic. But as we look at 2025, and given what we're working on, we remain confident that we are going to be bringing to the table both gaming and non-gaming deals, big and small. It will continue the growth profile we've had over our seven years."
},
{
"speaker": "Operator",
"content": "The next question comes from John Dave from CBRE. John, your line is open, please go ahead."
},
{
"speaker": "John Dave",
"content": "Ed, John, I wanted to go back to your response to an earlier question because it's something I've been thinking about a lot, and I apologize if your answer is going to be the same, but I wanted to talk about the regional gaming landscape and the trend where we're seeing maybe some new openings and some areas where there's been a lot more unit growth, some cannibalization or same-store sales declines. You mentioned you're being very cognizant of that, but I was curious if you could go into a little bit more detail about investments and some of the things that you'd consider in underwriting. Is it higher rent coverage? Is it unique or certain operators that perhaps have a competitive scale advantage? Would you maybe only consider larger assets that have a couple larger barriers to entry? I'm just curious how you think about deploying capital in regional gaming where maybe the markets, the regulatory environment, I think is a bit more predictable given history, but John, you pointed out some markets that have casinos today that we weren't thinking about before. So I'm curious how you underwrite some of the criteria you might look at."
},
{
"speaker": "Ed Pitoniak",
"content": "Yes, I'll turn it over to John in just a moment, John, but I'd say as a starting point, you really have to look at every situation market-by-market to understand what the competitive marketplace is? And for a given asset and for a given operator, what is their opportunity to carve out a profitable position in that marketplace? It won't necessarily always be the big assets. It could be small assets that in the hands of the right smaller asset operator who knows how to compete and make money with smaller assets in a given market. Those can still be very attractive to us. But it really comes down so much to the degree to which a given operator has a really, really healthy competitive response function. That's something obviously we've always valued, but I think to your implicit point, John, at a time like this, you really want to understand a given operator's ability to compete profitably for market share. John, do you want to add to that? John Payne?"
},
{
"speaker": "John Payne",
"content": "Yes, I will, John. When Ed and I started VICI back in 2017, one of the things I asked myself as I left my operating career was would the views from an operator make a difference inside a REIT in the way we underwrite our real estate? To your question, this is where my old job actually has some value in underwriting the business. We can dig into the business and the beauty of our operators is they have great detail on the consumer and where the consumer is coming. If we're looking at an asset that potentially gets their guests from hundreds of miles away, the chance of impact from a new casino is probably greater than an asset that gets their consumers from 15 miles away. That's just one example of how we are going to be disciplined as we go into regional markets. Of course, we'll weigh asset quality, operator quality, credit quality, structure of lease quality, those types of things, but we can also, with our operations background, go in and better understand could it get disrupted should the landscape change? Because remember, about being disciplined, we're not investing just for the near term. I think anyone could invest for the near term and look good. Our mission is for the long term, and I think you need to be disciplined in the environment we're in and understand what could ultimately impact the business, maybe it's not this year or next year, but over the next decade."
},
{
"speaker": "John Dave",
"content": "Thanks. I appreciate the incremental color there. That's helpful. And maybe a quick one. We talked a little bit earlier also about maybe some gaming investments and opportunities in the Las Vegas locals market off the Strip, but the city is just kind of thriving in all ways. I'm curious if some non-gaming stuff outside of the Las Vegas Strip but in the Las Vegas metro area is something that's on the radar and opportunities that are starting to maybe bubble up. I mean, it's becoming a massive sports town, and so thinking about some of the other assets in your portfolio, youth sports, et cetera, is that an area of focus, non-gaming in Las Vegas off the Strip that you're paying attention to or looking at in a meaningful way right now?"
},
{
"speaker": "Ed Pitoniak",
"content": "Yes, I'll turn it over to John. Yes, I was just going to say it's interesting you bring that up. We've gotten to know Jose Bautista, Joey Batts, as some of you may remember, who is now the owner of the Las Vegas Lights, the soccer team in the USL. As he looks at how he gives his team a really good home in the Las Vegas basin, one of the things we've talked about is the degree to which projects like the Homefield project we've invested in in Kansas City make so much sense in an environment like that in terms of the demand for those kind of youth sport facilities, John would agree. But, John Payne, go ahead, please."
},
{
"speaker": "John Payne",
"content": "Yes, John, it's an excellent question, and when you spend as much time as we have not only on the strip but in the locals market, downtown, and the regional market, many of the operators are entrepreneurs. They're involved in things, not only casinos, which we love casinos, but other experiential assets, and so you're right on point. Ed's right on point. Not only are we studying the opportunity to own great real estate, casino real estate, in these locals regional market of Las Vegas, other opportunities have opened up, and we'll study them and see if there's something that we can get involved in in the near term or even in the long term. Great question."
},
{
"speaker": "Operator",
"content": "The next question comes from Jim Kammert from Evercore. Jim, your line is open. Please go ahead."
},
{
"speaker": "Jim Kammert",
"content": "Ed, reflecting on your earlier comments, the rates backing up and obviously a lot of volatility, I would have thought naively, does that not potentially help the Experiential Credit Solutions book, given your ability to close certainty and scale of available capital?"
},
{
"speaker": "Ed Pitoniak",
"content": "It does, Jim. It does, and I would say we've got a lot of lines in the water right now on the lending side, but the uncertainty on a week-by-week basis can cause us and any potential borrower to just wonder, well, what is market this week, right? What's my spread this week? But if I commit to this spread, what's that spread going to look like next week? So again, I think it's all part and parcel of capital markets, consumer markets, and just about every other market having been here in a state of flux and volatility that has made decision making more challenging. Jim, I'll just share with you that we began preparation of our annual long-term goals and strategic plan on July 1. We ended up presenting it to our Board at Canyon Ranch in Lenox in mid-September. Over that 70-day period, our stock went from a point that was in two percentage points of our 52-week low and then went to a new 52-week high. And over that period, the U.S. 10-year went from 4.5 down to, I think, as low as 3.6. So again, now we're talking about a period of four months, July, August, September, and October, that have just been really tumultuous. And I think it definitely has affected deal flow and it's affected how we and everybody else underwrite. But I think we all have to hope and believe that things will calm down to a degree where everybody feels a bit more conviction in the visibility and certainty of what they can commit to."
},
{
"speaker": "Jim Kammert",
"content": "That's fair enough. Good comments. And then back to your opening comments regarding the quadrant analysis, I would imagine VICI presumes we're in the top, above the horizontal line in terms of real estate and REIT capital markets. But where are you thinking in terms of the consumer sentiment, et cetera, and how is that potentially influencing how you're thinking about investing going into 2025?"
},
{
"speaker": "Ed Pitoniak",
"content": "Yes. I was hoping somebody would ask that question, Jim. Where do we think we are right now? I would say, yes, we're in the upper right quadrant. Obviously, the consumer generally looks good. But I think it was Smedes who asked a little bit earlier, what is going on across the entire consumer spectrum? And are we seeing signs of potential weakness, whether it be in credit card delinquency, car loan delinquency, footfalls into retail and other metrics? And it's a bit of a mixed picture, but I think overall consumer economic conditions are quite good. And I would say REIT capital market conditions have been generally good since mid-July, but they've certainly been volatile in the last few weeks. So I would say upper right. But what we always focus on, as I alluded to, Jim, is not only where we are, but what do we think the trajectory is in terms of where we might be going. Given the amount of time it takes us to pull a deal together, we need to know where we're likely to be in a period in the future as much as we need to know where we are today."
},
{
"speaker": "Operator",
"content": "The next question comes from John Kilichowski from Wells Fargo. John, your line is open. Please go ahead."
},
{
"speaker": "John Kilichowski",
"content": "Last quarter, we spent a lot of time talking about the Harrah's Hoosier Park call option. And remind me if we've spoken about this before, but when I think about that asset and the forum, there's also put options attached to that that expire December of this year. How are you thinking about those put options? Is it likely or have you made any sort of commentary or have they made commentary to you about the likelihood of them exercising those put options? And does that keep capital sidelined as you wait to see what's going to happen there?"
},
{
"speaker": "Ed Pitoniak",
"content": "Yes, actually, Caesars has stated very explicitly on a number of occasions they have no intention of putting the Indiana assets to us. So, no, that has not affected how we think about our capital and our funding capabilities."
},
{
"speaker": "John Kilichowski",
"content": "Okay, understood. And then maybe on just on the election here, anything on the ballot as it pertains to regional gaming that we should be thinking about?"
},
{
"speaker": "Ed Pitoniak",
"content": "Not that I'm aware of. John Payne, are you?"
},
{
"speaker": "John Payne",
"content": "Yes, there's a couple things. I mean, there's Missouri, Arkansas and Virginia, New Casino, Virginia, Arkansas, Polk County. And then in Missouri, they are talking about online sports betting as well as in New Casino and Ozark. So, actually quite quiet for gaming, particularly when you compare it to other years."
},
{
"speaker": "John Kilichowski",
"content": "Okay. And then maybe last one for me, the capital that you put to work in the quarter, there was 150 million that went to Venetian. But the other 80 you mentioned loan, and I don't know if I caught the terms of that loan or what fund that was in. Could you give us a little more color on that capital?"
},
{
"speaker": "Ed Pitoniak",
"content": "David?"
},
{
"speaker": "David Kieske",
"content": "Yes, John, it's David. Good to talk to you. Those are the incremental 80 odd million is incremental draws primarily under the Great Wolf loans up in Foxwoods and then the Homefield development as well as some smaller fundings for Cabot and Canyon Ranch. So, previously announced loans that have continued draw schedules."
},
{
"speaker": "Operator",
"content": "The next question comes from Dan Guglielmo from Capital One. Dan, your line is open. Please go ahead."
},
{
"speaker": "Dan Guglielmo",
"content": "It's been a tough earnings for some operators and Vegas softness seems to be on investor minds. In your experience, do Vegas trends like this impact cap rates for the casino real estate there, or is it too short term and just kind of the nature of owning those assets?"
},
{
"speaker": "Ed Pitoniak",
"content": "Yes, Dan, good to talk to you. I'm going to have John Payne just remind everybody what MGM's occupancy was on the strip in Q3. But when it comes to cap rates, I would say cap rates are probably much more dependent on real estate investment capital market conditions and general valuation trends than they are on operator performance quarter-to-quarter. John, you want to just talk a little bit about how to really understand what's going on in the strip."
},
{
"speaker": "John Payne",
"content": "Well, I am a recovering operator, Dan, as you know. So, I've seen the comments about the performance of our two largest tenants, MGM and Caesars. And you look at some of the numbers and they ran, as Ed was saying, MGM ran 94% occupancy in quarter three. ADR was up some single digits. So, I know as you dig in and as they talk about what's coming up, you see some critical comments about F1, which again, long term F1 is great for the city and short term, it's great for the city. It's driving a weekend that was very slow. It's down a tiny bit from last year. It looks like we'll have to wait and see. But as Ed and I talk about, I'm not sure if a hotel company reported that they had 94% occupancy in quarter three, that there'd probably be a huge party thrown for them. So, it's interesting. It's hard to measure these large assets on an every 90 day period. And these are the best operators in the world. Every time something is thrown at them, they figure out how to continue to grow the business. When every casino was shut down during COVID, they came back and ran them more profitably than they've ever run them before. So, again, if they have a tough 90 days, they'll figure it out over the next 90, 180 next couple years. So, we feel really good about Las Vegas and the teams that are running their businesses there."
},
{
"speaker": "Dan Guglielmo",
"content": "Thank you. Appreciate all that, color. And that makes sense. And just around the experiential partners, it's tough from kind of RC to get a view of how the Great Wolfs, Cabot, and Canyon Ranches of the world are doing in kind of this complex time. So, high level, when you all talk with those partners, what are some of the tailwinds and headwinds that they're thinking about?"
},
{
"speaker": "Ed Pitoniak",
"content": "David, you want to take that?"
},
{
"speaker": "David Kieske",
"content": "Yes, sure. Happy to. Dan, good to speak with you. Look, when you drill into each of the partners, they have an offering that's very unique and part of the reason we partnered with them in the first place. And so, Great Wolfs is a casino without gaming. The performance continues to be solid, maybe a little bit of fall off in the weaker consumer, the lower end consumer, similar to gaming. But the drive to destination of that offering and the affordability of that offering, you can go for a day, you can go for five days, and you don't take vacations away from your kids. And so, their business continues to be strong. They've opened four assets, three assets this year with another one opening early next year up in Foxwoods. And so, the pipeline and the performance of those assets are great. And then we've talked about with Pilgrimage Golf and Cabot, the higher end consumer, the golfer is very, very avid of going out and trying new courses. Cabot does a phenomenal job of bringing in new guests and the marketing that they do for their assets and highlighting the quality of the golf experience that they're providing. And then we've talked about with you in the past around wellness and mindfulness and people's desire for longevity and better living. And so, the Canyon Ranches of the world are performing well and continue to attract customers and provide a level of service that is second to none."
},
{
"speaker": "Operator",
"content": "The next question comes from Caitlin Burrows from Goldman Sachs. Caitlin, your line is open. Please go ahead."
},
{
"speaker": "Jeremy Cohen",
"content": "Hi, this is Jeremy Cohen for Caitlin. I know you guys mentioned that this was the start of the property growth agreement with the Venetian. Are there any other specific partner property growth opportunities in the pipeline you're considering or can approach by? Thanks."
},
{
"speaker": "Ed Pitoniak",
"content": "John?"
},
{
"speaker": "John Payne",
"content": "We continuously look for opportunities to invest in our current assets, particularly the ones in Las Vegas. We don't have anything to announce, but as I said in my opening remarks, the Sports Triangle where we own six assets around an area of the town that is growing and becoming more dense, we hope over the coming years there'll be an opportunity for us to invest there, but nothing to announce at this time."
},
{
"speaker": "Ed Pitoniak",
"content": "Yes, Jeremy, I was just going to add for those of you who don't follow MGM, I'd encourage you to go look at their Q3 earnings deck, which does have a few pages talking about exactly what John Payne just talked about, which is the opportunity to intensify, densify the assets that MGM operates and that we own in the area defined by Allegiant, T-Mobile Arena, and the forthcoming A-Stadium. We stand to be, together with MGM, the biggest beneficiaries of the intensification of that area of Las Vegas. In fact, there's a credit analyst out there who speculated that MGM will actually be the greatest beneficiary when the A-Stadium comes into operation."
},
{
"speaker": "Jeremy Cohen",
"content": "Got it. That's helpful. And then, I guess, one more question. As VICI continues to build relationships and explore opportunities to get recurring transactions and growth, would you say the majority of these new relationships are in the non-gaming space?"
},
{
"speaker": "Ed Pitoniak",
"content": "John or David, you want to take that?"
},
{
"speaker": "John Payne",
"content": "I'll take that. I wouldn't necessarily say it's more non-gaming at all. There's still opportunities on the gaming side. As we said before, the non-gaming and experiential transactions most likely will be of smaller scale than the gaming side. So, we may have more frequent smaller, and that may lead to more non-gaming partners. But there's still many opportunities with new partners in the casino space, not only in the United States, but all over the world."
},
{
"speaker": "Ed Pitoniak",
"content": "Yes. And let me just add that, and because nobody's asked about it in a little while, and that, of course, has to do with the New York gaming license approval process. But when, well, I should say if the day comes, and when the day comes, we hope, that MGM is granted a full gaming license for the property that we own the real estate of in Yonkers, that will be a major property partner growth fund opportunity for VICI."
},
{
"speaker": "Operator",
"content": "Next question comes on David Katz from Jefferies. David, your line is open. Please go ahead."
},
{
"speaker": "David Katz",
"content": "I think you may have answered this in part, but I do want to just double back on the non-gaming opportunities, which today are small. And John, I think you touched on the fact that they perhaps remain small. If we look out a little longer term and start thinking three to five years, can they become something that is more or less than 10% or 15%, or I don't expect you to necessarily put a number on it, but give us a vision for how those could become much larger and longer term, please."
},
{
"speaker": "Ed Pitoniak",
"content": "Yes. I think, David, the way we think about it is really in the context of how do we build our rent base on a year-by-year basis with an ambition to grow the rent base at a base level about maybe three odd percent a year, right? And so that would represent on our current rent base a run rate of about 90 odd million bucks of new rent every year. And so we evaluate every opportunity, including non-gaming opportunities on the degree to which they can contribute to growing rent by a percentage point or two or three. And so when we speak about these smaller non-gaming deals, they are small by the standards of VICI deals. They are actually really large by the standards of conventional net lease deals, which tend to involve buying stores that might have between $200,000 and $400,000 of rent per box versus us doing deals that generally are going to have rents of many millions of dollars of rent per box."
},
{
"speaker": "Operator",
"content": "Our final question today comes from Ronald Kamdem from Morgan Stanley. Ronald, your line is open. Please go ahead."
},
{
"speaker": "Unidentified Analyst",
"content": "It's Jenny on for Ron, and thank you for taking my question. I think the first is I want to dig a little deeper on youth sports or recreational sports sector. Can you talk a little bit more on the outlook of this sector? And not only in Vegas, but nationwide, do you see more opportunities for growth? And do you look to do more strategic investment in this area in the next three to five years? Thanks."
},
{
"speaker": "Ed Pitoniak",
"content": "Yes, Jenny. Well, we definitely do. And I think you can see how this is manifesting itself in certain private equity firm investments in youth sport. Harris Blitzer is obviously a very good example, or I should say David Blitzer's family office is a great example of a company that's really focused on youth sport. And you see that in a number of shops. And they're all capitalizing on the way in which youth sport has grown as a key, key component of youth and family culture. And it's a little hard to tell exactly right now, given the data, what the youth population is going to look like over the coming years. But I can tell you anecdotally, there are a lot of little kids out there right now. Again, I'm not sure the data totally picks it up. But we were comparing notes on Halloween trigger treating participation rates last night. And I know, and Samantha was just blown away by how many kids were roaming the streets of Westport, Connecticut. And there's a lot of kids out there, and a lot of them are going to play sports at a high level. And we think that the need for facilities is only going to grow."
},
{
"speaker": "Unidentified Analyst",
"content": "Yes, I agree. The data side is a little bit tricky to get for youth sports. I guess my second question is, I want to know if you want to discuss more on the talent diversification strategy, like acknowledging VICI already have a pretty diversified talent base. But is there any specific sector that you think you want to broaden the current talent base? Any specific sector that you prefer going forward? Do you have more exposure?"
},
{
"speaker": "Ed Pitoniak",
"content": "John or David?"
},
{
"speaker": "John Payne",
"content": "Well, I'll talk. I think the question was about"
},
{
"speaker": "David Kieske",
"content": "Go ahead, John."
},
{
"speaker": "John Payne",
"content": "Go ahead, David. No, go ahead. Go ahead."
},
{
"speaker": "David Kieske",
"content": "Yes, I think the question, Jenny, just to make sure I heard you, is about Canada, right? And we look at Canada, we look at the globe internationally. And John touched on this comment about gaming operators earlier, that there's both gaming and non-gaming opportunities across the globe. We've spoken with a lot of you about how our team has really mapped the globe and tried to focus on where we can buy real estate. And that's a function of currency markets, rule of law, tax regime. Certain countries have very, very high foreign taxes on foreign real estate ownership, so that negates some of the competitive opportunity. But specifically in Canada, we've obviously made our first foreign investment into Canada since then. We've gone into Scotland, into St. Lucia. We'd like to do both more gaming and non-gaming north of the border. And we think there's great operators up there, great economies up there, great parts of the experiential spectrum that we'd like to go into. And so we don't have anything immediate, as John would say, but hopefully there's more to come up there."
},
{
"speaker": "Operator",
"content": "I'll now hand the call back to Edward for some closing remarks."
},
{
"speaker": "Ed Pitoniak",
"content": "Yes. Thank you, Adam. Thanks to everybody for joining us today. And hey, guess what? Guess where NAREIT is, this November in, I guess it's just a couple of weeks. It is in Las Vegas. We hope we see many of you there. We've got a lot of great events that are going to help showcase what's going on in Las Vegas and reach out to some of our respective banking partners if you're interested in those events because they're going to be fun. With that, bye for now."
},
{
"speaker": "Operator",
"content": "This concludes today's call. Thank you very much for your attendance. You may now disconnect your lines."
}
] |
vici | 2,024 | 2 | [
{
"speaker": "Operator",
"content": "Good day, ladies and gentlemen. Thank you for standing by. Welcome to the VICI Properties' Second Quarter 2024 Earnings Conference Call. At this time, all participants are in a listen-only mode. [Operator Instructions] Please note that this conference call is being recorded today. August 1, 2024. [Operator Instructions] I will now hand you over to Samantha Gallagher, General Counsel with VICI Properties. Samantha, please go ahead."
},
{
"speaker": "Samantha Gallagher",
"content": "Thank you, operator, and good morning. Everyone should have access to the company's second quarter 2024 earnings release and supplemental information. The release and supplemental information can be found in the Investors Section of the VICI Properties' website at www.viciproperties.com. Some of our comments today will be forward-looking statements within the meaning of the federal securities laws. Forward-looking statements, which are usually identified by the use of words such as will, believe, expect, should, guidance, intends, outlook, projects or other similar phrases, are subject to numerous risks and uncertainties that could cause actual results to differ materially from what we expect. Therefore, you should exercise caution in interpreting and relying on them. I refer you to the company's SEC filings for a more detailed discussion of the risks that could impact future operating results and financial conditions. During the call, we will discuss certain non-GAAP measures, which we believe can be useful in evaluating the company's operating performance. These measures should not be considered in isolation or as a substitute for our financial results prepared in accordance with GAAP. A reconciliation of these measures to the most directly comparable GAAP measure is available on our website, and our second quarter 2024 earnings release or supplemental information and filings with the SEC. For additional information with respect to non-GAAP measures of certain tenants and our counterparties discussed on this call, please refer to the respective company's public filings with the SEC. Hosting the call today, we have Ed Pitoniak, Chief Executive Officer; John Payne, President and Chief Operating Officer; David Kieske, Chief Financial Officer; Gabe Wasserman, Chief Accounting Officer; and Laurie McCluskey, Senior President of Capital Markets. Ed and team will provide some opening remarks, and then we'll open the call to questions. With that, I'll turn the call over to Ed."
},
{
"speaker": "Ed Pitoniak",
"content": "Thank you, Samantha. Good morning, everyone. As you may have figured out by now, I enjoyed putting my thoughts together for VICI's earnings call. I try to share through these opening remarks, not only what we've done, but what we're observing and learning from the marketplace. I may not always succeed in sharing anything genuinely fresh, but at the very least, I don't want my opening remarks to become repetitive. When I began putting these thoughts together in early July, the risk of repetitive remarks was high given that, until a couple of weeks ago, for REITs generally and net lease REIT specifically, not a lot had changed since last quarter's earnings call when I spoke of the big tech investing party that we REITs hadn't been invited to. In Bank of America's most recent fund manager survey, Michael Hart net showed that fund managers were underweight real estate at a level equal to and not being since the great -- the depth of the great financial crisis. Then came a welcome CPI print and REITs have begun to come back that we believe can endure. Before you hear from John and David, and before we field your questions, let me say a few words about the principles that guide us in a REIT marketplace like the ones we've been living through for a while now. We start by asking ourselves is what we're going through, whether for all REITs generally or net lease REIT specifically, cyclical or secular in nature. There are REIT sectors that have secular issues right now. Office is an obvious example of a sector with negative secular trends. Data centers is the obvious sector with positive secular trends. We strongly believe that experiential real estate is another real estate category with positive secular trends as evidenced by research recently published by McKinsey showing that indexed back to 1959, the share of consumer discretionary income spent on experiences has grown to an index level of nearly 160, while the share of consumer discretionary income spent on things has shrunk to less than 75. Capitalizing on positive secular trends is fun, addressing negative secular trends, not so much. Positive cycles for REITs are fun, negative cycles for our specific REIT sector not so much. But it's always key to remember that cycles begin and cycles end, almost always driven by factors that are beyond the control of a REIT management team and Board. In a period of lagging stock performance, driven by cyclical factors, it can be tempting for REIT management teams and boards to start deviating from the REIT's long-term goals and strategies in hopes that the deviation can somehow overcome the cycle. At VICI, we strive very hard not to deviate. Here's the strategic principle we strive to stay true to in all cycles. We dedicate ourselves to investing in experiential buildings that meet these three fundamental quality factors. Location quality, in other words, well located in markets that have sound fundamental demographics and economics. Asset quality, meaning designed and built to serve the distinct needs of experiential businesses that have high economic dynamism and economic durability. Operator quality, meaning occupied by an experiential operator that has high economic energy, ingenuity and expertise, and a strong balance sheet and credit profile. With every investment we make, we, of course, seek accretion as measured in AFFO per share. But that is not the only accretion we seek and measure. With every investment opportunity we evaluate, in addition to AFFO accretion, we ask, is a given investment opportunity accretive to asset quality. Is a given investment accretive to tenant diversity and tenant quality? Is a given investment accretive to geographic and potentially categorical diversity and quality? Finally, can it give an investment be accretive to balance sheet quality and, potentially, our credit ratings? We have not and will not grow for growth's sake, if that growth doesn't continuously improve the quality and intrinsic value of our portfolio and balance sheet. We will not, as some of our net lease peers do, tell you we spend x hundreds of millions of dollars and y percentage cap rate to generate z dollars of new rent, but then never tell you into what we invested that amount of money. We will tell you what we invest in so that you can know what you own. The very good news is that our business development team, led by John Payne, is identifying and developing opportunities to meet our broader accretion criteria. And with that, I'll turn the call over to John. John?"
},
{
"speaker": "John Payne",
"content": "Thanks, Ed, and good morning to everyone. We acted on the investment criteria Ed just spoke of when, in the second quarter, we made capital commitments of up to $950 million in the highly differentiated experiential buildings that have indispensable value to their occupants, namely the Venetian and a collection of Great Wolf Resorts. These are investments that live up to our quality criteria, and at the same time, the $650 million firmly committed to those investments will generate a blended investment yield of 7.9%. Our conviction that we can continue to identify and invest in experiential properties that are accretive against multiple quality factors is a key reason that we have decided that we will not be exercising our call right to acquire Harrah’s Hoosier Park in Horseshoe, Indianapolis. We can and are making this decision because of our confidence and conviction that we are actively identifying and pursuing investment opportunities that enable us to generate future AFFO growth and accretion, while furthering the strength and diversity of our portfolio and tenant roster. At this time, we believe that we have the opportunity to create greater portfolio value by allocating VICI's capital to other gaming and nongaming opportunities the team is actively pursuing. This is an approach that we believe will produce 2024 AFFO [Indiscernible], bit higher in our net lease category. And with our newly [Indiscernible], we're in 2024 growth 2% at the midpoint is nearly 3 times the 2024 AFFO per growth rate guided into last week by our one gaming REIT peer. The factor that continues to accrue to our overall portfolio quality and structured tenant credit is the success of the dynamic city of Las Vegas, where VICI collects 45% of our rent from assets that we own. Over the years, I've cited on record-breaking [Indiscernible] in the first half of 2024. Harry Read International Airport had back-to-back record months reporting 5.1 million passengers arriving and parting in June. June was the third best month ever. Trailing May, the second best month ever. And October of 2023 was the best month ever. In May, international visitation of Vegas also jumped 23% year-over-year. And in June, it was reported that city officials are contemplating adding a second airport to Las Vegas, with executives from Southwest Airlines stating and I quote, \"It feels like any flight we add in a Vegas gets filled. It's almost this insatiable appetite for people wanting to come and see Vegas.\" Our Las Vegas tenants continue to benefit from this momentum as evidenced by our up to $700 million capital investment to fund extensive reinvestment projects at the Venetian in exchange for increased rent. The size and the success of our gaming properties allows us a unique opportunity to put large dollars to work into assets we already own. There continues to be a variety of opportunities on the horizon [Indiscernible] to the growth of our portfolio. Casino gaming assets continue to present the largest opportunity, both domestically and internationally, inclusive of investment opportunities into the casino resort properties we already own. The magnitude and consistency of gaming cash flows and the creativity of our gaming tenants continue to drive conviction in this section, and have set the blueprint REIT to extend our TAM and other experiential sectors. I now will turn the call over to David, who will discuss our financial results and guidance. David?"
},
{
"speaker": "David Kieske",
"content": "Thanks, John. Based on balance sheet, liquidity, results and our updated full year guidance, which we are very excited about. As we work on the right side of the balance sheet, we are constantly focusing on VICI's balance sheet quality, bringing our leverage further down within our range of 5 times to 5.5 times, diligently working with the rating agencies to improve our credit ratings over time and ultimately lowering our cost of capital, balancing the right long-term leverage for the company, all while ensuring we have the dry powder to continue to fund accretive growth for our owners. In terms of dry powder, as of today, we have approximately $3.2 billion in total liquidity, comprised of $347 million in cash and cash equivalents, $566 million of estimated proceeds available under our outstanding cohorts and $2.3 billion of availability under our revolving credit facility. In addition, our revolving credit facility has an accordion option, allowing us to request additional lender commitments of up to $1 billion. Subsequent to quarter end, we sold 4 million shares and received approximately $115 million under our forward sale agreements. These proceeds were used to partially fund the Venetian capital investment John mentioned earlier. In terms of leverage, our total debt is currently $17.1 billion. Our net debt to annualized second quarter adjusted EBITDA, excluding the impact of unsettled foreign equity is approximately 4.4 times -- excuse me, 5.4 times, within our target leverage range of 5 times to 5.5 times. We have a weighted average interest rate of 4.36%, taking into counter hedge portfolio at a weighted average 6.6 years to maturity. Touching on the income statement, AFFO per share was $0.57 for the quarter, an increase of 5.9% compared to $0.54 for the quarter ended June 30, 2023. We are very proud to deliver this continued consistent growth to our owners. Our results once again highlight our highly efficient triple-net model given the increase in adjusted EBITDA as a proportion of the corresponding increase in revenue. Our margins continue to run strong in the high 90% range when eliminating noncash items, and we have the highest net income margin in the S&P 500 as noted in an article published by Barron's during the month of July. Our G&A was $15.8 million for the quarter, and as a percentage of total revenues, it was only 1.6%. This continues to be one of the lowest ratios in not only the triple-net sector, but across all REITs. Turning to guidance. We are raising our AFFO guidance for 2024 in both absolute dollars as well as on a per share basis. AFFO for the year ending December 31, 2024, is expected to now be between $2.35 billion and $2.37 billion, or between $2.24 and $2.26 per diluted common share. Based on the midpoint of our updated guidance range, VICI expects to deliver year-over-year AFFO per share growth of 4.7%. As a reminder, our guidance does not include the impact on operating results from any transactions that have not closed, interest from any loans that do not yet have final draw schedules, possible future acquisitions or dispositions, capital markets activity or other nonrecurring transactions or items. And as we have mentioned in the past, we reported noncash CECL allowance on a quarterly basis which was its inherent unpredictability leaves us enable forecast net income and FFO with accuracy. Accordingly, our guidance is AFFO focused as we believe AFFO represents the best way of productivity on our equity investments and evaluating our financial performance and ability to pay dividends. With that, operator, please open the line for questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] And our first question comes from Caitlin Burrows from Goldman Sachs."
},
{
"speaker": "Caitlin Burrows",
"content": "Well, thanks for the update on the plans to not execute options that you have this year. I guess just as you think bigger picture, on deals you might do going forward and the options that you might create, does the way that this one ended up kind of working out or turning out, and your decision-making process have any impact on, I guess, how you structure options in the future, what the details might be, how far in advance they are? Anything like that."
},
{
"speaker": "Ed Pitoniak",
"content": "John or David, do you want to take a first crack at that in terms of how we think about options going forward?"
},
{
"speaker": "John Payne",
"content": "Yes, it's a very good question. I do think it's important. I heard my comments were broken also a little bit. But it is important to understand that this was a strategic decision really based on capital allocation and portfolio management at this time. We have great conviction with opportunities that are in front of us that will further our tenant and geographical and category diversity. And as we continue to look at opportunities and we negotiate put calls or renegotiate [Indiscernible], we'll think about the length of those and the appropriate times of those. Again, it's important to understand that we have great conviction to continue to grow the business around the world."
},
{
"speaker": "Caitlin Burrows",
"content": "And just as a follow-up on that geographic diversity point, I noticed the prepared remarks also mentioned international potential opportunities. So just wondering if you comment further on kind of what sort of international opportunities for this side type of you think could come up over the medium term or where?"
},
{
"speaker": "Ed Pitoniak",
"content": "John?"
},
{
"speaker": "John Payne",
"content": "Yes. Another good question. We have been busy traveling, not only domestically, but internationally. And I think on other calls, we've talked about countries that we've been studying. We've spent some time in Australia, in New Zealand. We've spent some time in Europe and the U.K. and other parts of the world where it makes sense and our capital can work. I don't have anything to announce now obviously, but we see opportunities to continue to diversify not only in location, but with new tenants as well."
},
{
"speaker": "Operator",
"content": "And our next question comes from Barry Jonas from Truist Securities."
},
{
"speaker": "Barry Jonas",
"content": "As you look at that international opportunity set, just curious how that's split between gaming and non-gaming?"
},
{
"speaker": "Ed Pitoniak",
"content": "John, do you want to take that once again?"
},
{
"speaker": "John Payne",
"content": "It seems like I am answering the first three questions today, Barry, but it's all good. I'm not sure we'll have the exact percentage of what's going to come in gaming and non-gaming. But I think you can imagine when we travel around the world, we spend time in countries with legalized gaming and understanding the real estate of those assets, while at the same time meeting with experiential operators. In my remarks, and I've said this for the past 7 years, the greatest opportunity we see is still in casino gaming, both domestically and internationally. But we do spend time with operators in both the experiential sectors in gaming when we travel around the world."
},
{
"speaker": "Ed Pitoniak",
"content": "And Barry, I'll just add that -- Barry, I'll just add that pretty much by definition and by logic, the dollar percentage will always tend -- whether domestically or internationally, the dollar percentage will very much favor gaming investment given the magnitude of the assets and the capital required to acquire them."
},
{
"speaker": "Barry Jonas",
"content": "And then just as a follow-up, seriously how you're thinking about your strip land and just development these days. You obviously owned several acres on the strip and office strip, and then your -tenant caesars is now talking about maybe selling some noncore assets, which I presume include land."
},
{
"speaker": "Ed Pitoniak",
"content": "Yes. So Barry we -- as John talked about in his opening remarks, we are just great believers in the Las Vegas ecosystem, which is obviously got ganing at its center. But as we see with really almost each passing quarter, the amount of innovation that's going on in terms of the broadening and deepening of Las Vegas experiences truly makes it like no other place on earth. We obviously have a lot of exposure to Las Vegas right now as a percentage of our annual base rent. But we would -- we are and we will be very comfortable and continuing to invest incremental capital, much the way we did with the Venetian investment in Las Vegas, because it is, is truly one of a kind destination in the world. And that has implications, obviously, for putting incremental money into the assets we already own, with the Venetian, with our Caesar asset, and especially, obviously, given magnitude of MGM assets we own, particularly at the South end of the strip that's seeing more and more demand drivers. And then in addition to that, as you alluded to, we do have a vacant land that, over the coming years and decades, obviously represents further potential to invest capital and broaden and deepen our exposure to Las Vegas."
},
{
"speaker": "Operator",
"content": "Our next question comes from Wes Golladay from Baird."
},
{
"speaker": "Wes Golladay",
"content": "I know you target full cycle investments with high-quality partners, but there has been some pockets of weakness in the consumer. Has this led you to change how you're looking at the current acquisition pipeline?"
},
{
"speaker": "Ed Pitoniak",
"content": "Yes. It's a very good question, Wes. And obviously, whether it's the McDonald's earnings report or other earnings reports, you are starting to hear about weakness, especially in the lower end consumer. And even recently, there's been some talk among gaming operators about seeing some weakness on -- at the lower end in the regionals. I would not say at this point it's yet affected how we are thinking about our investments going forward. We focusing on the categories of experiences that we do, focusing generally on middle to higher end, it hasn't caused concern for us yet. Especially when, of course, you take in the existential fact that we as a net lease asset owner are not exposed to the variability quarter-by-quarter in consumer spending."
},
{
"speaker": "Wes Golladay",
"content": "And then you do have a highly predictable business model, but you have the Caesars lease coming up in November. It does have a variable component. That's a little bit harder to model. Could you maybe put some goalposts on that, how we should think of that?"
},
{
"speaker": "Ed Pitoniak",
"content": "David?"
},
{
"speaker": "David Kieske",
"content": "Yes. Thanks, Wes. It is a good question. We're entering lease year 8 with Caesars. Hard to believe it's -- we're getting the lease year 8. So it seems like yesterday we started this company. But November 1 will be the start of that year and there does -- start of that lease year and there does become a variable component and a base component. And we are -- the way that the calculation runs for the Vegas lease, 80% is based, 20% is variable for the regional lease, it's 70% based and 30% variable. It's based on a comparison of net revenues for years 5 through 7 versus year 0 through 1. We are still collecting the data of Caesars because the calculation period actually runs through September of 2024. But based on what we're seeing, it should be relatively neutral to no impact to our escalation in November 1, 2024."
},
{
"speaker": "Operator",
"content": "Our next question comes from John DeCree from CBRE?"
},
{
"speaker": "John DeCree",
"content": "Maybe one on your decision today to say that you're not going to move forward with Centaur. So I thought you may have had until the end of the year to make a decision, and so we certainly can appreciate being decisive and looking at your pipeline. But curious if you could talk a little bit about why make that announcement today with still maybe several months ahead to consider that?"
},
{
"speaker": "Ed Pitoniak",
"content": "Yes. No, it's a very, very good question, John. The reason we decided to announce this today is that the strategic factors that went into making our decision are of a nature that they were not going to change over the ensuing, whatever it is now left in the year, 5 months of the year. And so in fairness, obviously, to our partners at Caesars, but also recognizing our need to always be as ruthlessly efficient as we can be with return on management time, we decided -- again, because the strategic decision factors will not change in the next 5 months, decided to announce it today. So that everyone can understand, our team can understand, Caesars can understand, you all can understand that we will not be calling it, and none of us have to spend time wondering if and when wee might between now and the very end at the end of the year."
},
{
"speaker": "John DeCree",
"content": "And that's probably but the last question from us get us on Centaur, although there's been many over the last 8 months or so. So I appreciate that. Maybe bigger picture, in terms of underwriting gaming assets today, so a lot has happened. We've talked about some of consumer trends. We've looked at where some recent deals have gone out. And just kind of curious if your -- any updated thoughts on how you think about full 4-wall coverage kind of cap rates in the gaming space now. There's a little bit more strict in how you think about 4-wall coverage and kind of where you think cap rates are going. And I know kind of every asset and transaction is a little different, but just high level, would be good to kind of get any kind of thinking on broad strokes."
},
{
"speaker": "Ed Pitoniak",
"content": "Yes. Yes. So I think our starting point, John, is that we always want our capital investments to pass the test of if this was our last dollar capital, would this be the highest and best use of that capital. And as we have engaged in the continuous learning given at the heart of our creation of VICI is both a company and a culture, I think very much to the point of the question you're asking, we continue to refine our thinking on what will drive the strongest, continuous improvement in our access to and our cost of capital. And that really guides our decision-making in many different forms, including, obviously, tenant diversity, geographic diversity, tenant credit quality, strength of tenant balance sheet and, very much to your point, rent coverage. So as we look at that, that mosaic factors, we -- again, we feel very good about the discipline we've developed around capital allocation. And the degree to which it can, again, just to stress the point, lead ultimately to strongest comparative cost of capital advantage over the long term."
},
{
"speaker": "Operator",
"content": "Our next question comes from Nick Joseph from Citi."
},
{
"speaker": "Nick Joseph",
"content": "Maybe just following up on the [Indiscernible] question. Is this deal fully bedded? And I guess would -- is there any chance that the assets are put to you? Or is that all put to that as well?"
},
{
"speaker": "Ed Pitoniak",
"content": "John?"
},
{
"speaker": "John Payne",
"content": "The way the contract reads, you are correct, that the assets could be put to us. But Tom Reeg at Caesars, I think, has been very vocal about this, at least over the past year, that they had no plans to put these two assets to us. But the contract does last until the end of the year, as we spoke about earlier today."
},
{
"speaker": "Nick Joseph",
"content": "And then just as we look to November, I'm just curious if there's any legislative issues on any ballots that you're watching that could be important for regional gaming."
},
{
"speaker": "Ed Pitoniak",
"content": "John?"
},
{
"speaker": "John Payne",
"content": "We all take that -- yes, I'll take that, Ed. We continue to look not only, I think you mentioned regional gaming, but I think we're looking all over the world where there are changes happening to the good, and I guess it could be to the bad, but where are there going to be opportunities to deploy capital with new tenants and new locations, possibly in new categories. And there are some places around the world that are going through quite a bit of change that we're better understanding. We'll continue to watch opportunities in the United States as well. Every year, I think you know the state of Texas and the state of Georgia, state of Kentucky often come out with some form of gaming. And then obviously, with online sports betting, which is spread across the United States, there will be other states that think about that. And usually, in some deals, they talk about the bricks-and-mortar casinos. So not specifically, but we stay in touch to see if there ultimately will be some opportunities for us to invest. And then I'll finally say, we continue to monitor New York, where that process continues to proceed into 2025. And we'll have a better understanding when 3 licenses will be awarded and to whom they are awarded."
},
{
"speaker": "Ed Pitoniak",
"content": "Nick, I would just add that -- Nick, I'll just add that we obviously do monitor continuous -- continuing legislative change and, in many cases, the associated emergence of new supply across American regional gaming. And I do think we obviously need to take care, as capital allocators, that as we allocate capital into regional gaming assets, which we will continue to do. They were doing so aware of the supply-demand trends on a mark-to-market basis. Because in regional gaming, catchment areas for regional gaming, obviously tend to be more confined than we would find in Las Vegas, because the catchment area for Las Vegas is global. As John said in his opening remarks, international travel to Vegas has rebounded stronger than any place else in the U.S., probably one of the strongest international travel rebounds around the world. And so while new supply will come to Las Vegas, it will come into a market whose catchment area, again, is global. And we obviously need to be mindful in regional areas that the catchment areas are somewhat infinite, and we need to weigh our capital allocation decisions based upon supply/demand trends on a highly localized basis."
},
{
"speaker": "Operator",
"content": "And the next question comes from Haendel St. Juste from Mizuho."
},
{
"speaker": "Ravi Vaidya",
"content": "This is Ravi Vaidya on the line for Haendel. Just had a couple of quick follow-ups here on the Indiana assets. Was the cap rate not attractive enough in the current rate environment? And did the emergence of Bala Chicago coming up the next 5 years' payroll as it could possibly impact casino operations throughout the midwest?"
},
{
"speaker": "Ed Pitoniak",
"content": "Yes. I'll let John take the second part of that. On the first part, the cap rate is perfectly fine cap rate. As we look across our array of investment opportunities and as we contemplated potentially investing more than $2 billion of capital or close to 5% of our total capital, we, again, wanted to be relentless in our scrutiny as what would this be the highest and best use of our capital both on a cap rate basis and the associated accretion, but also on the key, if you will, nonfinancial accretion factors of tenant diversity, geographic diversity and those secondary factors. So the cap rate by itself was not the gaining issue. And then I will turn it over to John for his thoughts on midwestern gaming."
},
{
"speaker": "John Payne",
"content": "Yes. The question about will the facility that ultimately is built in downtown Chicago will impact the Indianapolis to casinos, the answer is now on that. To Ed's comments earlier about where consumers go to regional gaming and how far do they drive, the Indianapolis market is considerably far away from downtown Chicago. In fact, there's many other casinos between Indianapolis and Chicago that consumers can choose from as well. So that was not a factor in our decision to not call the to Indianapolis asset."
},
{
"speaker": "Ravi Vaidya",
"content": "How large do you forecast the experiential credit solution strategy to become? And we noticed you have a couple of deals with Great Wolf here over the years, how important is that as a defense and entertainment option in this recessionary environment?"
},
{
"speaker": "Ed Pitoniak",
"content": "David, do you want to take the first part of that?"
},
{
"speaker": "David Kieske",
"content": "Yes. Thanks, Ravi. Roughly, our credit book today is $2.2 billion, it's 4% to 5% of total assets, and we feel good in and around that area. We developed a credit book as a way to broaden our means and to expand our relationships. And you've heard us talk about, at the end of the day, our capital is relationship capital. And the credit book allows us to develop new partnerships, develop new relationships, ultimately through some of the deals that have call options at our discretion. But along the way, we learn about new segments and new businesses, and we've learned things that ultimately we may not like, we -- our loan gets repaid and we move on. But if we learn things we like, we continue to want to grow in those areas through either real estate ownership or deepening the existing relationships. So it's been a very, very effective tool and it's been something we're excited about, and something that we continue to use in our toolkit as we expand both domestically and internationally."
},
{
"speaker": "Ed Pitoniak",
"content": "And Ravi, could you repeat the second half of that question?"
},
{
"speaker": "Ravi Vaidya",
"content": "Sure. We've had a couple of deals with the Great Wolf over the years, I just wanted to hear your comments on how this is particularly defensive and important entertainment source as we go into a recessionary environment here where the consumer is stretched?"
},
{
"speaker": "Ed Pitoniak",
"content": "Yes. David, do you want to talk about what we have seen historically on Great Wolf's durability through all cycles?"
},
{
"speaker": "David Kieske",
"content": "Yes. In the broader indoor water park sector or, broadly, Gabe Wasserman is in the room here and he did our first white paper back in '18 when we started looking at indoor water parks and the economic vitality of these businesses. When the original Great Wolf went public back in '04, '05, it was Thursday through Sunday, Thursday through Monday business. Now it's a 7-day a week business. And we call them casinos without gaming, because of the economic leverage they have and the multiple cash registers they have, both with the water park, the family entertainment center, the food and beverage, the lodging. And as an example, Perryville opened just earlier this year -- last year. And within 3 months, it was exceeding its initial underwriting and ultimately went into the broader refi package. So these things open, they open quick and they open producing a lot of cash flow. So we're excited about that. And hopefully, there's an opportunity someday to own the real estate of some of these indoor water park businesses."
},
{
"speaker": "Operator",
"content": "The next question comes from David Katz from Jefferies."
},
{
"speaker": "David Katz",
"content": "So a little bit of a different -- great, a little bit of a different kind of question for John, which is through our window past couple of days, we've seen a pretty consistent outlook shift to something more moderate or even down, specifically around leisure transient activities across hospitality. And not that it will impact your earnings stream imminently, but John, I assume in your travels, you have a finger on that pulse as well. I just would love a little bit of insight from what you're seeing and hearing through your window, please?"
},
{
"speaker": "John Payne",
"content": "Yes, David. Nice to talk to you. And hopefully, I'll see you on the road while I'm traveling. Look, you are correct. We're hearing in some businesses some softness and hearing about the consumer, and Ed touched on this earlier in his comments, particularly around the lower-end consumer. I was telling my colleague, David, a story about I was in Scotland recently. And every person I met talked about visiting United States. And guess what city -- if they were only going 2 to 3 cities, they said they would have to go to, it was Las Vegas. And what's become so interesting traveling the world is that 10 years ago, that wouldn't have been the answer, right? Everyone has said, I flying to New York. When I hit Chicago, I'm going to go on to San Francisco and the West Coast, and you probably wouldn't hear about Las Vegas. The beauty about what our tenants have done is diversifying the reasons to come to Las Vegas. And no matter what sector, whether you're in the high-end sector that comes by private jet, or where you're a sector that, like myself, travels by Southwest Airlines, they continue to attract different folks to that city. So I'm not giving you a macro answer about the whole world of the United States, I'm giving you an answer about where we look to put our money and where our money is right now, and that's why we're so bullish on Las Vegas. As we study other sectors, as we study other parts of the world, we will definitely make sure we understand what the consumer is doing up and down with spending tree. But I will tell you, in my travels, I'm excited about where we have our money and continue to put money in because that people are traveling to that destination of Las Vegas."
},
{
"speaker": "Ed Pitoniak",
"content": "And that -- operator, before we go to the next question, I'd just like to add to David Katz's question. In a time like this, where we could be potentially looking at a period of economic volatility as measured in consumer spending, it really highlights the value of dividend-paying stocks when it comes to reducing the volatility of the equity versus the volatility of the consumer economy. And that is why, again, we're so careful in what we investing because we want to make sure we're investing in assets and partner relationships that we believe very strongly can endure up and down cycles in consumer spending. We do not go seeking C guard but real estate, to use the old Benjamin Graham term. We are seeking real estate that we know can endure a cycle and cycle out and has positive secular trends, such that we can feel very confident in our ability to continually pay a dividend and steadily grow the dividend ideally at a rate that is equal to or exceed inflation."
},
{
"speaker": "Operator",
"content": "Our next question comes from Michael Herring from Green Street."
},
{
"speaker": "Michael Herring",
"content": "My question on balance sheet. Your [Indiscernible] $2 billion in notes coming due in the first half of next year. How did that factor into the decision to not exercise those call rights, particularly as you look to potentially reduce your leverage and earn a better investment-grade rating?"
},
{
"speaker": "Ed Pitoniak",
"content": "Yes. I'll turn it over to David in a moment, Michael. But I would say it really factored in, virtually not at all. And not that we're not mindful of the obligation we have to refinance as effectively as we can in the coming year. But we, again, made the decision we made on those call rights because of how compelling our other investment opportunities are, which you should be hearing about in due course. And so that was not a constraining factor. And Dave, I don't know if you want to add anything in terms of how we're thinking about leverage and the ratings curve."
},
{
"speaker": "David Kieske",
"content": "Yes. No, you touched on it, Ed. It's portfolio management around not exercising the book call. Michael, in terms of the balance sheet, we've got 3 maturities next year, February, May and June. And as you saw us actively and very successfully refi our 2024 maturity with a well, well, well oversubscribed refinancing that we did back in March, we're working and planning towards refi those maturities that, again, come due first part -- in the first quarter and then in late second quarter of '25. And then you saw our peer, GLPI, had a very, very successful refi or a debt offering 2 days ago. And being investment-grade rated, having a very deep liquid investment-grade credit profile accrues to our benefit. And we're -- we feel very good about our ability to refi those maturities and continue to extend and ladder our maturity profile. And ultimately, over time, my data the BBB curve, lowering our cost of capital being able to continue to compete for asset acquisitions across the globe."
},
{
"speaker": "Michael Herring",
"content": "Maybe just one more, switching gears a little bit. As there's been some M&A chatter on the operator side, can you just speak broadly -- maybe this is more for John on just the practical protection that VICI has on its master leases in the event there is a change of control on the operator side."
},
{
"speaker": "Ed Pitoniak",
"content": "John?"
},
{
"speaker": "John Payne",
"content": "Yes, it's a very good question, Michael. It's a hard one to answer simply because we have -- we used to be a company when we started that had 1 or 2 leases, now we've got over double digits. But in all our leases, we do have protection. Samantha Gallagher, our General Counsel is on the line, that could add to that. But we feel good. We're staying in touch with our operators to better understand what's going on in the market. I think you used the word chatter, I think that's probably the best word out there right now. But we do have protection in our many leases that we have. Sam, I don't know if you would like to add anything to the question?"
},
{
"speaker": "Samantha Gallagher",
"content": "Yes, John, you did a great job. I think just to John's point, while we do have a number of different leases, all of our leases are mined. What happens in a change of control and have strong protections to ensure. And just as a reminder, we have gone through a change of control with one of our tenants already, where -- we see the Caesars Eldorado merger. So we feel very comfortable with how our leases are structured to address any change and control."
},
{
"speaker": "Operator",
"content": "Our next question comes from Jim Kammert from Evercore."
},
{
"speaker": "Jim Kammert",
"content": "David, was there anything in particular that led you to bump the guidance at this point? I mean the acquisition investing activity has been well disclosed and you don't include prospective activity and guidance. So I was just curious there are 1 or 2 factors that motivated to do it at this time?"
},
{
"speaker": "Ed Pitoniak",
"content": "David?"
},
{
"speaker": "David Kieske",
"content": "I mean, Jim, you touched on that. I think when we lapped our first quarter earnings call, the thing -- the funding timing and some of the -- how we were going to fund some of the announcements that we had previously made weren't finalized. And so as we talked about in our guidance, we don't project any unknown capital markets activities or any unidentified or unknown activities. So those announcements plus the continued funding through our loan book has led us to feel very confident about the increase in guidance and feel very good about achieving that guidance. And a lot of it came from the Great Wolf impact, which closed slightly after our earnings."
},
{
"speaker": "Jim Kammert",
"content": "And then the second question, please. Ed, you almost get -- I've obviously enthused about you said your alternatives to invest capital other than the Caesar option properties. Obviously not going to give us a whole lot of color, but are they -- these future opportunities, is this a ramp in the tools of bucket or opportunity set in dollar value in your mind? What would the split maybe be between further credit book or more fee interest?"
},
{
"speaker": "Ed Pitoniak",
"content": "Yes. It will very much predominantly be fee interested, Jim. And I think one thing you can expect is that as we continue to allocate capital it will be on a cadence that is not necessarily as heavily weighted to one single investment, as would have been the case with the Indiana assets. Again, that -- just to reiterate, that would have been almost 5% of capital into one deal. And I do think as a REIT from both a return and a risk management point of view, we will always be very happy to achieve a sustained and sustainable capital allocation cadence, which, again, will be principally in gaming and principally fee over time."
},
{
"speaker": "Operator",
"content": "Our next question comes from John Kilichowski from Wells Fargo."
},
{
"speaker": "John Kilichowski",
"content": "Kind of going back to the embedded growth pipe, maybe if we can jump down to the experiential side following the comments of Heros and Caesars. I'm just curious, and I know that these are a little less pressing in terms of time line, but how are you thinking about the call options for Canyon Ranch and Cabot and home field to market retail?"
},
{
"speaker": "Ed Pitoniak",
"content": "Yes, John, I'm happy to start with that. And before I do, I just wanted to add one last comment to the last question that Jim Kammert asked. And that has to do with not only a sustained and sustainable capital allocation cadence, that lends itself to a more sustained and sustainable funding cadence as opposed to the need to draw a whole lot of funding at one time for one deal. Anyway, to go on to your question about Cabot, Canyon Ranch and the others, we obviously -- we're talking here about assets that are under development or otherwise ramping. So we will obviously take the time we need and the time the operator needs to get the assets to where they can best sustain the opco/propco model, none of which at this point are immediately imminent. We were very excited about, obviously, what Cabot is doing in Cabot Citrus Farms. They have really created some session there. And I think, Samantha, we're pretty confident in saying that we look forward to the day when we can exercise our call right at Cabot Citrus Farms. But in the meantime, Samantha, do you want to add any color to what we're seeing in terms of mind share and market share."
},
{
"speaker": "Samantha Gallagher",
"content": "Yes -- no, thanks, Ed. Just as some may know, when we follow and we talk about the Cabot relationship, they continue to expand their global portfolio. We're excited about that and we're excited about our opportunities in the future to exercise our call rights. No changes in our commitment there."
},
{
"speaker": "John Kilichowski",
"content": "And then maybe just jumping quickly to your guidance. And there was a sentence there that reflects the dilutive effect of the roughly 90 million shares, under your for sale agreements. Just wondering what the -- like the impact of that dilutive effect for the rest of the year?"
},
{
"speaker": "Ed Pitoniak",
"content": "David?"
},
{
"speaker": "David Kieske",
"content": "Yes, John, it's David. Yes, it's very minimal. If we've got to account for the forwards under the treasury stock dilution method, and it's a very, very minimal impact to the share count that shows up in our guidance range."
},
{
"speaker": "Operator",
"content": "Our next question comes from R.J. Milligan from Raymond James."
},
{
"speaker": "R.J. Milligan",
"content": "I think John was probably a little early calling the last question on Centaur. I just have one follow-up. There was some overhang on the stock given the uncertainty, the Centaur assets. And I'm curious how much of an impact that had on your decision to announce today that you wouldn't be calling the assets? I'm just curious if we can interpret that as doing other opportunities between now and the end of the year that you may pursue and don't want this overhang on your cost of equity?"
},
{
"speaker": "Ed Pitoniak",
"content": "R.J., Good to hear be from you. That was not a deciding factor by any means. Obviously, we are aware, we're aware of the perception of overhang on the stock, and that was obviously -- it felt like a more significant factor through much of Q2 and even into the first couple of weeks of Q3 given the general state of the REIT equity market. But no, that wasn't a deciding factor and are deciding to announce it now. Again, the real driving factor was just to make sure everybody understood we've made a decision. And we're comfortable -- very comfortable announcing the decision. Very comfortable that we have very compelling other opportunities to allocate capital. And again, I would just go back to the point of our desire -- and we won't achieve it every time, but our desired capital allocation and capital funding strategies are based on being sustained and sustainable. We obviously spent a good number of our early years doing very big deals that had very big funding requirements, that generally needed to happen all in one day. And as VICI matures and as we achieve a sustained and sustainable cadence in AFFO growth, we want that to be driven by a sustained and sustainable cadence in both capital allocation activity, i.e., acquisitions and funding."
},
{
"speaker": "R.J. Milligan",
"content": "Should we interpret that funding comment as you're likely to be a bigger user of the ATM going forward versus overnights?"
},
{
"speaker": "Ed Pitoniak",
"content": "I'll turn that over to David. But before I do, we obviously want to take care that the market never develops VICI ATM fatigue. And with that, I'll turn it over to David for any further color he wants to add."
},
{
"speaker": "David Kieske",
"content": "No. Ed, you stole my line. That's exactly right. You've heard us say, under Mo’'s leadership, we have a balanced approach to raising equity, whether that be an ATM, blocks, overnights, smart deals in connection with larger transactions. So we want to ensure that we raise capital the most efficiently, but also ensure that we are not developing or becoming stale in our style and then developing fatigue out there with our owners."
},
{
"speaker": "Operator",
"content": "The next question comes from Dan Guglielmo from Capital One Securities."
},
{
"speaker": "Dan Guglielmo",
"content": "Just one from me on the credit solution investments. Most of the recent growth has been in the mezz and preferred investments, which do historically carry more risk. How are you all monitoring those investments? And could you pull future funding commitments if the macro economy does get choppy?"
},
{
"speaker": "Ed Pitoniak",
"content": "David?"
},
{
"speaker": "David Kieske",
"content": "Yes. Gabe is the envy of the VICI experiential credit solutions. He's here in the room, our Chief Accounting Officer. So for this Credit Solutions head on and answer that."
},
{
"speaker": "Gabe Wasserman",
"content": "Dan, thanks for the question. So we're very and thoughtful with our underwriting. Even though those certain investments are structured as mezz and preferred equity, we're very thoughtful about where our attachment point is and our last dollar. Looking at the operating history of the property kind of future underwriting projections and strength and sophistication of the sponsor, so that all goes into our underwriting. We have quarterly investment loan reviews, where we're working at the property performance and discuss it as a management team. And then in terms of contractual rights, if there's something that went sideways in the macro economy, generally, that wouldn't allow us to have funding. But we certainly have protections under all of our loan agreements, that the borrowers have to meet certain conditions precedent in order for us to fund."
},
{
"speaker": "Ed Pitoniak",
"content": "And Dan -- Dan, this is Ed. I would just add that we are always lending against experiential assets, that, in a worst-case scenario, would meet our strategic investment criteria. If again, in the worst case, the asset ever came into our hands, we would want -- we always want these to be assets that, in the worst case, we would be willing to own."
},
{
"speaker": "Operator",
"content": "Our next question comes from Chad Beynon from Macquarie."
},
{
"speaker": "Chad Beynon",
"content": "You guys a few times have highlighted the strength in Las Vegas, some of the stats in terms of visitation, which is obviously being driven by the casino assets, but also the growth in sports and entertainment that we've seen out there, that gets a lot of people who don't visit the casino to still come to the city. So with that in mind, you obviously benefit from the visitation. But has anything changed in terms of you looking to do deals with some of those live entertainment, concert event stadium types of businesses? And how do you think about the durability and pricing of that sector?"
},
{
"speaker": "Ed Pitoniak",
"content": "John?"
},
{
"speaker": "John Payne",
"content": "Yes, it's a great question, Chad. And I think you've heard us over the years talk about the sectors that we're looking at. And obviously, we've made investments in Pilgrim's Golf, indoor water parks, wellness sports. I think you're asking us a question about would we make an investment in the live entertainment, real estate and facilities. I know you're asking that question about Las Vegas, but would we also -- I think filters out into the rest of the United States. It is a sector that we have been spending some time and better understanding. We love what has happened in the city of Las Vegas with the growth of sports and entertainment. We're better understanding the economics of what happens inside those big buildings. They're absolutely beautiful and the shows are great, but can they support our model. And we're continuing to study that. And could there be an investment over time? There could be. But we want to make sure that the cash flows are durable and that the operator is a tenant that we want to be partners with for a long time. But it sure is exciting how Las Vegas has diversified its revenue stream and attracting new consumers by adding sports and entertainment, not just gambling and food and nightlife."
},
{
"speaker": "Operator",
"content": "And this concludes today's question-and-answer session. I would now like to hand over to Edward Pitoniak for any final remarks."
},
{
"speaker": "Ed Pitoniak",
"content": "Thank you, Carla. And we'll just thank all of you for your time on today's call. And wish you, once earnings season is over, an enjoyable rest of the summer. Bye for now."
},
{
"speaker": "Operator",
"content": "And this concludes today's conference call. Thank you for joining. You may now disconnect your lines."
}
] |
vici | 2,024 | 1 | [
{
"speaker": "Operator",
"content": "Good day, everyone, and thank you for standing by. Welcome to the VICI Properties First Quarter 2024 Earnings Conference Call. [Operator Instructions] Please note that this conference call is being recorded today, May 2, 2024. I will now turn the call over to Samantha Gallagher, General Counsel with VICI Properties."
},
{
"speaker": "Samantha Gallagher",
"content": "Thank you, operator, and good morning. Everyone should have access to the company's first quarter 2024 earnings release and supplemental information. The release and supplemental information can be found in the Investors section of the VICI Properties website at www.viciproperties.com. Some of our comments today will be forward-looking statements within the meaning of the federal securities laws."
},
{
"speaker": "",
"content": "Forward-looking statements, which are usually identified by the use of words such as will, believe, expect, should, guidance, intends, outlook, projects or other similar phrases, are subject to numerous risks and uncertainties that could cause actual results to differ materially from what we expect. Therefore, you should exercise caution in interpreting and relying on them. I refer you to the company's SEC filings for a more detailed discussion of the risks that could impact future operating results and financial condition."
},
{
"speaker": "",
"content": "During the call, we will discuss certain non-GAAP measures, which we believe can be useful in evaluating the company's operating performance. These measures should not be considered in isolation or as a substitute for our financial results prepared in accordance with GAAP. A reconciliation of these measures to the most directly comparable GAAP measure is available on our website and our first quarter 2024 earnings release, our supplemental information and our filings with the SEC. For additional information with respect to non-GAAP measures of certain tenants and our counterparties discussed on this call, please refer to the respective companies' public filings with the SEC."
},
{
"speaker": "",
"content": "Hosting the call today, we have Ed Pitoniak, Chief Executive Officer; John Payne, President and Chief Operating Officer; David Kieske, Chief Financial Officer; Gabe Wasserman, Chief Accounting Officer; and Moira McCloskey, Senior Vice President of Capital Markets. Ed and team will provide some opening remarks, and then we'll open the call to questions. With that, I'll turn the call over to Ed."
},
{
"speaker": "Edward Pitoniak",
"content": "Thank you, Samantha, and good morning, everyone. The first quarter of 2024 was, shall we say, an interesting quarter in the American equity marketplace. A fair part of the S&P 500 packed into a house and held a magnificent party. One Wall Street shop went so far as to say the party reached the rarified state of euphoria. Euphoria, that sounds kind of fun. But to be clear, American REITs were not invited to this party."
},
{
"speaker": "",
"content": "Those of us who work within REITs were out on the curb outside that party house. From the outside, one could wonder if this was a party in which new monarchs were being coronated for perpetual rule or the kind of party that eventually ends with ambulances and/or cops being called and a few of the partygoers fleeing naked down the street out of their minds like Will Ferrell in Old School."
},
{
"speaker": "",
"content": "The first quarter of 2024 is now over. The ambulances or cops haven't necessarily showed up yet, but the party inside that magnificent house seems to be running out of steam. The MOVE Index, which measures U.S. treasury market volatility, was relatively high but relatively steady through much of the first quarter and even fell a bit in late March in a flight to safety, but in early April, started acting rowdy again. And it's much the same with the VIX equity volatility index, which having slept through much of the magnificent party, recently spiked almost 50% since the start of the year before settling back down."
},
{
"speaker": "",
"content": "Amidst all this noise, the general investment marketplace is having a hard time focusing on the income and capital appreciation dynamics of good REITs. At VICI, we can deal with all of this. We don't spend a lot of time standing on curbs wondering or complaining about parties we're not invited to. We just keep doing what we do at VICI, and that's working within our resources and capabilities to keep improving and growing our company for the long-term benefit of our stakeholders. That's what we did in Q1 2024."
},
{
"speaker": "The first quarter of 2024 was a quarter in which we produced 6.1% growth in AFFO per share over Q1 2023 and continued to flow our revenue growth through to the EBITDA line at what we believe is one of the higher rates among S&P 500 REITs. The first quarter of 2024 was also a quarter in which we focused on 3 key strategic imperatives",
"content": "imperative number one, expanding our scope and TAM in investment with our investment in Homefield Kansas City, a market-leading sports training complex that will also soon feature a Margaritaville resort. This is an investment that builds on our initial entry into the sports and recreation sector with a late 2023 acquisition of the primary leasehold interest in Chelsea Piers, an investment that validates the use of our lending platform to ultimately acquire a real estate interest, in this case, 780,000 magnificent square feet of New York recreational and entertainment space on the Hudson River."
},
{
"speaker": "",
"content": "Imperative number two, being ready to refinance our maturing 2024 debt at an opportune time, debt that would have come due on May 1; yesterday, in other words. During Q1, May 1st seemed a fair way off, but given the volatility of market conditions, we didn't want to wait too long. We went to market on March 7 and did so on what turned out the second lowest point in March for U.S. 10-year yields. Yes, our timing was fortunate, but our good fortune relied on us being ready to go."
},
{
"speaker": "",
"content": "Imperative #3, which we've just announced, capitalizing on the scale and rarity of our existing assets by working throughout Q1 with our partners at Apollo to develop a property enhancement plan for The Venetian, which gives VICI the opportunity to invest up to $700 million of capital into this magnificent Las Vegas Strip asset."
},
{
"speaker": "",
"content": "In a moment, John and David will give you more color on each of these 3 Q1 2024 imperatives."
},
{
"speaker": "",
"content": "I'll close out my opening remarks by saying the obvious. The first 16 or so weeks of 2024 haven't been a lot of fun for REIT investors. It's not clear at this point when the marketplace will recognize what we believe to be the total return value that REITs can and do represent at this point. Most, not all, but most REIT categories currently offer dividend yields that are materially in excess of current inflation rates. And REIT dividends, unlike money market or bond interest payments, have the potential to grow over time, as VICI's has, with VICI posting a dividend growth CAGR of 7.9% since the first quarter of 2018 following our IPO."
},
{
"speaker": "",
"content": "We've been living through a period in the equity marketplace in which the power of compounding has been somewhat ignored or forgotten. REITs can be powerful compounding tools. As a VICI shareholder, I haven't forgotten or ignored that compounding dynamic and benefit. I look forward to answering your questions, but first, a few words from John and David. John?"
},
{
"speaker": "John W. Payne",
"content": "Thanks, Ed, and good morning to everyone. Relationships are at the core of what we do at VICI and the quality of the relationships we have sets us apart. Our team works hard to strengthen existing ones and develop new ones so that we are best positioned for future growth opportunities, whether or not we are invited to what Ed has called the party."
},
{
"speaker": "",
"content": "Our focus on trust in finding mutually beneficial solutions with our partners multiplies the beneficial impact of each relationship and we believe lays the groundwork for future growth through both good and bad market environments. One of the best examples of this is our relationship with Apollo and the team at The Venetian. The opportunity to acquire The Venetian originated during the COVID pandemic, another period of uncertainty with a challenging market backdrop."
},
{
"speaker": "",
"content": "Since that time, the team at The Venetian has outperformed all expectations as Las Vegas has continued to solidify itself as the entertainment center of the world. We are thrilled to further expand our close relationship with Apollo and announced our opportunity to invest up to $700 million at The Venetian through VICI's Partner Property Growth Fund. This capital investment will fund several projects that seek to improve the overall guest experience and enhance the value of the property."
},
{
"speaker": "",
"content": "The impact of our increasingly dynamic Las Vegas has continued to accrue to the benefit of The Venetian since we acquired the property together with Apollo in 2022, particularly with the neighboring Sphere, events like F1 and Super Bowl and an active convention schedule. The Venetian is set to celebrate its 25th anniversary this Saturday, and we're thrilled to partner with Apollo once again in their efforts to maximize the economic potential of this amazing iconic Strip asset."
},
{
"speaker": "",
"content": "Gaming remains at VICI's core with over 98% of rent coming from our gaming partners, and the sector remains broadly healthy from a tenant credit perspective. Las Vegas continues to enjoy healthy growth with GGR up low single digits following the Super Bowl this quarter, and that is on top of an already impressive baseline, given gaming revenue increased 12% in the first quarter of 2023 over 2022."
},
{
"speaker": "",
"content": "Since the market emerged from the pandemic, there has been 12 straight quarters, I'm going to repeat that, there has been 12 straight quarters of GGR growth in Las Vegas. Additionally, Las Vegas visitation numbers were up 4.2% in the first quarter, demonstrating the continued diversity of the revenue streams and the vast array of consumers enjoying this amazing city. In fact, based on a recent study from the University of Toronto that evaluated North American cities pre and post pandemic, Las Vegas is the only city that has surpassed pre-pandemic unique visitation numbers."
},
{
"speaker": "",
"content": "In the regional gaming markets, while we recognize idiosyncratic weather headwinds this winter, we believe fundamentals remain sound, and we see steady consumer discretionary spend driven by the middle and high-end consumers on the casino floor. Although interest rate volatility has impacted transaction volume in the gaming market, we are active in dialogue around real estate opportunities in the gaming sector. Outside of our embedded growth pipeline, our relationships and gaming focus put us in a strong position when transactions or opportunities to invest in our existing properties arise."
},
{
"speaker": "",
"content": "We continue to monitor the performance of Harrah's Hoosier Park and Horseshoe Indianapolis, for which we have a call right to acquire the real estate and buildings of these unique assets. This call right expires at the end of 2024 and we continue to work through the process with the appropriate Indiana regulatory agencies to gain the necessary gaming approvals should we elect to execute this option."
},
{
"speaker": "",
"content": "VICI is also well positioned for incremental opportunities outside the gaming space as we've continued to expand our scope and our TAM of investments. We are committed to ensuring that each experiential sector and potential partner meets our investment criteria of low cyclicality, low secular threat, improving track record of growth and favorable supply and demand dynamics."
},
{
"speaker": "",
"content": "In January of this year, VICI expanded its investment in the youth sports sector with the announcement of the up to $105 million construction loan agreement with affiliates of Homefield Kansas City to fund the development of a Margaritaville resort that will be embedded within Homefield's broader youth sports complex. The youth sports training center hosted 115 teams this last weekend for a basketball tournament and the baseball facility is open and in use. The Margaritaville resort is expected to be completed in 2025. Having visited the area a few weeks ago, I can tell you all the facilities are truly amazing."
},
{
"speaker": "",
"content": "The Homefield partnership adds to our youth sports investment, as Ed said, which we initiated with our 2020 mortgage loan to Chelsea Piers in New York City. And at the end of 2023, we acquired the leasehold interest in the property and converted the initial loan into real estate ownership."
},
{
"speaker": "",
"content": "While REITs were broadly excluded from, as Ed put it, the party that took place in the first quarter of 2024, the effects of the transactions and relationships announced at the end of last year and the beginning of this year contributed to our 6.1% growth in AFFO per share. As I stated earlier, our relationships are at the foundation of our business and drive our growth. Our standard for prudent underwriting gives us confidence in our roster of existing partners with whom we believe we have many growth opportunities. We look forward to developing new relationships with best-in-class operators so that VICI can continue to grow its quality experiential real estate portfolio."
},
{
"speaker": "",
"content": "Now I will turn the call over to David, who will discuss our financial results and guidance. David?"
},
{
"speaker": "David Kieske",
"content": "Thanks, John. It's great to speak with everyone today, and we greatly appreciate your time. Starting with our balance sheet, as Ed mentioned, in the first quarter, we successfully -- I'll say, very successfully executed our first refinancing of the $1.50 billion May 2024 notes that came -- that would have come due yesterday."
},
{
"speaker": "",
"content": "On March 7, we launched a bond offering and at its peak, we are 12x oversubscribed. We ultimately issued $550 million of 10-year notes at a coupon of 5.75% and $500 million of 30-year notes at a coupon of 6.125%, for a blended yield of 5.9% before the impact of our forward interest rate swaps. When compared to the coupon of 5.625% that we refinanced, we feel really good about the all-in coupon we were able to achieve and at the same time, extend the duration of our maturity profile."
},
{
"speaker": "",
"content": "During the quarter, we also bolstered our liquidity and sold 9.7 million shares, raising $305 million in gross proceeds under our ATM via the forward. Currently, we have approximately $3.5 billion in total liquidity comprised of $515 million in cash, cash equivalents and short-term investments as of March 31, $683 million of estimated proceeds available under our outstanding forwards, and $2.3 billion of availability under our revolving credit facility."
},
{
"speaker": "",
"content": "In addition, our revolving credit facility has an accordion option, allowing us to request additional lender commitments of up to $1 billion. As we sit here today, we believe we are well positioned to navigate the current macro environment and do not need to raise any incremental capital."
},
{
"speaker": "",
"content": "In terms of leverage, our total debt is currently $17.1 billion. Our net debt to annualized first quarter adjusted EBITDA, excluding the impact of unsettled forward equity, is approximately 5.4x, within our target leverage range of 5 to 5.5x. We have a weighted average interest rate of 4.36%, taking into account our hedge portfolio, and a weighted average 6.8 years to maturity."
},
{
"speaker": "",
"content": "Touching on the income statement, AFFO per share was $0.56 for the quarter, an increase of 6.1% compared to the $0.53 for the quarter ended March 31, 2023. Our results once again highlight our highly efficient triple net model given the increase in adjusted EBITDA as a proportion of the corresponding increase in revenue, and our margins continue to run strong, in the high 90% range when eliminating noncash items."
},
{
"speaker": "",
"content": "Our G&A was $16.2 million for the quarter and as a percentage of total revenues was only 1.7%, and continues to be one of the lowest ratios in not only the triple net sector but across all REITs."
},
{
"speaker": "",
"content": "Turning to guidance. We are reaffirming AFFO guidance for 2024 in both absolute dollars as well as on a per share basis. As we originally highlighted on our Q4 earnings call, AFFO for the year ending December 31, 2024 is expected to be between $2.32 billion and $2.355 billion, or between $2.22 and $2.25 per diluted common share."
},
{
"speaker": "",
"content": "As a reminder, our guidance does not include the impact on operating results from any transactions that have not yet closed, interest income from any loans that do not have final draw structures, possible future acquisitions or dispositions, capital markets activity or other nonrecurring transactions or items."
},
{
"speaker": "",
"content": "And as we have previously mentioned, we recorded noncash CECL allowance on a quarterly basis, which due to its inherent unpredictability leaves us unable to forecast net income and FFO with accuracy. Accordingly, our guidance is AFFO focused, and we believe AFFO represents the best way of measuring the productivity of our equity investments in evaluating our financial performance and ability to pay dividends. With that, operator, please open the line for questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] The first question comes from Caitlin Burrows at Goldman Sachs."
},
{
"speaker": "Caitlin Burrows",
"content": "I guess one of the ways for VICI to identify and complete deals is when your partners are growing and expanding. So can you give some color on how your partners are doing and to what extent they're in the position to be expanding right now? I guess we can see the opportunity with The Venetian, but what else should we consider?"
},
{
"speaker": "Edward Pitoniak",
"content": "John, do you want to start?"
},
{
"speaker": "John W. Payne",
"content": "I will start, and I'll start first in our portfolio in Las Vegas because I think that's been a real center of where we've grown our company, and we have great operators there. We obviously announced The Venetian today, and you heard in my opening remarks that I believe, and maybe I'm a little bit biased, but this is the fastest-growing or the best city in hospitality in the world as it continues to attract a wide variety of consumers. So that provides opportunities for our partners, whether that's MGM, Caesars, we announced with Venetian. We've got a partner in Hard Rock that owns the Mirage that are all studying ways to continue to reinvent their business and add additional amenities to these amazing assets."
},
{
"speaker": "",
"content": "The beauty of the assets in Las Vegas is the magnitude of opportunities that they have and the magnitude of square footage that they have in these assets to continue to not only remodel, but there are large parts of these assets that are unused at this time that could be brought either back to life or have never been in life with new concepts. So I can't give you any details that we haven't announced, but our operators have all talked about the development of their Las Vegas assets."
},
{
"speaker": "",
"content": "Outside Las Vegas, there are some regional markets that continue to grow. We own some of the best assets out there, and we continue to talk to our partners about how we could potentially use our capital to grow their businesses. And we've announced previously some opportunities with Century, and I think there'll be some opportunities with some of our larger and our smaller operators. So Ed, I'll start with that if you want to add anything to that answer."
},
{
"speaker": "Edward Pitoniak",
"content": "I would only add, John, and Caitlin, good to hear from you, that obviously, depending on the outcome of the New York gaming licensing process, were the MGM asset in Yonkers, which we own the real estate of, to gain one of the full licenses, that would obviously be an opportunity for us to invest substantial capital in the recreation of that asset."
},
{
"speaker": "Caitlin Burrows",
"content": "Got it. And then you guys were talking about the Homefield partnership. I was wondering if you could just maybe remind us the status of your current construction loan there, which I don't think itself is a huge exposure for VICI, but as we think about the potential growth and scope of that relationship, what it could be like?"
},
{
"speaker": "Edward Pitoniak",
"content": "David?"
},
{
"speaker": "David Kieske",
"content": "Yes, Caitlin, we started funding that upon an announcement. And so that's an 18-odd-month development builds, but it's really the proceeds that are going into the Margaritaville Hotel to use to build the Margaritaville Hotel, excuse me. As John mentioned, the team was out there a week or so ago and saw the sports facilities that are ultimately part of our real estate that we do have the option to call in the future once everything is up and running and stabilized. But they are a best-in-class youth sports operator, and while there's no immediate intentions to grow, they are realizing the benefits of what they're creating and may have opportunities in the future to expand what they are successfully building in Kansas City."
},
{
"speaker": "Operator",
"content": "The next question comes from Anthony Paolone from JPMorgan."
},
{
"speaker": "Anthony Paolone",
"content": "I guess my first question is, can you talk a bit about how you're thinking about return requirements and your cost of capital and any sort of spread? When I look at Venetian, it's obviously a tremendous asset and a strong relationship, and you talked about the importance of that. Then the flip is, I guess you got some flat term for a little bit, and it's also more of a CapEx investment as opposed to new assets. So maybe just help us with putting some dimensions around how you're thinking about the right levels of return in your own cost of capital."
},
{
"speaker": "Edward Pitoniak",
"content": "Yes. Tony, good to hear from you. The starting point is that, over time, we are obviously solving for blended yield on our investments. When we have the opportunity to put capital into an asset as rarefied as The Venetian and still maintain an accretive spread, to the point of your note, not a vast accretive spread and not our targeted blended rate of return. But if we can match an investment like The Venetian with investments, whether acquisitions or property or lending investments that give us more substantial yields, more substantial spreads, we feel, on a net-net basis, we're creating a lot of value for shareholders."
},
{
"speaker": "Anthony Paolone",
"content": "Okay. And then just my second one, John, you mentioned on the Centaur assets going through some regulatory process right now. Does that mean that if you do exercise the option, the close would be pretty immediate? Is that what to read there? Or just wondering what that meant."
},
{
"speaker": "John W. Payne",
"content": "Tony, I don't think that's necessary. It's funny. First of all, it's funny we still call them the Centaur assets. It is Harrah's Hoosier Park and Horseshoe Indianapolis. We do the same the same thing. But no, Tony, I mean we're going through the process with the appropriate Indiana regulatory agencies. And should we elect to execute this option, we will make sure that we follow all the rules and the regulations. But to your question about timing, really no position on that other than we're going through and spending the appropriate time with those agencies."
},
{
"speaker": "Operator",
"content": "Our next question is from Barry Jonas from Truist."
},
{
"speaker": "Barry Jonas",
"content": "I was curious, how deep is the pipeline for additional partner property growth investments? And then I guess, as we think about those investments like Venetian, how should we think about the potential for those ROI improvements converting to sale leaseback at some point?"
},
{
"speaker": "Edward Pitoniak",
"content": "Yes. So I think as a starting point, Barry, it's valuable to remember that from what we can determine, we are the largest owner of hotel room real estate in America. We're the largest private sector owner of convention space in America, one of the largest owners of restaurants, theaters, other kinds of entertainment spaces. What are we right now, David, about 130 million square feet?"
},
{
"speaker": "David Kieske",
"content": "Just under that. That's right."
},
{
"speaker": "Edward Pitoniak",
"content": "Yes. So Barry, when you think about having 130 million square feet of existing property, 1% and 2% of that number as potential reinvestment opportunities is a pretty compelling opportunity unto itself. As John mentioned, The Strip obviously represents a very compelling opportunity. We're particularly excited about the opportunities that could be at the south end of The Strip. We're in partnership with MGM. We own 5 assets, I believe it is. And that is an end of The Strip that, as you know, Barry, has taken on a vitality in recent years that it didn't have before."
},
{
"speaker": "",
"content": "The T-Mobile obviously added to the vitality at that end of The Strip, Allegiant definitely added a lot and the A's stadium could potentially add a lot of vitality. And so when you look at assets like MGM Grand, New York, New York Excalibur, Luxor, Mandalay Bay and Park MGM, we, with our partners, MGM, who obviously reported a very good quarter last night, are excited about what the densification opportunities could be over the coming years."
},
{
"speaker": "John W. Payne",
"content": "Barry, can I add just one thing to that. Not only are -- do I agree 100% with Ed on the assets, it's also the operators that run these assets, that they are constantly looking at ways to attract more consumers and to generate more business. So you can have a great asset, but if the operator doesn't want to change it and wants to sit on their hands, the gaming operators, particularly in Las Vegas, are the best in the world in the hospitality space, and they are constantly looking at ways to build, reinvent their business. And so those 2 things combined, not only the assets are incredible, but having operators that want to change and grow and innovate is a formula for us to be able to continue to grow with the Property Growth Fund."
},
{
"speaker": "Edward Pitoniak",
"content": "And Barry, before we move to your second question, Samantha wants to clarify an assumption that you made in your question that, in fact, isn't quite right."
},
{
"speaker": "Samantha Gallagher",
"content": "Yes. Thanks, Barry. So you asked if we will have the opportunity to convert that via sale leaseback. And we actually don't need to do that because we own the capital improvement and that reverts to us via rent. So it's not something that we need to then, in the future, convert via sale leaseback. That's one of the benefits we think of the Property Growth Fund."
},
{
"speaker": "Barry Jonas",
"content": "But do you have a chance, I guess, to -- I think like if you look at the predecessor MGP, there are instances where they acquired an additional improvement and that drove increased rent. Does that opportunity exist, just so I'm sure I understand?"
},
{
"speaker": "Edward Pitoniak",
"content": "Yes. I mean it's in essence what we're doing, yes, exactly. We're investing incremental capital and in return for incremental capital, we get incremental rent."
},
{
"speaker": "Barry Jonas",
"content": "Okay, okay. Understood. And then just quickly as a follow-up, curious as you're looking at deals if the competitive environment is the same or if you're seeing kind of any new spaces at those parties, as it's called?"
},
{
"speaker": "John W. Payne",
"content": "It continues to remain -- it's the same, Barry."
},
{
"speaker": "Operator",
"content": "Our next question comes from John DeCree from CBRE."
},
{
"speaker": "John DeCree",
"content": "Maybe one to start on Las Vegas. John, I think in your prepared remarks, you've mentioned what a great hospitality market Las Vegas is, and we certainly agree. Curious how you guys think about your net exposure to the market following The Venetian investment. And in the context of -- if you could remind us if you have officially committed to anything at the Mirage yet. Obviously, Hard Rock is considering a pretty big rebrand there. And you've mentioned a number of partners possibly considering activating space. So when you think about all the potential opportunities, are you kind of comfortable with that? Do you kind of have a ceiling in which you'd like to go to and how much capital you deploy to Las Vegas, how do you kind of think about your exposure to that market over the near to medium term?"
},
{
"speaker": "John W. Payne",
"content": "Ed, do you want me to take that?"
},
{
"speaker": "Edward Pitoniak",
"content": "Yes. Yes, he was asking you, John."
},
{
"speaker": "John W. Payne",
"content": "Yes. John, so let's talk a little bit about all the different areas of Las Vegas. So today, we have an incredible amount of assets in -- on The Strip. We have 10 assets on the Las Vegas Strip that we're very excited about. Where we do not have any investments yet, where we see potential for growth is in the regional market of Las Vegas and in the downtown market of Las Vegas. So you could see VICI continue to grow in the Las Vegas market, and it could be on The Strip, but it also could be in these other areas. And those are great segments of the business that we simply don't have real estate or partners yet along the way."
},
{
"speaker": "",
"content": "So -- and then I think you also asked about the Mirage and our work with -- we continue to speak with the Hard Rock team who's running the Mirage on ways that we can help them grow, but we have not made any announcement on that yet, John."
},
{
"speaker": "John DeCree",
"content": "Got it. Maybe a high-level follow-up for whoever wants to take it. It's kind of an observation first that a lot of the casino industry, your partners and others' preference for development or project CapEx right now. We see that with The Venetian. Interest rate volatility is probably a part of the answer to the question, but why do you think we've seen more capital deployed in existing properties or new development relative to M&A, assuming your kind of cost of capital as a financing source for casino industry participants is still pretty competitive? So we would think M&A could still be a logical option yet we've seen kind of all developments. So just curious if you guys have a view why that might be other than maybe just interest rates."
},
{
"speaker": "Edward Pitoniak",
"content": "And just so we're clear, John DeCree, here's being about M&A among the gaming operators themselves? Are you speaking more narrowly about the trading of assets?"
},
{
"speaker": "John DeCree",
"content": "Yes. I guess it's probably more amongst the strategic buyers of your partners, buying and selling, which would maybe pull you in as a financing source. So the casino industry developing and investing in properties rather than acquiring. It seems like we're in a different part of the cycle. Presumably, if we saw more M&A amongst your partners, that would create more opportunities for you as well."
},
{
"speaker": "Edward Pitoniak",
"content": "Yes. Yes, you're right. And honestly, you probably have -- you'd have to ask the operators as to why they believe there isn't more M&A right now. I could speculate, and that's all I'm doing. Obviously, the operators, so many of them are trading so cheaply right now, bafflingly, bafflingly so, however you want to measure the valuation, including obviously, free cash flow yield. And so it could be a time when people say, I'm not going to sell, not at this point."
},
{
"speaker": "",
"content": "But again, you really have to ask them. And it could also be the fact that the economic performance of the operators has been so strong coming out of COVID. I think one open question could obviously be okay, are these peak earnings? Are we going to sustain them? We believe that the earnings power of our operating partners is going to continue, but one could reasonably ask, okay, I don't want to be the guy who buys at what turned out to be a peak only to see economic performance normalize as the COVID effect wears away."
},
{
"speaker": "Operator",
"content": "Our next question comes from David Katz from Jefferies."
},
{
"speaker": "David Katz",
"content": "And I wanted to just get your take on some of the non-gaming initiatives and pursuits. Obviously, they're exciting in terms of TAM. But can you just talk about the -- how you view the durability, the long-term durability of those asset classes such as Bowlero or Canyon Ranch, et cetera, and how that compares with your initial core in Las Vegas?"
},
{
"speaker": "Edward Pitoniak",
"content": "Yes. No, it's a very good question, David. And it's an essential question we're continually asking ourselves as we investigate new experiential categories. And you've heard us talk in the past about our 4 key criteria of healthy supply/demand balance, low to no secular, threat the durability of the end-user experience and lower-than-average cyclicality."
},
{
"speaker": "",
"content": "I would add to that, that we're looking for businesses that have an economic dynamism to them, which tends to really center on a certain amount of revenue complexity, or as we've come to like to say, cash register intensity. And we want that to be coupled with an operator who knows how to make the most of that economic dynamism. They're energetic operators and they're very economically astute operators."
},
{
"speaker": "",
"content": "And I would say that one of the key criteria among those is the durability question. Is it an asset class that has been around for decades? Has it proven itself through every economic cycle and through all the different demographic cycles? And I will give you an example right now of a category that we would be nervous about. And that is the -- I guess if you want to call it a category into itself, that would be pickleball, right? It's an incredibly popular sport right now. It hasn't been around long. And the supply/demand balance question is very much an open one because it's not hard to put pickleball courts just about anywhere, public parks, parking lots, you name it."
},
{
"speaker": "",
"content": "And I am old enough to remember a sport called racketball, which was a very popular sport in the '70s and the '80s. And I don't know about you, David. I don't see a lot of racketball courts around anymore. I have no idea why they're not around, it was a fun game. You didn't have to be terribly highly skilled to play it and have fun, but it's kind of gone. So we take very, very seriously the question of durability. And there is really no better evidence of durability than durability, that it has been around a while and it has succeeded through all cycles."
},
{
"speaker": "Operator",
"content": "Our next question comes from Smedes Rose from Citi."
},
{
"speaker": "Bennett Rose",
"content": "John, I wanted to follow up with something John said and you -- I think you said in your opening remarks that in the regional market, revenues are being driven by the middle and the high end of the market. And my question is, is that kind of always the case? Or are your operators starting to see some weakness with a lower-end consumer? And do you have any concerns about that, I guess, as you sort of think about the portfolio overall?"
},
{
"speaker": "John W. Payne",
"content": "Yes, Smedes, good to talk to you. Probably a better question for the operating side of our business or the operators, but I'll give it a go here a little bit. In my comments, we're about in the regional markets, like you said, the middle and the high-end consumers are still coming in their frequency based on the information from our tenants. I think you're asking or do we believe that those lower segments will come back. I think that really depends on the operator. Is the operator pulling back incentives to those consumers and they've elected not to come because they find more ways to spend their marketing dollars in a more efficient way? So again, more an operator conversation."
},
{
"speaker": "",
"content": "But Smedes, again, you're asking how does that affect VICI? As I always like to say, and you know this well, even with every casino closed in the world during the pandemic, VICI collected 100% of our rent on time and in cash. So if segments of the business see a little bit of a downturn, not even negative, VICI is going to collect our rent or historically has collected our rent."
},
{
"speaker": "",
"content": "So we monitor these things. I stay on top of it because I'm a recovering operator, but in the core business of what we do, those downturns, upturns don't have a huge change in our look at the business. We look much more big picture, longer-term, years out. Does that make sense, Smedes?"
},
{
"speaker": "Bennett Rose",
"content": "Yes. No, absolutely. I just -- it sounds like maybe it's more of a strategic goal from the operator side. And just -- we're just hearing on other calls, there just seems to be a sense that maybe consumers are starting to pull back a little bit. There's some weakness in different leisure segments. So I'm just kind of curious if you guys had insight there."
},
{
"speaker": "",
"content": "I wanted to ask you as well, there's been press reports that MGM Resorts is looking to I guess, sell their operating rights at the MGM Springfield. And whether or not they do or not, I don't know if -- you probably can't comment on that, but I'm just -- could you talk about sort of what VICI's role would be in that process and how you guys are thinking about it from your perspective, if that were to move forward?"
},
{
"speaker": "Edward Pitoniak",
"content": "John, do you want to take that? Or do you want Samantha to take that?"
},
{
"speaker": "John W. Payne",
"content": "Samantha."
},
{
"speaker": "Samantha Gallagher",
"content": "Yes. As you know, obviously, we wouldn't comment on any of our operators' sale transactions. But to the extent they were to sell an operating business, we obviously retain the asset and would enter into a lease with any transferring of that asset."
},
{
"speaker": "Edward Pitoniak",
"content": "And you've seen that happen in a few -- yes, and Smedes, I'll just add that you've seen that in a few instances with our assets, Southern Indiana being one, Gold Strike being another. So we have definitely figured out how to work through those processes with existing tenants and new."
},
{
"speaker": "Operator",
"content": "Our next question is from Daniel Guglielmo from Capital One."
},
{
"speaker": "Daniel Guglielmo",
"content": "You all have a diverse group of partners and tenants, both large and small. This earnings season, there have been some questions around the health of the U.S. and Canadian consumers from a risk perspective. And just acknowledging that you all are well fortified at the lease level, but are there certain areas of the portfolio you're thinking about more trying to understand better in this environment?"
},
{
"speaker": "Edward Pitoniak",
"content": "I wouldn't say, Daniel, it's so much about particular assets or even particular geographies. But I do think it goes back to the question Smedes asked a moment ago, which is what kind of behaviors you're seeing for consumer segment and their income and their spending power. And I do think one of the more -- one of the elements of cognitive dissonance right now is this disparity between lower-income consumers and higher-end consumers and the degree to which you are seeing some degree of stress and/or at least less liquidity for these lower-end consumers than you might have a year or 2 ago when we were seeing the benefits of so many of the stimulus plans that came out of COVID."
},
{
"speaker": "",
"content": "So we obviously -- we monitor it closely. We monitor it for the impact it can obviously have on our partners. But we also monitor it as part of our overall monitoring of the economy and the credit markets. And the degree to which the remarks that Jerome Powell made yesterday when he was kind of nice Jerome as opposed to scary Jerome, I think there's a recognition even at the Fed that despite a lot of our macro measures appearing to be very robust, there are some tensions in the economy right now."
},
{
"speaker": "Daniel Guglielmo",
"content": "Great. Yes. I appreciate the detailed response, and that makes sense. And then just real quick around some of the development financing in the loans and securities bucket. I'm sure you all talk with those teams on a regular basis. Can you just give us an idea if there have been any recent headwinds or tailwinds that you're hearing about from them?"
},
{
"speaker": "David Kieske",
"content": "Yes, Dan, it's David. Good to hear from you. No, we have a very thorough asset management loan administration process and we monitor both our tenants and our loan investments very closely. And we talk to, as John mentioned, we talk to the operators and we also talk to our borrowers, and they are not seeing any headwinds in terms of development completion or asset performance where we do have these loan investments."
},
{
"speaker": "Operator",
"content": "The next question is from Michael Herring from Green Street."
},
{
"speaker": "Michael Herring",
"content": "Just looking at the Venetian deal, it obviously looks like a win-win from our perspective, at least just in the sense of Apollo's cost of finance and then the yield that VICI gets to invest on The Strip in Vegas. I was wondering, could you guys walk through maybe how those negotiations kind of transpired and how you came to that final yield number given that it is favorable or it looks favorable on both sides? And how that might look for future similar investments on The Strip with other partners that you guys have?"
},
{
"speaker": "Edward Pitoniak",
"content": "Sure. Yes, Michael, good question. John?"
},
{
"speaker": "John W. Payne",
"content": "Michael, it's nice to talk to you this morning. And we agree that this is a win-win for both companies. You initially asked when did these discussions started. They actually started when we initially did the lease back in -- during the pandemic. And when we bought the real estate with Apollo or we bought the real estate and they bought the operation of Venetian, we knew that they were going to grow the business. We didn't know they were going to grow it as fast as they hadn't been so successful there, and we're very, very proud of them. But we talked about the Property Growth Fund and where there could be opportunities for us to grow. So the discussion started, and we do this often when we're doing deals to not only think about the deal that's in front of us, but where there are opportunities for us to grow, particularly with great assets like The Venetian."
},
{
"speaker": "",
"content": "And then as it comes to the pricing, like anything, we -- since we started the company, we tried to create beneficial deals for both sides. If one side kind of wins, it's not great for a long-term relationship. So I opened up my remarks today and I -- someone may have rolled their eyes about that this is about relationships, but it really is about relationships. And when you can look across the table from a good partner, you get to a price that they feel good about, we feel good about and the transaction happens. And as you said, it's been a win-win, and we're just excited to help them add these great new amenities and upgrade the amenities that they have."
},
{
"speaker": "Michael Herring",
"content": "Got it. And just sticking with the Venetian deal. Obviously, you laid out the terms of the initial disbursements and the $400 million [ tallied ] can be up to $700 million. Is the entire scope of the project that Apollo is looking to take on, is that included in the initial $400 million? Or will they eventually need that $300 million eventually, it's just whether or not they want to use that option?"
},
{
"speaker": "David Kieske",
"content": "Michael, it's David. One of the things you should look at is the Venetian press release that they put out yesterday where they, ahead of a 25th anniversary of the asset this Saturday, actually, where they have laid out extensive value enhancement plans well in excess of $700 million actually. So it's just a little bit of timing on their side as they work through the initial $400 million this year. They've got a lot of things in the hopper and things that they've already done. And then just a bit of as that all comes together, what their pace of potentially drawing that incremental $300 million, where that falls in and how they use that capital going forward."
},
{
"speaker": "Edward Pitoniak",
"content": "And Michael, just to add to that, I believe you'll see the press release talks about a total of about $1.5 billion of total investment into The Venetian, of which we may end up being about half of that. But I want to stress the point that I don't know of another REIT category where tenants put more capital into the REIT's asset than ours. If you look across our portfolio, both our Las Vegas portfolio and our regional portfolio, any given year, our tenants are putting hundreds of millions of dollars, if not billions of dollars into our assets, making our assets more valuable. That obviously doesn't get captured in the models per se, given that obviously, the transparency around the exact capital that our tenants put into each one of our assets is not necessarily there. But we can tell you, based on what we know of their investment activities, that no other REIT that we know enjoys greater benefit from tenant reinvestment into our properties."
},
{
"speaker": "Operator",
"content": "The next question comes from Greg McGinniss from Scotiabank."
},
{
"speaker": "Greg McGinniss",
"content": "So given that the Venetian deal originally had potential to be up to $1 billion, does that mean there remains another $300 million here down the line? Or does this exhaust that initial agreement?"
},
{
"speaker": "",
"content": "And in general, for the Partner Property Growth Fund, is there -- could there potentially be more concrete agreements ahead of time like in the case of The Venetian or for situations like you're talking about in terms of the south side of The Strip and MGM where there might be something? Is it more likely to just have an actual investment be announced as opposed to, again, the potential for one?"
},
{
"speaker": "Edward Pitoniak",
"content": "Yes. David or John?"
},
{
"speaker": "David Kieske",
"content": "Greg, I can start, and John can maybe chime in. Yes, potentially, there could be more than $700 million that comes out of our agreement here. The original $1 billion announcement back in 2022, we modified that as the team worked through and got in under the hood, so to speak, of the asset and realize what they wanted to do or what they want to undertake. So there's some tweaks to the original agreement on our side. And as Ed just laid out, the announcement that The Venetian put out yesterday has up to $1.5 billion or their plan is to invest $1.5 billion into the assets. So there could be incremental capital. But what we've documented and announced with our great partners at Apollo and Patrick and team and Rob into The Venetian is this incremental $700 million investment today."
},
{
"speaker": "",
"content": "And to the second part of your question, there could be incremental dollars that we put in across the portfolio. It was because of the uniqueness of our assets versus any other REITs out there."
},
{
"speaker": "John W. Payne",
"content": "Yes, Greg, I think you should hear that we like these opportunities. And as Ed just pointed out a few minutes ago, there aren't many REITs that have this unique lever to pull to grow. I mean there aren't many REITs that are going to say, \"Hey, we're going to put $700 million into an asset.\" There are some REITs that can't even say I want to put $700 million into my whole portfolio. We're talking one of our 93 assets. So we like this opportunity to help our partners grow, and that's one of the uniqueness that VICI has that we have the -- and we were talking earlier, we can go to M&A. We can help buy other assets, but we also have this lever that we've been talking about for years that is coming to life today with The Venetian."
},
{
"speaker": "Greg McGinniss",
"content": "Okay. And David, just on the maintained guidance real quick. Was there no additional drawdown on loans without final draw structure in Q1? Or is it just at an immaterial level to have no impact on the full year guide?"
},
{
"speaker": "David Kieske",
"content": "No -- sorry, the first part of your -- around the draw schedules, Greg? I mean we still feel really good about our guidance -- sorry, go ahead."
},
{
"speaker": "Greg McGinniss",
"content": "Yes. So I understand that for loans without draw schedules, that's not included in future guidance. And I'm not exactly sure what was drawn, if anything. Assumption would be that there was."
},
{
"speaker": "David Kieske",
"content": "Yes, it's immaterial if there were any, so we feel really good about our guidance range where we sit here today."
},
{
"speaker": "Operator",
"content": "Our next question is from Ronald Kamdem from Morgan Stanley."
},
{
"speaker": "Ronald Kamdem",
"content": "Just 2 quick ones. Just first, just looking for some qualitative comments starting with the annual letter about sort of higher rates and the impact of activity, just as you've seen sort of this recent spate of movements on the rate front, just qualitative comments on what that's doing to the pipeline, where the decisions are taking longer and so on and so forth, or if anything's falling out?"
},
{
"speaker": "Edward Pitoniak",
"content": "Yes, it's a timely question, Ron. I mean it's definitely having a fairly chilling effect on trading activity really across most all asset classes. And that's why we really value having levers to pull or tools in our toolbox where we can generate growth during periods when it would otherwise be difficult to do through conventional asset trading activity. Those obviously include things like our property partner growth fund, The Venetian being an example, through our credit book, through our expansion of existing relationships. And then again, too, having the tool in the toolbox of non-gaming and being able to do things with partners like Chelsea Piers, Homefield, Cabot and Canyon Ranch when, again, the trading of assets would otherwise be difficult -- and is difficult, frankly."
},
{
"speaker": "Ronald Kamdem",
"content": "Great. And then just the second question, just staying on the pipeline, is there sort of more activity on the gaming side, non-gaming side, all of the above? Just any sort of color there would be helpful."
},
{
"speaker": "John W. Payne",
"content": "We continue to spend time..."
},
{
"speaker": "Edward Pitoniak",
"content": "John?"
},
{
"speaker": "John W. Payne",
"content": "Yes, we continue to spend time in a lot of different sectors on the non-gaming side, whether that's wellness, indoor water parks, pilgrimage golf, youth sports, you've heard us make an investment. But at the same time, let's remember, as I said in my opening remarks, we get 98% of our rent from our gaming assets, and we continue to spend time with our current partners and others to grow. So for us, I know we get asked a fair amount about our non gaming, but it shouldn't be forgotten that we're also spending a lot of time in gaming. So the answer is both, spending time in both."
},
{
"speaker": "Operator",
"content": "Okay. We have no further questions on the call. So I'll hand the floor back to Ed for the final closing remarks."
},
{
"speaker": "Edward Pitoniak",
"content": "All right. Thanks, everybody. So I want to close out the call by just reiterating how much value we believe we're creating with the announcement we made yesterday afternoon of our investment in The Venetian with our partner, Apollo. And I'm going to actually read from somebody's note because, frankly, this note expresses it better than I ever could."
},
{
"speaker": "",
"content": "And in this note, the author says we view the Venetian cap rate spread as attractive, especially considering how tight spreads are elsewhere in net lease. Bigger picture, we view this as VICI capitalizing on its relationships to double down on a winning hand. In parenthesis, The Venetian may be VICI's best acquisition to date, close parenthesis. Despite higher interest rates, there's just nowhere else in today's triple net lease market where you can put that amount of money, $700 million up to, to work into that kind of irreplaceable real estate at a 7.25% cap rate. Then in parenthesis, delusional sellers are still looking for sub-7 cap rates on their poorly-located Red Lobsters. I could not have said it better myself."
},
{
"speaker": "",
"content": "And again, we just want to thank you for your time today and reemphasize that as noisy as it is out there and confusing at times in the marketplace, the VICI team is a team that continues to get good things done. Again, thanks for your time today, and we'll see you again in the next quarter."
},
{
"speaker": "Operator",
"content": "This concludes today's conference call. Thank you all very much for joining."
}
] |
vlo | 2,024 | 4 | [
{
"speaker": "Operator",
"content": "Greetings, and welcome to Valero Energy Corp. Fourth Quarter 2024 Earnings Conference Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Homer Bhullar, Vice President of Investor Relations and Finance. Thank you. You may begin."
},
{
"speaker": "Homer Bhullar",
"content": "Good morning, everyone, and welcome to Valero Energy Corporation’s fourth quarter 2024 earnings conference call. With me today are Lane Riggs, our Chairman, CEO and President; Jason Fraser, our Executive Vice President and CFO; Gary Simmons, our Executive Vice President and COO; and several other members of Valero’s senior management team. If you have not received the earnings release and would like a copy, you can find one on our website at investorvalero.com. Also attached to the earnings release are tables that provide additional financial information on our business segments and reconciliations and disclosures for adjusted financial metrics mentioned on this call. If you have any questions after reviewing these tables, please feel free to contact our Investor Relations team after the call. I would now like to direct your attention to the forward-looking statement disclaimer contained in the press release. In summary, it says that statements in the press release and on this conference call that state the company’s or management’s expectations or predictions of the future are forward-looking statements intended to be covered by the Safe Harbor provisions under federal securities laws. There are many factors that could cause actual results to differ from our expectations, including those we’ve described in our earnings release and filings with the SEC. Now, I’ll turn the call over to Lane, for opening remarks."
},
{
"speaker": "Lane Riggs",
"content": "Thank you, Homer, and good morning, everyone. I would like to start by highlighting some of our team’s accomplishments last year. 2024 was our best year for personnel and process safety and one of our best years for environmental performance. Safe and reliable operations drive overall performance and disciplined operations. In refining, we processed a record volume of heavy sour crude in the fourth quarter. This demonstrates our refining systems flexibility and highlights the capability of our commercial and operations teams to be able to secure and process the most economic crude oils. Finally, we set a record for ethanol production with the expansion of the Charles City plant and process optimization in other sites. Our team’s relentless focus on operational excellence and low cost operations enabled us to deliver positive results in the fourth quarter in an otherwise weak margin environment. On the strategic front, we continue to deliver on our commitment to grow Valero’s earnings capacity through organic investments. The DGD Sustainable Aviation Fuel project was successfully started up in the fourth quarter and is now fully operational. Looking ahead, we are progressing with an FCC Unit Optimization project at St. Charles that will enable the refinery to increase the yield of high value products including high-octane alkylate. The project is estimated to cost $230 million and is expected to start up in 2026. And, we continue to pursue other short cycle high return optimization projects around our existing refining assets. On the financial side, we continue to honor our commitment to shareholder returns with a strong payout ratio of 78% for the year. And earlier this month, our Board approved a 6% increase in the quarterly cash dividend further demonstrating our strong financial position. Looking ahead, refining margins should be supported by low light product inventories ahead of the driving season. And longer-term, we still expect product demand to exceed supply with the announced refinery shutdowns this year and the limited capacity additions beyond 2025 supporting long-term refining fundamentals. So with that, Homer, I’ll hand it back to you."
},
{
"speaker": "Homer Bhullar",
"content": "Thanks, Lane. For the fourth quarter of 2024, net income attributable to Valero stockholders was $281 million or $0.88 per share compared to $1.2 billion or $3.55 per share for the fourth quarter of 2023. Excluding the adjustments in the earnings release tables, adjusted net income attributable to Valero stockholders was $207 million or $0.64 per share for the fourth quarter of 2024, compared to $1.2 billion or $3.57 per share for the fourth quarter of 2023. For 2024, net income attributable to Valero stockholders was $2.8 billion or $8.58 per share, compared to $8.8 billion or $24.92 per share in 2023. 2024 adjusted net income attributable to Valero stockholders was $2.7 billion or $8.48 per share compared to $8.9 billion, or $24.96 per share in 2023. The Refining segment reported $437 million of operating income for the fourth quarter of 2024 compared to $1.6 billion for the fourth quarter of 2023. Refining throughput volumes in the fourth quarter of 2024 averaged 3 million barrels per day or 94% throughput capacity utilization. Refining cash operating expenses were $4.67 per barrel in the fourth quarter of 2024. Renewable Diesel segment operating income was $170 million for the fourth quarter of 2024 compared to $84 million for the fourth quarter of 2023. Renewable Diesel sales volumes averaged 3.4 million gallons per day in the fourth quarter of 2024. The Ethanol segment reported $20 million of operating income for the fourth quarter of 2024 compared to $190 million for the fourth quarter of 2023. Ethanol production volumes averaged 4.6 million gallons per day in the fourth quarter of 2024. G&A expenses were $266 million for the fourth quarter of 2024 and $961 million for the full year. Depreciation and amortization expense was $698 million. Net interest expense was $135 million and income tax benefit was $34 million for the fourth quarter of 2024. The effective tax rate was 19% for 2024. Net cash provided by operating activities was $1.1 billion in the fourth quarter of 2024. Included in this amount was $119 million of adjusted net cash provided by operating activities associated with the other joint venture member share of DGD. Excluding this item, adjusted net cash provided by operating activities was $951 million in the fourth quarter of 2024. Net cash provided by operating activities in 2024 was $6.7 billion. Included in this amount was a $795 million favorable change in working capital and $371 million of adjusted net cash provided by operating activities associated with the other joint venture member share of DGD. Excluding these items, adjusted net cash provided by operating activities was $5.5 billion in 2024. Regarding investing activities, we made $547 million of capital investments in the fourth quarter of 2024, of which $452 million was for sustaining the business including costs for turnarounds, catalysts and regulatory compliance and the balance was for growing the business. Excluding capital investments attributable to the other joint venture member share of DGD and other variable interest entities, capital investments attributable to Valero were $515 million in the fourth quarter of 2024 $1.9 billion for the year. Moving to financing activities, we returned $601 million to our stockholders in the fourth quarter of 2024, of which $339 million was paid as dividends and $262 million was for the purchase of approximately 2 million shares of common stock resulting in a payout ratio of 63% for the quarter. In 2024, we returned $4.3 billion to stockholders consisting of $2.9 billion in stock buybacks and $1.4 billion in dividends, resulting in a payout ratio of 78% for the year. In fact, since the start of 2021, our total cash flow from operations have exceeded our total uses of cash over this period, including capital investments. During this time, we’ve delivered over $4 billion of debt reduction and returned approximately $18.7 billion to stockholders through dividends and share buybacks. Through share repurchases, we reduced our share count by approximately 6% in 2024 and by 23% since year-end 2021. With respect to our balance sheet, we ended the quarter with $8.1 billion of total debt, $2.4 billion of finance lease obligations and $4.7 billion of cash and cash equivalents. Debt to capitalization ratio, net of cash and cash equivalents was 17% as of December 31, 2024. And, we ended the quarter well-capitalized with $5.3 billion of available liquidity excluding cash. Turning to guidance, we expect capital investments attributable to Valero for 2025 to be approximately $2 billion which includes expenditures for turnarounds, catalysts, regulatory compliance and joint venture investments. About $1.6 billion of that is allocated to sustaining the business and the balance to growth. For modeling our first quarter operations, we expect refining throughput volumes to fall within the following ranges: Gulf Coast at 1.72 million to 1.77 million barrels per day, Mid Continent at 415,000 to 435,000 barrels per day, West Coast at 190,000 to 210,000 barrels per day and North Atlantic at 455,000 to 475,000 barrels per day. We expect refining cash operating expenses in the first quarter to be approximately $4.95 per barrel. With respect to the Renewable Diesel segment, we expect sales volumes to be approximately 1.2 billion gallons in 2025. Operating expenses in 2025 should be $0.51 per gallon, which includes $0.22 per gallon for non-cash costs such as depreciation and amortization. Our Ethanol segment is expected to produce 4.6 million gallons per day in the first quarter. Operating expenses should average $0.41 per gallon, which includes $0.05 per gallon for non-cash costs such as depreciation and amortization. For the first quarter, net interest expense should be about $130 million and total depreciation and amortization expense should be approximately $710 million. For 2025, we expect G&A expenses to be approximately $985 million. That concludes our opening remarks. Before we open the call to questions, please limit each turn in the Q&A to two questions. If you have more than two questions, please rejoin the queue as time permits to ensure other callers have time to ask their questions."
},
{
"speaker": "Operator",
"content": "Thank you. The floor is now open for questions. [Operator Instructions] Today’s first question is coming from John Royall of J.P. Morgan. Please go ahead."
},
{
"speaker": "John Royall",
"content": "Hi, good morning. Thanks for taking my question. So, my first question is maybe to Gary, just broadly on market color. You’ve always given us a good view of the fundamental picture in the sector. How do you view the supply demand balances today for products and the outlook for cracks for this year? And, what do you think are the key things we should look out for in terms of just any early indicators of when this market might turn back up?"
},
{
"speaker": "Gary Simmons",
"content": "Yes John, it’s always difficult to get much of a read on the market this early. I’ll tell you that we typically see our sales through our wholesale channel dip fairly significantly through the holiday season, kind of goes through the first couple of weeks of the year then starts to recover. We saw that same dynamic this year, sales kind of dipped to about 85% of average. The last couple of weeks we’ve seen a nice recovery back to kind of, a 1 million barrels a day level that we typically see. I think yesterday we did 1,040,000 barrels a day. Gasoline sales in our system year-to-date are slightly down year-over-year. I think when you look at the concentration of our marketing this makes sense. The snow in the south and southeast kept people off the road and then the Colonial Pipeline outage limited our volumes we had available to sell in some markets. For that window the pipeline was down. Our current 7-day average data shows gasoline sales up 2% year-over-year. Overall what we can see is gasoline demand looks good and we expect gasoline demand in the United States to be fairly flat to last year. Diesel sales year-to-date in our system are also off a few percent. This was a little more surprising to me mainly because of the cold weather that we’ve seen. But, I think if you look into the data a little bit more it makes sense. We had about 10,000 barrels a day of Renewable Diesel from Port Arthur that was going to our wholesale channel that we were selling. That material is now going to produce sustainable aviation fuel. So, that’s a chunk in the year-over-year decline in diesel sales. In addition to that, we saw the same dynamic on diesel with some of the snow impacting on-road diesel demand. And then, I think if you look at Valero, we don’t have a big marketing presence in the markets where you see high heating oil demand. So, we don’t really see that big uplift from the cold weather that you may see. We definitely get that on the bulk side but not through wholesale. 7-day average shows diesel sales are up about 1% and that’s kind of what we expect for the year about a 1% increase in diesel demand in the United States. Most consultants I’ve read are showing about a 250,000 barrel a day increase in diesel demand just due to cold weather in the North Atlantic Basin. Not only do we expect diesel demand to be better but we expect a greater percentage of that to be supplied by refinery derived diesel. Last year we had the big wave of bio and renewable diesel projects hitting the market. We don’t see that same dynamic this year. So, I think overall things are shaping up pretty nicely. We’re at total light product inventory 9 million, 10 million barrels below where we were last year at this time. So, inventory is in good place. I think at the beginning of the year the supply demand balances look similar to last year, but as you progress through the year you’ll see gradual tightening of supply demand balances."
},
{
"speaker": "John Royall",
"content": "Great. It’s very helpful. Thank you, Gary. And then, my second question is on capital allocation. You finished the year with another quarter well above your 40% to 50% floor and high-70s for the full year. But assuming we don’t have a significant recovery in cracks from here, how should we think about that payout ratio in a lower crack environment in ‘25? Should we expect you to move closer to that 40% to 50% floor?"
},
{
"speaker": "Jason Fraser",
"content": "Good morning, John. This is Jason. I’m going to ask Homer to give you a little more detail on that."
},
{
"speaker": "Homer Bhullar",
"content": "Sure. Yes, John, I mean, you’re right. We had a 78% payout for the year, but that was partly funded by our excess cash balance going into the year. But, if you want to put this into context with some numbers, if we had held our shareholder payout ratio at 50% for the year, we would have built almost $1.7 billion of cash for the year. Even if you excluded the $795 million of positive impact for working capital for the year and include the $167 million debt repayment we did in the first quarter of 2024, we would have still built over $700 million of cash. Now taking that a bit further, even if you look at the low margin environment in the fourth quarter, we still would have been able to honor our minimum payout commitment of 40% to 50% without leaning into the balance sheet or drawing down cash. So, hopefully this gives you some context of the earnings capacity of the portfolio even in a low margin environment and our ability to invest capital obviously honor our shareholder commitment and flexibility with debt in our balance sheet."
},
{
"speaker": "John Royall",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. The next question is coming from Doug Leggate of Wolfe Research. Please go ahead."
},
{
"speaker": "Doug Leggate",
"content": "Thank you. Thanks guys. I think Gary, you might be the most popular man in the call today, Lane, I apologize, but there is obviously a lot going on."
},
{
"speaker": "Lane Riggs",
"content": "That’s okay, with me Doug."
},
{
"speaker": "Doug Leggate",
"content": "So, I got to try just a couple of, someone has got to do it. I am going to try a couple of high-level ones if I may. The headlines I saw just a couple of hours ago was that Trump is still going to go ahead with tariffs on Canada. And, I seem to recall that the last time there were problems with heavy oil supply at Canada, there was a second order effect that everyone seems to have forgotten about. And, I wanted to run this past year and just get your perspective on it. And that is that, if you need to find a substitute for that much heavy oil, you’re going to have run cuts, you’re going to have utilization yield issues funding your system and so on. And, I wanted to see if you guys thought there was any sense to that in the context of actually became a thing as it relates to the substitution of lighter crude and some heavy grades. What would you guys do?"
},
{
"speaker": "Gary Simmons",
"content": "Yes, so Doug this is Gary. And, I can tell you we’ve been aware of this for a couple of months and so our commercial teams and optimization teams have been working hard to develop every possible scenario we can think of and how we would respond to that. Of course it’s why we like our position on the U.S. Gulf Coast because you can source feedstocks from anywhere around the world and where we also like our feedstock flexibility. But yes, there is a point where if heavy feedstocks become limited, it affects rate and production of clean products certainly from our assets and we’d expect industry-wide."
},
{
"speaker": "Doug Leggate",
"content": "So, presuming this, assuming this is transit rate is not a big deal, but if it did drag on for an extended period of time, particularly as we switch into summer grade, I mean could it be meaningful or is that a rounding error?"
},
{
"speaker": "Gary Simmons",
"content": "Greg, you want to? Yes."
},
{
"speaker": "Greg Bram",
"content": "Hey, Doug, this is Greg. Yes, when we think about it and look at some of those different scenarios, you might see a 10% change in throughput. A lot depends on how far it goes and how deep you have to back off on some of those heavy barrels. But, it wouldn’t be driving things to a much greater degree than that, I don’t think."
},
{
"speaker": "Doug Leggate",
"content": "Okay. I want to start meaningfully enough when you were talking about the situation you got right now. So, we’re searching for green shoots, that’s really what these questions are about. So I apologize I’m going to try another high-level one and it really relates to your throughput guidance. So obviously everyone is focused on whether it does focus or Lyondell closing or Grangemouth or whatever it happens to be. But it seems to me that coming out of COVID, utilization rates, the concentration or the absence of good maintenance got solved and the concentration of great maintenance meant everybody run well. And, it seems to us with no storms and all the things you run through, Gary, there are probably about 3% or 4% of utilization that was kind of a best-in-class world for the U.S. last year, which is basically four refineries if you think about it. And so, when I look at your guidance for the quarter, you obviously don’t give forward cadence for commercial reasons through the rest of the year. But at a high-level, how do you see the likelihood that the industry, the U.S. industry specifically can continue to run at those kind of levels given the backdrop we’ve had and the fact that we’re down 10% in the last three weeks in utilization?"
},
{
"speaker": "Gary Simmons",
"content": "Yes. So, I think certainly what you’ve seen utilization in the last few weeks is somewhat weather related along with the maintenance activity. I think given the advantages that U.S. refiners enjoy on feedstock cost and energy cost, you should expect to see that U.S. refining continues to run at higher utilization rates and when you have run cuts, they occur elsewhere in the world where they don’t have the natural resources advantages that we have."
},
{
"speaker": "Doug Leggate",
"content": "I think I was thinking more about the reliability aspect as opposed to the cost advantage aspect?"
},
{
"speaker": "Gary Simmons",
"content": "Yes, and I’m sure we’ve certainly seen an improvement in our system on mechanical availability and I suspect our peers have as well and it’s something we always strive to get better and better at."
},
{
"speaker": "Doug Leggate",
"content": "Great. All right, guys, sorry for the high-level questions. But I’ve had my two, so I’ll leave it there. Thanks so much."
},
{
"speaker": "Gary Simmons",
"content": "Thanks, Doug."
},
{
"speaker": "Operator",
"content": "Thank you. The next question is coming from Neil Mehta of Goldman Sachs. Please go ahead."
},
{
"speaker": "Neil Mehta",
"content": "Yes. Good morning, team. Just a couple of questions on the quarter itself. Renewable Diesel performance came in I think better than what most market participants were expecting and better than implied by the indicators. So, just curious on any thoughts there and the outlook for that business as we work our way through 2025?"
},
{
"speaker": "Eric Fisher",
"content": "Yes, this is Eric. I think a lot, there was a one-time benefit with some inventory optimization at the end of the year that was the bulk of that higher than expected performance. There is a little bit of SAF in that, but I would make it clear that that was mostly some inventory optimization we did at the end of the year. In terms of forward-looking in Renewable Diesel and SAF for us, we are all kind of waiting to see how this market is going to develop and how the policy is going to develop. But overall, things are very much staying in-line with kind of what we thought was going to happen. The 45Z has now replaced the blender’s tax credit. We can see that that’s now going to limit product imports into the U.S. It is going to make it a carbon intensity scale rather than a flat dollar to every renewable product. All of that is advantageous to Diamond Green Diesel and our platform because like the refining platform, our feedstock flexibility, our ability to export to any of the other markets. And, I think consistent with our outlook from last year, the most attractive markets are going to be in Europe and Canada compared to U.S. and California. So overall, we’re waiting to see how RINS are going to respond, how LCFS is going to respond. And, I think you will see those changes emerging in the market in the next couple of months as some of those production and credit reports emerge on how the year ended. Gary already mentioned that we don’t see any increase in renewable production this year. It’s still long compared to say D3 RIN credit bank or D4 RIN credit banks and LCFS credit banks but we do also expect you’re going to see some correction in production that will eventually start to pull those credit banks down throughout the year."
},
{
"speaker": "Neil Mehta",
"content": "That’s helpful. And then, independent of tariffs it was notable the amount of heavy that you were able to run through the system. And I think there were some concerns about coking economics in the quarter given how tight fuel oil was, but clearly you were able to optimize the system to run over 600,000 barrels a day of heavy sour oil. So can you just talk about how you were able to do that and the commercial approach to maximizing heavy in a time when fuel oil is pretty tight?"
},
{
"speaker": "Greg Bram",
"content": "Hey, Neil, this is Greg. I’ll start and then Gary can talk some more about the market. But, you hit on I think the key factor which is as the fuel oil prices, those differentials narrowed that with fuel oil typically being a feedstock in our Gulf Coast system, we pivoted away from that towards the heavy crudes as an alternative, which continued to show some good value. So, that’s why you see that shift towards more heavy sour crude. You also notice a reduction on the heavy resid feedstocks that we’ve processed as well. And that’s kind of how we got to the high-level of heavy crude processing. Also keep in mind, we’ve got the Port Arthur coker online that shifts us to a bit of a heavier feed slate as well. So, that’s part of what you see in that number as well."
},
{
"speaker": "Neil Mehta",
"content": "Thanks you."
},
{
"speaker": "Operator",
"content": "Would you like to move on to the next question?"
},
{
"speaker": "Greg Bram",
"content": "Yes, please."
},
{
"speaker": "Operator",
"content": "Thank you. The next question is coming from Theresa Chen of Barclays. Please go ahead."
},
{
"speaker": "Theresa Chen",
"content": "Good morning. Thank you for taking my questions. On the tariff topic specifically, understanding that you’re not captive to any specific source of crude based on your footprint and the optionality you have on the Gulf Coast. But as we think about the tariff on Canada, Mexico incremental sanctions potentially on Venezuela, how are you thinking about light heavy differentials as we move through the year?"
},
{
"speaker": "Gary Simmons",
"content": "Yes, Theresa, this is Gary. I think I’ll start with kind of fundamentals but then cut to really what’s driving the market and certainly on the fundamental side typically this time of year you see less buying of medium and heavy sours just due to turnaround activity. In addition to that, Lyondell coming down puts another 200,000 barrels a day heavy on the market. Calls for OPEC crude, second quarter 2025 180,000 barrels a day of medium sour crude. So, all those things would be supportive of water quality differentials, but in reality the discussions on sanctions and tariffs are really what’s driving the market and until we see some resolution to that, I don’t expect any meaningful moves in the quality differentials."
},
{
"speaker": "Theresa Chen",
"content": "Understood. And, related to the St. Charles FCC project, would you be able to provide a little bit more color on this, what the optimization means in terms of incremental improvement in the yield of high value products?"
},
{
"speaker": "Greg Bram",
"content": "Sure, Theresa, it’s Greg. Lane mentioned it costs about $230 million. It definitely meets our investment hurdle at mid-cycle pricing. And, one of the key outcomes for the project is increasing the production of light olefin product out of the FCC. And, what that really means is that’s additional feedstock we can use to fill the alkylation capacity we have downstream of the FCC there. You might remember we started up a C5 alkylation unit at St. Charles back in late 2020 and with some tweaks and optimizations we’ve done to that unit since. We’ve got some spare capacity in the alky and with this project, you will increase high-octane alkylate production by something on the order of 6,000 to 7,000 barrels a day. That’s one of the key outcomes and the things that drive the value. It’s really a good example of identifying some key equipment constraints within the operation that when we modify those constraints of that equipment, allows us to take full advantage of the capability not only of the FCC unit in this case, but other equipment and other units in the refinery and again in this case the alky and that’s how we generate a good return from the project."
},
{
"speaker": "Theresa Chen",
"content": "Thank you very much."
},
{
"speaker": "Operator",
"content": "Thank you. The next question is coming from Manav Gupta of UBS. Please go ahead."
},
{
"speaker": "Manav Gupta",
"content": "Good morning. I wanted some additional color on the North Atlantic capture. Looks like it jumped from 102% last quarter to about 118% and similarly the Gulf Coast capture jumped from about 76% to 86%. So Gary, if you could help us out a little, what were the some of the factors helping you drive that kind of capture improvement?"
},
{
"speaker": "Gary Simmons",
"content": "Sure. I’ll let Greg answer."
},
{
"speaker": "Greg Bram",
"content": "Hey, Manav. A couple of things I’d point out on the North Atlantic, really it’s a bit of a system question. So, it’s North Atlantic and Gulf Coast as well, but we go into the wintertime, we start blending more butane into the higher RVP gasoline. That gives us a bit of a bump in capture as that adds value into the gasoline pool. In both those regions as well, you had good contributions from the wholesale side of the business, the commercial parts. So, we saw some benefit from that. On the Gulf Coast, the other notable item would really be, if you look at Maya relative to the Canadian grades that we use for the benchmark, Maya was a bit more discounted. Certainly, when you look at it quarter-over-quarter, and so that helped you improve the crude cost that we saw for the heavy crudes into the Gulf Coast."
},
{
"speaker": "Manav Gupta",
"content": "Quick follow-up here is, we are seeing a very strong diesel margin and slightly weaker gasoline and I know Valero can move the yield around a lot. So, are you already operating in max diesel mode or how much more can you swing the yield more towards diesel or do you think this is very temporary like once you come February and March the gasoline demand will improve and the cracks will start to balance out each other?"
},
{
"speaker": "Greg Bram",
"content": "Manav, this is Greg. Yes, we are definitely in max diesel mode. As you mentioned the cracks would drive us in that direction and we’ll see as we get into gasoline season whether the gas crack shifts enough to push us the other way."
},
{
"speaker": "Manav Gupta",
"content": "Thank you for taking my questions."
},
{
"speaker": "Operator",
"content": "The next question is coming from Paul Sankey of Sankey Research. Please go ahead."
},
{
"speaker": "Paul Sankey",
"content": "Hi, everyone. Just continuing on the themes that we’ve had this morning. Can you talk a bit about the Atlantic basin and all the trade arbitrages? And, I think it’s obviously tough to make a firm’s outlook here with all that’s moving around. But, I wondered what have you been seeing, let’s say over the past two months to six months in terms of the major new Nigerian refinery. There’s been a lot of action in the dollar versus the euro. There’s obviously been all the cold weather effects. So, I just wondered if you could describe a little bit what we’ve been seeing in the market in the Atlantic Basin and what your outlook is for the coming year? Thanks a lot. Tough question."
},
{
"speaker": "Gary Simmons",
"content": "Yes, so I’ll start with the Dangote Refinery. I think, from what we can see and what we read they do have their resid FCC up and running. We see that commercially. They’re not offering out the fuel oil or the resid that we were buying from them. We also see less imports of gasoline into West Africa which is all consistent with Dangote continuing to ramp up. With that though, however, what we’ve seen is that generally tends to impact Europe more than it does the U.S. gasoline that was going to West Africa gets backed into Europe. We haven’t really seen much of an impact from that. Our gasoline exports primarily go to Latin America. You can see in the fourth quarter, we were 98,000 barrels a day of gasoline exports into that market, which is consistent of where we’ve been. I can tell you in the first quarter, we’re right about that same level again. Diesel has been somewhat interesting. The cold weather in the U.S. kind of has the U.S. market strong, so you actually see a few cargos from Europe actually booked in the New York Harbor, which is an abnormal trade flow. We do see that correcting when you get to the second half of February. We’re already seeing an open arb to export back from the U.S. to Europe. So, nothing too abnormal on trade flows. I think by and large what you’ve seen is that the Dangote startup in the North Atlantic Basin has been largely offset with Lyondell coming down and Grangemouth coming down and they’re kind of counterbalancing each other and keeping trade flows about what we’ve seen historically."
},
{
"speaker": "Paul Sankey",
"content": "That’s brilliant. Thanks very much. And just, if I could follow-up, thinking about the reality of tariffs, could you describe maybe a situation of how they would work? I mean what happens? Do you just suddenly have to stop paying it overnight or how does it work? If you’ve got any ideas, I’d be grateful. Thanks."
},
{
"speaker": "Gary Simmons",
"content": "Without having really any clarity on what’s going to happen, there’s no reason for us there, no way we can really speculate on how we deal with it. We’re just going to have to deal with it when it comes up."
},
{
"speaker": "Lane Riggs",
"content": "Hey Paul, it’s Lane. All I add is, I mean it depends on the market, right. If you’re a captive market, they’re going to, it will somehow get shared between the refinery and say the Canadian crude producer because there’s some captive markets in the Mid Continent. In the Gulf Coast, somehow that will all ultimately get sort of priced in depending on what how the refiners configured and what their alternatives are and then we’ll just have to see how long it lasts."
},
{
"speaker": "Paul Sankey",
"content": "Got it. Have there been examples of it happening in the past that you can think of where you suddenly have to pay 25% more for a given crude?"
},
{
"speaker": "Lane Riggs",
"content": "No, and I’ve been around a long time."
},
{
"speaker": "Paul Sankey",
"content": "Got you. I think that, Lane."
},
{
"speaker": "Operator",
"content": "Thank you. The next question is coming from Roger Read of Wells Fargo. Please go ahead."
},
{
"speaker": "Roger Read",
"content": "All right. Lane, I’m still chuckling from, you’ve been around a long time answer there. Maybe coming back a little bit on the whole changing in capacity, so obviously you mentioned the shutdown of Grangemouth. We had to shut down here locally of Lyondell and we have some more stuff likely coming in Europe beyond what’s been announced. I’m just curious how you all are seeing some of those dynamics play out in terms of just crude availability, let’s leave the tariff thing aside and maybe how that’s playing out along the Gulf Coast?"
},
{
"speaker": "Gary Simmons",
"content": "Yes, so I think the only thing we can see is you’ve definitely seen the dynamic in the market of Lyondell stopping to buy and they were buying a lot of especially a lot of Canadian. And so, we’ve seen more of those barrels become available to us as they backed off the market."
},
{
"speaker": "Roger Read",
"content": "Does that materially change price or is it just an availability question?"
},
{
"speaker": "Gary Simmons",
"content": "It’s so difficult to tell because it’s been going along at the same time with all these tariffs and sanctions discussions. So, it’s kind of those discussions have muted any market impact there would be of Lyondell pushing the barrels back so far."
},
{
"speaker": "Roger Read",
"content": "Okay. And then, as a follow-up question from earlier about I think Doug was asking it about the industry’s ability to maintain utilization as you look forward through the year thinking about some of these closures that have happened. And, if you look at on a year-over-year change of U.S. inventories, whether you look at crude alone or crude plus products or just products, all are down year-over-year, little more severe on the crude side than on the product side, but it would imply a lot of tightness. And if you can’t, I’d say if you can, if the industry cannot maintain these levels of utilization, it would imply either much lower inventories or lower exports, but is there anything I’m missing in that general thought process?"
},
{
"speaker": "Gary Simmons",
"content": "No, I think you’ve got it nail on the head. When we look at the balances, the inherent assumption that you’re going to see similar supply demand balance as the last year and gradually tightening is the fact that the industry at a high actual utilization is going to go up to meet demand. And so, that certainly we haven’t had a major weather event the last year. Any kind of a major weather event to knock capacity offline or unreliability event can tighten things up a lot. If you look we’re especially on the diesel side we’re within 10% on inventory where we were in 2023. In 2023 we had a $45 diesel crack versus where it is today. I mean the inventory position is not significantly different if the margin environment is fairly significantly different. It could change in a hurry."
},
{
"speaker": "Roger Read",
"content": "Appreciate that. Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. The next question is coming from Ryan Todd of Piper Sandler. Please go ahead."
},
{
"speaker": "Ryan Todd",
"content": "Thanks. Maybe a couple of follow ups on the biofuel side. I mean, you talked some about your, like the broader 2025 outlook with all the moving pieces there. As we think about the early part of this year, like first quarter in particular, PTC goes away December 31. It feels like it’s going to take some time, at least a few months for the market to kind of meet you in equilibrium with the 45Z and some of the impacts on imports and domestic production. Is there a risk to like first how does this play out in the first quarter? Is there a risk that economics kind of fall off the table in the first quarter as this stuff gets sorted before it reaches kind of a better equilibrium later on in the year?"
},
{
"speaker": "Eric Fisher",
"content": "Yes, I think if you look at the conversion of the PTC where everyone got a dollar to now this carbon intensity based credit, we’ve run the U.S. credit model that was just released. For veg oil that’s zero for canola oil, it’s $0.16 for soybean oil and waste oils are in the $0.50 to $0.60 per gallon range. And so, at the end of the day that is all less than a dollar. So, if you needed that dollar to breakeven and now you’re getting $0.16 it’s a fairly negative margin environment for non-waste oils. I think everyone can see that. I think there’s growing recognition that this is going to be very difficult to see a lot of the biodiesel side and veg oil side operate at these lower incentives. How that plays out in terms of production reconciliation through the first quarter, everyone’s looking to see well, but hand-in-hand we also see the imports that were coming to the U.S. to get that dollar are now stopped. So, how will that balance out? We haven’t seen a lot of change in feedstock prices to reflect a lot of this, but I think there’s great recognition that there’s going to be some movement in overall production and overall feedstock prices kind of as you go through the first quarter and see some of these early reports coming in on what are we seeing in terms of generation of credits. And so again I think being a waste oil unit on the Gulf Coast we’re the most advantaged in terms of how we can react to these things and it still mostly favors waste oils which our platform is based on. So, I think we’re still in a good position versus our competitors. It’s just but there’s no doubt overall there’s lower incentive for all of this in this PTC world."
},
{
"speaker": "Ryan Todd",
"content": "Thanks. And then, maybe a follow-up on SAF. I mean can you maybe just provide a little bit of an update in terms of your SAF operations at this point, maybe some idea of level of production and how you think about the contribution of SAF economics there in 2025?"
},
{
"speaker": "Eric Fisher",
"content": "Yes. So, as Lane mentioned this in his opening comments, the project started up in the fourth quarter. Again, credit to our project team on finishing ahead of schedule and under budget. We had a flawless start up. It started up on spec. We spent most of the time in the fourth quarter doing test runs and initial fills on tanks. But throughout all our test run trials, we showed a very wide range of operability, all of which more than met our project goals operationally. So, unit hardware looks great, production has been very smooth and we made our first sales in November and we saw the QA/QC and all of the traceability and accreditation flow all the way from production to neat SAF to blended SAF to delivery to final customer. And so, we spent a lot of time in the fourth quarter just sort of proving the system out. In terms of going forward, we’re not going to really get into a lot of detail because what I’d say is what we have now is very good flexibility to meet all the project economic goals and that we set out with the original project. But if you look at say the Argus market in the EU and the U.K., right now you see HBO at or better than SAF. So, we have flexibility to make either barrel into the European market and so really what we’re doing now is just tuning that optimization as we see SAF customers really starting up in the first quarter because of the 2% mandate that you see in the EU and U.K."
},
{
"speaker": "Ryan Todd",
"content": "Great. Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. The next question is coming from Paul Cheng of Scotiabank. Please go ahead."
},
{
"speaker": "Paul Cheng",
"content": "Hey guys, good morning."
},
{
"speaker": "Lane Riggs",
"content": "Good morning."
},
{
"speaker": "Paul Cheng",
"content": "Maybe this is, I want to go back to Eric. The PTC, I don’t think that the detail is out. So, when you guys report the first quarter, should we just assume that in your gross margin the PTC is also that you will drop by $1 per gallon, but you’re not going to recall any benefit or that you would put some kind of provision or anything that you would just come through? And also, whether that you can share how much is the fourth quarter inventory benefit or optimization benefit that you are referring to earlier? That’s the first question. The second question maybe for Lane. U.S. natural gas price look like it’s going to be higher. So, if we look at your system, do you see a lot of opportunity of reducing your energy cost further or that you have already done so much is really difficult and will be too expensive if you’re trying to have any meaningful reduction in the energy cost from the current level?"
},
{
"speaker": "Eric Fisher",
"content": "Okay. So, I’ll start on the margin indicator. We had the same discussion that our margin indicator still includes the $1 PTC in the calculation. One of the challenges in this PTC environment is because it’s carbon intensity based, that will vary with our feedstock slate. And so, we haven’t had enough run time or as you said, enough clarity to really know how this is all going to line out because we can think of scenarios where certain feedstocks get very cheap that might have a higher CI or we’ll continue to see the incentive to run the lowest CI feedstocks and those obviously have higher benefits in the PTC. So, it’s a little hard to nail down the, how we want to adjust the margin indicator. So our decision, we’re going to keep it the same for now until we see a little more development on how we’re going to be running in this new policy environment."
},
{
"speaker": "Paul Cheng",
"content": "Eric, I’m sorry, I’m not asking about the margin indicator. I’m asking that when you report the first quarter result in your result, should we just assume that you would take out the $1 per gallon for the PTC in your margin and not including any benefit from the PTC because that’s not being finalized or that when you report the result in the first quarter, you actually will do some provisional estimate of what your DGD results should be under the PTC as you understand?"
},
{
"speaker": "Lane Riggs",
"content": "Hey Paul, this is Lane. The way we do our financials is particularly on that side, it’s really on the act. There won’t be a provisional like, hey, we think the PTC benefit is going to ultimately be this, if it’s not, we don’t have clear policy in the first quarter, it will be whatever it is."
},
{
"speaker": "Paul Cheng",
"content": "Okay, so we will just pick out the PTC benefit but not including any estimate for the PTC for you guys?"
},
{
"speaker": "Lane Riggs",
"content": "Correct."
},
{
"speaker": "Paul Cheng",
"content": "Okay. And how about in terms of Eric, can you share what is the inventory benefit in the fourth quarter?"
},
{
"speaker": "Eric Fisher",
"content": "Yes, I don’t think we’re going to give that level of detail out. But, it was just an end of year optimization that we did at both units in the fourth quarter."
},
{
"speaker": "Paul Cheng",
"content": "All right. So, how about, Lane, about the energy cost?"
},
{
"speaker": "Lane Riggs",
"content": "I’m going to at least initially push this over to Greg. So, go ahead Greg."
},
{
"speaker": "Greg Bram",
"content": "Hey, Paul. So, with low energy costs and a lot of that meaning low natural gas and low cost for power for our plants in North America. You don’t see a lot of incentive to try to do a project to further reduce your energy consumption. There’s just not a lot of opportunity there from a value standpoint. We do see opportunities in Pembroke. We’ve done some things at the refinery there to improve energy efficiency because their costs are quite a bit higher. So, I would say in general that’s unless you see a marked change in the cost of natural gas or power, it’s going to be hard to justify some kind of an improvement project. Always trying to be as efficient as we can be in the base operation, so there’s no change there, but, in terms of some kind of investment to make a step change, that’s hard to do in the current environment."
},
{
"speaker": "Paul Cheng",
"content": "Okay. Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. The next question is coming from Joe Laetsch of Morgan Stanley. Please go ahead."
},
{
"speaker": "Joe Laetsch",
"content": "Great, thanks. Good morning, everyone. Thanks for taking my questions. So, I wanted to ask a couple on the quarter. From our standpoint, it looked like the Mid Con came in stronger on throughput and capture, while the West Coast was say remained a bit weaker, which I think was driven in part by maintenance. Could you just talk to any specific drivers during the quarter for the Mid Con and West Coast in particular from a capture and throughput standpoint?"
},
{
"speaker": "Greg Bram",
"content": "Yes, Joe, this is Greg. So, West Coast is fairly simple and you hit on it. It was maintenance work primarily at Venetia that impacted not so much throughput there, but it impacted the amount of transportation fuel we could make and so that had an impact on the capture rate. In the Mid Con, throughput was higher. We actually saw pretty good incentive to continue to maximize throughput there, good demand for products. And so, we were able to push throughput a little bit higher than we had planned going into the quarter. And then on the capture side, one of the factors there, you saw crude market structure on WTI less backward than you saw in the prior quarter that had a benefit to capture rates in addition to some of the things I talked about earlier on butane blending."
},
{
"speaker": "Joe Laetsch",
"content": "Great. That’s helpful. And then, I wanted to shift gears and ask about the Ethanol segment. So, the indicator continues to grind to lower to start the year. Could you just talk to some of the puts and takes going on in the industry as well as your forward outlook? And then, also the potential for year round E15, which was included in the executive orders released last week? Thank you."
},
{
"speaker": "Eric Fisher",
"content": "Yes. The ethanol margin has been challenged with high inventories and high production rates. I’ll say surprisingly high production rates that have been sustained really for the third quarter and fourth quarter and into the beginning of this year. We have seen some weather related impacts to production rates, but I think overall you’re looking at high inventories and high production rates. And so, it’s keeping ethanol margins currently, I would say, below mid-cycle. So, in terms of E15 there’s always a lot of positive outlook for that. As you know we’ve continued to see E15 approved by emergency order every 20 days. We don’t see a lot of E15 movements. We don’t see a lot of growth in that market. We do see Canada still talking about moving to E15 this year through their CFR program. I think there’s a high likelihood you’re more likely to see incremental E15 in Canada before appreciably in the U.S. But, I mean we’ll see how this develops this year by policy. It’s still a fairly significant logistics challenge to convert retail to E15. But, overall I mean it’s still something that certainly the Ethanol and Ag industry sees as a positive development for ethanol outlook."
},
{
"speaker": "Joe Laetsch",
"content": "Great, thank you all."
},
{
"speaker": "Operator",
"content": "Thank you. The next question is coming from Matthew Blair of Tudor, Pickering, Holt. Please go ahead."
},
{
"speaker": "Matthew Blair",
"content": "Good morning. Thanks for taking my question. Regarding the Canadian tariffs, you talked about some of the impacts on the crude side. How about the product side for Valero and especially in regards to your Quebec City plant? What kind of volumes does Quebec send to the New York Harbor? And, if there were tariffs imposed, do you think it’d be pretty easy to ship those volumes to Latin America or Europe or would we expect to see lower operating rates at Quebec City? Thanks."
},
{
"speaker": "Gary Simmons",
"content": "Yes. This is Gary. For the most part our Quebec system is short gasoline. So we import gasoline. A lot of that tends to come from Pembroke. There are periods in the year where we’re long diesel and typically that does go to New York Harbor. We could place those barrels anywhere in the world. So, I wouldn’t expect to see a throughput reduction as a result of tariffs."
},
{
"speaker": "Matthew Blair",
"content": "Sounds good. And then, you mentioned some of the potential impacts from the 45Z. One other impact is that RD from foreign UCO appears to no longer qualify for a credit. Is DGD a major importer of foreign UCO? And if so, how would you expect to replace those volumes?"
},
{
"speaker": "Eric Fisher",
"content": "Yes, so you’re correct foreign UCO no longer qualifies for domestic RD. Our foreign UCO is and has always been pointed at SAF going into Europe and the U.K. So, the PTC doesn’t really change what we were going to do strategically with that feedstock. And so, that’s our view as we’ll continue to run that into the SAF into the Europe and U.K. markets."
},
{
"speaker": "Matthew Blair",
"content": "Great, thank you."
},
{
"speaker": "Operator",
"content": "Thank you. The next question is coming from Jason Gabelman of TD Cowen. Please go ahead."
},
{
"speaker": "Jason Gabelman",
"content": "Yes. Hey, morning. Thanks for taking my questions. I wanted to ask first on the CapEx budget. I believe you said $1.6 billion of sustaining CapEx, which is about $300 million above the five year average, it’s the highest level since 2019. So, I’m wondering if that is an indicator of above average turnaround activity in your system for 2025 and if not what’s driving that higher sustaining spend?"
},
{
"speaker": "Lane Riggs",
"content": "Hey Jason, this is Lane. So, we normally we sort of talk about our sustaining capital in terms of sort of average and so we average about or, we think about it being $1.5 billion that’s inclusive of turnaround, inclusive of CapEx for ongoing sustaining operations. And so, if you sort of and catalyst, so when you think in your mind well if it’s lumpy, if it gets lumpy on the higher side or the lower side, the only thing it can be is additional turnaround work."
},
{
"speaker": "Jason Gabelman",
"content": "Okay. Thanks. And, my follow-up is just, sorry I’m going to ask another one on the Canadian tariffs. Valero, I believe, has a lot of its refineries within foreign trade zones and those foreign trade zones typically aren’t subject to tariffs. So, given that 1Q, just clarify that most of your U.S. Gulf Coast system is in foreign trade zones and because of that, do you think you would be able to, if the tariffs are implemented in a very direct way, you’d be able to sidestep those tariffs? And also, do you get any benefit now from operating in those foreign trade zones? Thanks."
},
{
"speaker": "Richard Walsh",
"content": "Yes. This is Rich Walsh. I would just say that you can’t tell anything until you see what the program comes out with, right? So, it just depends on how this is all structured. So, we also bring in a lot and export a lot. And so, that’s really what the foreign trade zone helps with. And so, I don’t know that it’s really trying to avoid domestic tariffs in any way along those lines. So, until you see what they’re proposing and how it’s structured, you really can’t tell whether there’s going to be benefit or not."
},
{
"speaker": "Lane Riggs",
"content": "But, we do have foreign trade zones."
},
{
"speaker": "Richard Walsh",
"content": "Yes, yes, we have foreign trade zones."
},
{
"speaker": "Jason Gabelman",
"content": "Got it. Great. Thanks for the color."
},
{
"speaker": "Operator",
"content": "Thank you. At this time, I would like to turn the floor back over to Mr. Bhullar for closing comments."
},
{
"speaker": "Homer Bhullar",
"content": "Thank you, Donna. Appreciate everyone joining us today. Obviously, feel free to contact the IR team if you have any additional questions. Have a great day, everyone. Thank you."
},
{
"speaker": "Operator",
"content": "Ladies and gentlemen, this concludes today’s event. You may disconnect your lines or log-off the webcast at this time and enjoy the rest of your day."
}
] |
vlo | 2,024 | 3 | [
{
"speaker": "Operator",
"content": "Greetings, and welcome to Valero Energy Corp. Third Quarter 2024 Earnings Conference Call. [Operator Instructions]. As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Homer Bhullar, Vice President, Investor Relations and Finance. Thank you. You may begin."
},
{
"speaker": "Homer Bhullar",
"content": "Good morning, everyone, and welcome to Valero Energy Corporation's Third Quarter 2024 Earnings Conference Call. With me today are Lane Riggs, our CEO and President; Jason Fraser, our Executive Vice President and CFO, and Gary Simmons, our Executive Vice President and COO; and several other members of Valero's senior management team. If you have not received the earnings release and would like a copy, you can find one on our website at investorvalero.com. Also attached to the earnings release are tables that provide additional financial information on our business segments and reconciliations and disclosures for adjusted financial metrics mentioned on this call. If you have any questions after reviewing these tables, please feel free to contact our Investor Relations team after the call. I would now like to direct your attention to the forward-looking statement disclaimer contained in the press release. In summary, it says that statements in the press release and on this conference call that state the company's or management's expectations or predictions of the future are forward-looking statements intended to be covered by the safe harbor provisions under federal securities laws. There are many factors that could cause actual results to differ from our expectations, including those we've described in our earnings release and filings with the SEC. Now I'll turn the call over to Lane for opening remarks."
},
{
"speaker": "Lane Riggs",
"content": "Thank you, Homer, and good morning, everyone. Our third quarter results reflect a period of heavy maintenance in our refining segment during a relatively weak margin environment. Our refineries operated at 90% throughput capacity utilization in line with our guidance for the quarter. Product demand across the system remained strong with our U.S. wholesale volumes exceeding 1 million barrels per day for the second consecutive quarter. On the strategic front, we remain committed to executing projects that continue to enhance the earnings capability of our business and expand our long-term competitive advantage. I'm proud to report that the Diamond Green Diesel Sustainable Aviation Fuel or SAF project is now mechanically complete and is in the process of starting up. The project was completed on schedule and under budget and is a testament to the strength of our projects and operations teams. On the financial side, we continue to honor our commitment to shareholder returns with a strong payout ratio of 84% for the quarter and the year-to-date payout of 81%. Looking ahead, improving diesel demand against the backdrop of low light product inventories should support refining margins. Increases in OPEC plus crude supply should widen our sour crude oil differentials and further increase margins. And longer term, we expect product demand to exceed supply with the announced refinery shutdowns next year and limited capacity additions beyond 2025, supporting long-term refining fundamentals. In closing, our focus on operational excellence, capital discipline and honoring our commitment to shareholder returns have served us well and will continue to anchor our strategy going forward. So with that, Homer, I'll hand the call back to you."
},
{
"speaker": "Homer Bhullar",
"content": "Thanks, Lane. For the third quarter of 2024, net income attributable to Valero stockholders was $364 million or $1.14 per share compared to $2.6 billion or $7.49 per share for the third quarter of 2023. The refining segment reported $565 million of operating income for the third quarter of 2024 compared to $3.4 billion for the third quarter of 2023. Refining throughput volumes in the third quarter of 2024 averaged 2.9 million barrels per day or 90% throughput capacity utilization. Refining cash operating expenses are $4.73 per barrel in the third quarter of 2024. Renewable Diesel segment operating income was $35 million for the third quarter of 2024 compared to $123 million for the third quarter of 2023. Renewable diesel sales volumes averaged 3.5 million gallons per day in the third quarter of 2024, which was 552,000 gallons per day higher than the third quarter of 2023. The ethanol segment reported $153 million of operating income for the third quarter of 2024 compared to $197 million for the third quarter of 2023. Ethanol production volumes averaged 4.6 million gallons per day in the third quarter of 2024, which was 255,000 gallons per day higher than the third quarter of 2023. For the third quarter of 2024, G&A expenses were $234 million, net interest expense was $141 million, depreciation and amortization expense was $685 million and income tax expense was $96 million. The effective tax rate was 20%. Net cash provided by operating activities was $1.3 billion in the third quarter of 2024. Included in this amount was $166 million favorable change in working capital and $47 million of adjusted net cash provided by operating activities associated with the other joint venture member share of DGD. Excluding these items, adjusted net cash provided by operating activities was $1.1 billion in the third quarter of 2024. Regarding investing activities, we made $429 million of capital investments in the third quarter of 2024, of which $338 million was for sustaining the business, including costs for turnarounds, catalysts and regulatory compliance and the balance was for growing the business. Excluding capital investments attributable to the other joint venture member share of DGD and other variable interest entities, capital investments attributable to Valero were $394 million in the third quarter of 2024. Moving to financing activities. We returned $907 million to our stockholders in the third quarter of 2024, of which $342 million was paid as dividends and $565 million was for the purchase of approximately 3.8 million shares of common stock, resulting in a payout ratio of 84% for the quarter. Year-to-date, we have returned $3.7 billion to our stockholders in the form of dividends and buybacks, resulting in a payout ratio of 81%, well above our long-term minimum commitment of 40% to 50%. In fact, since the start of 2021, our total cash flows from operations have exceeded our total uses of cash over this period, including capital investments over $4 billion of debt reduction and over $18 billion returned to stockholders through dividends and share buybacks. With respect to our balance sheet, we ended the quarter with $8.4 billion of total debt, $2.5 billion of finance lease obligations and $5.2 billion of cash and cash equivalents. The debt-to-capitalization ratio, net of cash and cash equivalents was 17% as of September 30, 2024, and we ended the quarter well capitalized with $5.3 billion of available liquidity, excluding cash. Turning to guidance. We still expect capital investments attributable to Valero for 2024 to be approximately $2 billion, which includes expenditures for turnarounds, catalysts regulatory compliance and joint venture investments. About $1.6 billion of that is allocated to sustaining the business and the balance to growth with approximately half of the growth capital towards our low carbon fuels businesses and half towards refining projects. For modeling our fourth quarter operations, we expect refining throughput volumes to fall within the following ranges: Gulf Coast at 1.83 million to 1.88 million barrels per day Mid-Continent at 425,000 to 445,000 barrels per day; West Coast at 230,000 to 250,000 barrels per day; and North Atlantic at 380,000 to 400,000 barrels per day. We expect refining cash operating expenses in the fourth quarter to be approximately $4.60 per barrel. With respect to the renewable diesel segment, we still expect sales volumes to be approximately 1.2 billion gallons in 2024. Operating expenses in 2024 should be $0.45 per gallon, which includes $0.18 per gallon for noncash costs such as depreciation and amortization. Our ethanol segment is expected to produce 4.7 million gallons per day in the fourth quarter. Operating expenses should average $0.37 per gallon, which includes $0.05 per gallon for noncash costs such as depreciation and amortization. For the fourth quarter, net interest expense should be about $140 million and total depreciation and amortization expense should be approximately $690 million. For 2024, we expect G&A expenses to be approximately $975 million. That concludes our opening remarks. Before we open the call to questions, please limit each turn in the Q&A to two questions. If you have more than two questions, please rejoin the queue as time permits to ensure other callers have time to ask your questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions]. Today's first question is coming from Manav Gupta of UBS."
},
{
"speaker": "Manav Gupta",
"content": "My first question here is, can you talk a little bit about the demand for key products and how that is trending as we are coming to a close in 2024?"
},
{
"speaker": "Gary Simmons",
"content": "Sure, Manav. This is Gary. Obviously, a much weaker refinery margin environment than we -- in the third quarter than we've seen in the last couple of years. The interesting thing to us is it looks like the underlying market fundamentals actually improved during the third quarter and have continued to improve as we move into the fourth quarter, despite that, the improving market fundamentals, market sentiment seems to turn more negative, driving crack spreads even lower. To us in the markets where we have a presence, things look very similar to what we've seen in the past couple of years. Lane alluded to our sales in the third quarter through wholesale over 1 million barrels a day. We averaged 1.8 million in the third quarter, which is actually up year-over-year. Gasoline sales were fairly flat year-over-year. Diesel sales actually increased year-over-year. Thus far in the fourth quarter, we've actually seen about a 40,000 barrel a day increase in sales to our wholesale channel. So it's actually going up. You kind of compare that to get an indication of demand with some other indicators. Vehicle models traveled, were up about 1%. So that kind of matches with our numbers. Even the DOE data, although there's a lot of noise week to week. If you look at the year-to-date demand numbers from the DOE would kind of show gasoline demand flat to slightly up. And so we think that's kind of where we are. Again, I said diesel sales in our system up a little bit year-over-year. Again, if you look at some of the other indicators of the demand, especially the freight indices would indicate demand for diesel is a little bit softer compare that to the DOE numbers in the year-to-date DOE numbers, which show diesel demand down close to 100,000 barrels a day, I think we think that's pretty close. Some of that gap in diesel demand has been made up by an increase in jet fuel demand, about half of that. So net-net, I think in the U.S., we feel like total light products kind of flat to slightly down year-over-year. markets outside the U.S. where we have a significant market presence in Canada, the U.K., Mexico, all very similar trends. I think all three of those markets have witnessed a year-over-year growth in gasoline demand, year-over-year growth in jet demand and the decline in diesel demand. So demand looks pretty strong outside those markets. We continue to see good export demand. Gasoline exports in the third quarter, about 100,000 barrels a day typical markets, Latin America and Canada. Diesel exports in the third quarter were 260,000 barrels a day, again, kind of South America and Europe. So we continue to see demand that looks very similar to what we've seen in the last couple of years in the markets where we have a strong presence."
},
{
"speaker": "Manav Gupta",
"content": "Perfect, Gary, so my quick follow-up is, if there are no real red flags here in demand, and it's lightly softer in U.S., but stronger outside. Why did we suddenly hit this environment where the cracks are kind of trending below mid-cycle? And is that -- and do you see this as transient if the demand holds then the track should be able to get back to mid-cycle or maybe even higher?"
},
{
"speaker": "Gary Simmons",
"content": "Yes, Manav, I would say some of this, typically on the third quarter earnings call, you tend to have a little more negative market sentiment. And there’s some reasons for that. Each year around Labor Day, you typically had some hurricane hype in the market that tends to go away as people view your out of hurricane season, you’ve gone through RVP transition, you start our RVP transition on gasoline, slowing the gasoline pool. Labor Day kind of marks the end of driving season. So you can certainly understand some negative market sentiment around gasoline. And typically, the fourth quarter and first quarter tend to be driven more by strength in the distillate cracks. I think we came into this year and although the U.S. economy has been fairly resilient. We’ve seen some pockets of economic weakness throughout the globe, which have driven down diesel demand a little bit. And cause the pessimism around diesel cracks. If you look at where things are, though, the fundamentals look strong. We’re going into the year with very low inventories, gasoline inventory, 10 million barrels below where we were last year at this time, below the 5-year average. Some of the key things we tend to be focused on in the gasoline markets at this time of the year, market structure, market structure is backwards. So there’s no incentive to produce and store summer-grade gasoline. Typically, in the fourth quarter, the first quarter, you will have a positive transatlantic arb to ship from Europe to New York Harbor, at least on paper that arb is closed throughout the fourth quarter. Export demand for gasoline remains strong. We’re seeing good export demand into Latin America. So things look good for gasoline. I don’t think you’re going to see any big moves in the gas crack anytime soon. But as long as inventory remains in check, you get back into driving season RVP transition, we would expect gas cracks to respond. On the distillate side, again, like gasoline, the key thing is, although we’ve seen a little bit less demand than we’d hoped for. Distillate inventories are trending toward the lows that we’ve seen the last couple of years. I think you saw economic run cuts throughout parts of the world that took some supply off the market. Here recently, we’ve had turnaround activity, decreased supply as well. So it put us in a pretty good position heading into winter. And I think if you have some uptick in demand from heating oil demand with some colder weather, you’ll see distillate cracks respond as well."
},
{
"speaker": "Operator",
"content": "The next question is coming from John Royall of JPMorgan."
},
{
"speaker": "John Royall",
"content": "So my first question is on capital allocation. You were very aggressive on your buyback program in 3Q despite what's been a downtick in cracks. You've been pretty clear on your framework in sort of a mid-cycle and above environment. But assuming we stay in this lower margin environment, can you talk about how your approach to returning capital may or may not change in terms of that 70s or 80s percent of CFO type range that you've been in? And would you use your balance sheet a little bit at lower parts of the cycle?"
},
{
"speaker": "Jason Fraser",
"content": "John, this is Jason. I'm going to ask Homer to respond to your question."
},
{
"speaker": "Homer Bhullar",
"content": "Thanks, Jason. John. Yes, I mean, I think in this environment we're in and with the strength of our balance sheet, you should absolutely should continue to expect us to be in our posture. As I mentioned in the opening remarks, you can go back to start of 2021. We've been able to fund all our uses of cash, including capital. We've paid down over $4 billion of debt and returned over $18 billion to shareholders over that period, all through cash flow from operations. So turning to where we are now, let me start by reiterating that the 40% to 50% is a minimum commitment, not a target. So we're always going to honor that. As you noted, we've consistently been well above that despite the pullback in margins. And I think you can attribute that -- attribute our ability to do that because of our low-cost profile and then disciplined use of capital. So given the strength of our balance sheet and our cash position, I think you should rest comfortable that the 40% to 50% will continue to be a floor and all excess free cash flow will go towards buybacks."
},
{
"speaker": "John Royall",
"content": "Great. And then my next question is just on California. We've gotten news of a new closure out there, which all other things equal, will be a good thing for those who remain. But there are some new legislative pressures there, and you've also mentioned strategic alternatives, I think, in your 10-Q. I was wondering if you could just give us an update on how you're thinking about continuing to operate as a refinery in California and what those strategic alternatives might be."
},
{
"speaker": "Lane Riggs",
"content": "John, this is Lane. I'll let Rich start with the policy side, then I'll talk about the strategic side after the answer of the question."
},
{
"speaker": "Richard Walsh",
"content": "Okay. Yes. So it's really unclear at this time whether when and which one of these various policies that the state keeps proposing coming out of these legislations. So we'll just kind of have to we'll have to kind of see how that plays out. A lot of these are driven by a lot of political rhetoric that you see coming out of the state. And I think when we see that pass from the legislature and the political arena back over to the CEC for implementation, I think you see them struggle with a lot of these ideas. There are ideas that they sound good politically, but when you start putting them into the market realities, it has the potential to make things even more costly for consumers. So the reality is that California policy has cost the state a number of refineries and including this most recent announcement. And so you can't have policy that impairs supply and then expected to lower prices for customers. So -- and consumers. So recall, all of these regulations have a caveat in them that require the CEC to implement it only if they find that the actions will lower cost for consumers. And that's going to be the challenge for them."
},
{
"speaker": "Lane Riggs",
"content": "On strategy, we’ve been consistent for over a decade, probably even longer than that in terms of our – how we manage and steward the West Coast, and it’s largely driven by California policy. We’ve minimized strategic CapEx, we make sure we maintain a really reliable operation through our maintenance CapEx, which in turn positions us as a core call option on West Coast cracks. With that said, California is increasing its regulatory pressure on the industry. So it’s really considering everything, all options are on the table."
},
{
"speaker": "Operator",
"content": "The next question is coming from Theresa Chen of Barclays."
},
{
"speaker": "Theresa Chen",
"content": "Can you unpack some of the earlier comments on the evolution of global product supply over the more, I guess, medium to long term, taking into account the continued ramp up facilities abroad as well as planned closures in 2025. How do you think this trend? And do you expect changes in trade flows as a result?"
},
{
"speaker": "Gary Simmons",
"content": "Yes, Theresa, I can try. So overall, when we look at 2025, we see about 1,040,000 barrels a day of new refining capacity coming online. And so far, there's about 740,000 barrels a day of refinery closures announced. So net-net, about a 300,000 barrel a day net capacity additions. And then forecast for total light product demand we're looking at is about an increase in 700,000 barrels a day. So for next year, really, it all comes -- and it becomes about timing. When did those refineries close, when did the new capacity come online. So it gives a lot of uncertainty into next year. Even the demand side is a little uncertain. A lot of the economic stimulus in China, how long does it take to come into effect? But we see tightening balances through next year. And then when you get past next year, you kind of have a fairly extended period where when you look at net capacity additions, and total product demand growth, there's a pretty good gap there. So we see an extended period with tighter and tighter balances around the refining margins."
},
{
"speaker": "Theresa Chen",
"content": "Helpful. And then turning to the renewables front. Would you be able to provide an update on how the SaaS unit is operating following its recent in-service and any other commercial discussions to broaden this offering as well as your views on the subsidy prices."
},
{
"speaker": "Eric Fisher",
"content": "Yes, I'd say -- this is Eric, Theresa. The SaaS startup looks great. As we said in the call, the project finished ahead of schedule from our original timing that we had for 1Q of next year and it finished under budget. So project execution for Valero once again demonstrates its exceptional ability to beat expectations. And then you expect that performance as we go into full operations. So, so far, startup looks very good. I don't think we have any doubt it's going to meet its design capability. And commercially, we're seeing a lot of interest and continued contracting of the product, both from a SBK standpoint, as well as a blended SaaS standpoint. And I don't know, Gary, if you wanted to comment on any of that."
},
{
"speaker": "Gary Simmons",
"content": "No, I’m not going to go into a lot of details, but there’s been some press releases with some of the airlines, Southwest, JetBlue about contracts that we’ve signed. In addition to that, we’re dealing with freight carriers. There’s been an announcement with DHL. So I’m not going to go into a lot of the commercial details there. But when we made the decision to fund the project, we said we expected it to exceed our minimum return threshold of after tax, 25%, still confident with the contracts we have in place and the volumes sold that we’ll do that."
},
{
"speaker": "Operator",
"content": "The next question is coming from Doug Leggate of Wolfe Research."
},
{
"speaker": "Douglas Leggate",
"content": "Appreciate you take my questions guys. Gary, I wonder if I could go back to the balances question. I know it's an imperfect an imprecise assessment that we're all trying to make here. But I wanted to use Valero as an example. I look back, your -- obviously, your mechanical availability has been one of the hallmarks of the investment case. 2018 3rd quarter, 99%, '19, 94%. Pre-COVID '22, 95%, 95% last year. My point is that, you guys have obviously got a lot of upside to your potential utilization. And the same is probably true then of anyone who's cutting runs at this point, Singapore or whatever. So when you think about supply additions, what are you assuming for the response of a potentially oversupplied market raising utilization in some of those more challenged refineries. And I guess what I'm getting at is it not reasonable to assume we need around the refinery closures before we get back to that above mid-cycle that you were talking about."
},
{
"speaker": "Gary Simmons",
"content": "Yes. We look at historic refinery utilization rates and we look at the balances and kind of assume it's going to be in line with historic utilization rates. However, I do think you can see a lot of refining capacity in the world that's underwater, some of that is in need of a lot of capital investment. And so I think you will see additional refinery closures as well."
},
{
"speaker": "Douglas Leggate",
"content": "Okay. So I guess to be -- is that something you have any insight to? Or are you guessing."
},
{
"speaker": "Gary Simmons",
"content": "No, we can't name refineries that would close, but you can kind of see that refiners that are under pressure, some in Europe, some in the Far East. And our expectation is you'll see some additional announced closures coming."
},
{
"speaker": "Douglas Leggate",
"content": "Got it. Okay. Well, on the topic as my follow-up, if you don't mind, and that's going back to your comments about California. I mean, obviously, we've had ABX too, I guess, is it the title of it the inventory question. And it seems that when Phillips 66 shut down Rodeo, there was an equal and opposite impact from imports that seem to offset any potential tightness in the West Coast. So I guess as you look at your portfolio overall, and particularly the West Coast, how do you see the cost competitiveness? It's the only asset in the only area in your portfolio that lost money this year this past quarter. Any color you can give on how you're thinking about portfolio adjustments going forward?"
},
{
"speaker": "Lane Riggs",
"content": "Doug, it’s Lane. I sort of alluded to it before. It’s clearly our highest cost structure operation. Historically, they had been challenged with respect to cost of crude. So if you think about OpEx the regulatory environment and the supply situation in the West Coast, it’s – it’s always a challenge. And so – and it’s very different than maybe some of the other areas that we operate. And again, what we’ve historically done is try to position the assets to be a call option for when things get out of balance because the supply chain is so long. So with respect to these regulations, we’ll just have to see what they actually finally try to do. But clearly, the California regulatory environment is putting pressure on operators out there and how they might think about going forward with their operations."
},
{
"speaker": "Operator",
"content": "The next question is coming from Roger Read of Wells Fargo."
},
{
"speaker": "Roger Read",
"content": "Yes. I want to come back and hammer the California question as well. In the most recent 10-K and 10-Q, you put out -- you've highlighted issues with California from an asset value or an ongoing concern kind of question. With Philips closing down their unit or announcing the closure of their unit, California obviously hypersensitive about the price of fuels to consumers regardless of what their policy may do. Does it impact your ability, you think, going forward, if you have to make a hard decision on a California refining unit that someone else went first. I mean sort of -- does it invite more political interference? And how would that work?"
},
{
"speaker": "Richard Walsh",
"content": "I mean, I don't know that, that really factors into our thinking necessarily. I mean I think what we would be looking at is what are the regulatory programs that California puts forward. A lot of these programs were announced. I mean the initial one, the margin cap was announced almost 2 years ago, and they've still been collecting information and studying the market. I mean I think one of the realities is there's the market is incredibly efficient until you interfere with it. And I think the California is, I think, starting to realize that as the more they interfere, the worse the situation gets. And so that's, I think the challenge there. So I think we have to wait and see what they're going to do and what they decide. I mean, it's their choice, and then we just have to react to that. And what others do, that's their decision. We have great assets out there, and we have great people operating them. So I think we like our position."
},
{
"speaker": "Roger Read",
"content": "Appreciate that. Rich, you're more of an optimist than me because I don't really believe they quite grasp all the impacts of policies in terms of the outcomes. The follow-up question, I'd just like to ask, probably to Gary, diesel demand does look like it's starting to improve here in the U.S., the last kind of, let's call it, 2 months worth -- is there anything you're seeing that in terms of DOE information, is there anything you're seeing as you look at that in a more short-term basis versus like your full year commentary on demand?"
},
{
"speaker": "Gary Simmons",
"content": "I think both gasoline and diesel, we saw a little bit of demand softness, and it’s picked up as the year has gone on. I mentioned over the last 2 weeks, we’ve actually seen a surge. So in the last 2 weeks, we have about a 5% year-over-year increase in diesel demand kind of consistent with your comments. I think you’re seeing some of that in Europe as well. You can see the 211 in Europe has gone up $2 or $3 in the last few weeks, kind of indicating that some of that topping capacity, the diesel from some of that hydroskimming topping capacity is ’eeded to supply the market as things are getting tight heading into winter."
},
{
"speaker": "Operator",
"content": "The next question is coming from Paul Cheng of Scotiabank."
},
{
"speaker": "Paul Cheng",
"content": "I apologize. First I want to add -- one question is on California also. I think Gary and Lane. Historically, that refiner doesn't just shut down the refinery just because they're not making money. But typically, we wait until there's a substantial CapEx outlay requirement, maybe a major turn on before that they're being pushed to make a hard decision. Just curious that in your Benicia refinery, can you share that what that may be the time line, say, at what point that will be the next major capital data you need to put that you will have to make a decision or that more likely than we'll make you trying to have a decision whether that is a viable ongoing business or not. Is there any you can say?"
},
{
"speaker": "Lane Riggs",
"content": "Yes. Paul, this is Lane. Sorry for that. So good try. We don't normally provide outlooks with respect to our turnaround activity. But your premise is correct. I mean clearly, not only the cost structure out there is higher the cost turnarounds out there is significantly higher. And so it weighs any big outlay on turnarounds in the West Coast is in the way you think about assets going forward, it will -- and any other asset really in the world for that matter, it's largely driven by the next big capital outlay. But in terms of guidance on -- and we're going to do our next turnaround, we -- as a general policy, we just don't do that."
},
{
"speaker": "Paul Cheng",
"content": "Okay. Understand. And Europe [indiscernible] the margin capture is phenomenal. And it's interesting because I mean Europe, the market condition quite very difficult. So if the strong margin capture is really driven by your [indiscernible] refinery? Or that is -- I mean, Europe is also doing well. Just trying to help us understand -- I mean, over the past 2 or 3 years, quite [indiscernible] and then take often time surprised us on the upside. So trying to understand what's going on there."
},
{
"speaker": "Greg Bram",
"content": "Paul, it's Greg. So a couple of things that impacted the North Atlantic in the third quarter: One, we had some very good results from the commercial team that helped contribute; And then the second thing, you talked about Quebec, but really crude cost for that region. Sometimes it's Quebec, sometimes it's Pembrook but crude costs were fairly favorable. Some of that was some of the Canadian grades coming into Quebec. Some of that was just the relative value of the grades we're running versus dated Brent. And so while that market might have been challenged, remember that the capture is relative to kind of a market-based reference crack. And so we take into account where the market is at and putting that together, and we performed pretty well relative to that reference."
},
{
"speaker": "Operator",
"content": "The next question is coming from Jean Salisbury of Bank of America Merrill Lynch."
},
{
"speaker": "Jean Salisbury",
"content": "You referenced the growing OPEC supply next year. This primarily benefits Valero and heavy sour crude, but I believe also in some of the high sulfur intermediate margins. that you consume as feedstocks. Can you just go over the different ways that increasing OPEC supply could manifest in different markets and your exposure there?"
},
{
"speaker": "Gary Simmons",
"content": "Yes. So we see several bright spots in terms of supply fundamentals around heavy sour crude. Obviously, OPEC, 180,000 barrels a day on the market starting in December. Seasonally, we expect Canadian production to ramp up as well. We think Canadian production could hit record highs over the winter. Then you have continued Venezuelan production growth, and this time of year, you get to where you're past the period of time in the Middle East where they're burning fuel oil for power generation. So all that puts more barrels on the market. If you get into the first quarter and Lyondell shuts down, it takes some demand as way as well. So those things should be positive in terms of quality discounts."
},
{
"speaker": "Operator",
"content": "The next question is coming from Joe Laetsch of Morgan Stanley."
},
{
"speaker": "Joe Laetsch",
"content": "So I wanted to go back to the RD side, and it continues to be a tougher margin environment for the industry overall to margins recently. As we look towards 2025, could you just talk to how you're thinking about the moving pieces around credits, including RINs, LCFS prices as well as feedstock costs as it relates to profitability?"
},
{
"speaker": "Eric Fisher",
"content": "Sure. This is Eric. The -- it looks like a lot of good tailwinds start in 2025. So California intends to approve their LCFS modifications November 8, with the intent of starting that Jan 1, that should tighten the credit bank through 2025 and increase LCFS prices. You've got that. You've got Europe and U.K. starting their fit for 55 which starts the SAF mandate of 2% in that region. We're watching the Canadian B.C. election very closely to see what they do with the CFR, but nationally, that will still be in play in 2025. And all these obligations naturally ratchet as you go into next year. And then lastly, the IRA with the switch from the blenders tax credit to the production tax credit does create a lot of tailwind for us because that will switch from $1 for everyone to a CI base where we're the most advantaged and it does not allow importers to qualify for the credit. So if you look at those two benefits of the IRA, that is a good tailwind for DGD. Those things are all on paper that's waiting for a lot of policy clarification between now and the end of the year. But the one thing we look at is that is the policy intent of all those programs. And most of those take legislative action to change. And so that, we think, will be difficult and that means those policies will probably go forward as designed at least initially. So we're all waiting on seeing how that develops in the next couple of months. I think the whole renewables segment is all asking for this guidance to be given so that we can move forward with plans. But all of that looks pretty constructive. On the feedstock side, we've mostly seen prices equilibrate. There was previously a lot of advantage in foreign feedstocks. We've seen that largely equilibrate. We've seen the market really level out a lot of the price lag we've talked about for the last several months has evened out. So I think what you're seeing is the world is recognizing that waste oils are still the most advantaged. Our partnership with Darling still gives us the most advantaged access to domestic feedstock and some of their foreign feedstock that they now produce out of South America and Europe, all of that looks advantaged. And as we see vegetable oil and BD are going to be marginal going forward, and that will set a floor in this whole space. So as the blenders tax credit goes away, BD will be significantly underwater without an adjustment to the RINs. So the last piece that I think is positive is the expectation that RINs will have to go up to offset the loss that BD and vegetable oil RD takes as we migrate to the PTC. So that -- there's a lot of expectation that RINs will increase. That won't happen overnight, but if that does, it is a significant tailwind to DGD and RD."
},
{
"speaker": "Joe Laetsch",
"content": "Great. there. And then I just wanted to ask on the naphtha side, specifically, exports out of the Gulf Coast has been strong in the past couple of months, which I think has been supportive of margins. What are you seeing on your side? And how are you thinking about the outlook for naphtha here?"
},
{
"speaker": "Gary Simmons",
"content": "Yes. So I think there’s a couple of things driving the relative strength in naphtha. Some of that is with the economic run cuts of some of the hydroskimmers, you see less naphtha in the market. So U.S. Gulf Coast supply has had a step in for that. But we’re also seeing a bit of a pickup for petrochemical demand for naphtha, which looks to be improving. And so that’s also creating some of the export opportunities. So we expect it to continue."
},
{
"speaker": "Operator",
"content": "The next question is coming from Ryan Todd of Piper Sandler."
},
{
"speaker": "Ryan Todd",
"content": "Maybe what I know -- Lane, I know how much you love to talk about the concept of capture rate, but has been -- for the entire sector, it's kind of been steadily declining over the last 18 months. And some of that obviously is just that level of margins coming down. But can you maybe talk about some of the things that have been headwinds? And then what needs to happen to see improvements on that? And is it is it absolute margins, wider crude differentials, crude backwardation, secondary product pricing improvement. Any signs of encouragement as you look into the fourth quarter of 2025 in terms of maybe improvements in margin capture."
},
{
"speaker": "Lane Riggs",
"content": "Yes. Ryan, it's Lane. I fortunately I get to hand this off to Greg."
},
{
"speaker": "Greg Bram",
"content": "Ryan, so I think you noted most of the key factors, and we've talked about some of them already. Crude market backwardation certainly has been a bit persistent and strong here, particularly late in 2024 that's certainly a factor. In fact, I think if you look back in early 2023, we're actually in contango. So there's no doubt that continuing on an ongoing basis is not something you would necessarily expect. So seeing improvement there will help capture. Thinking about us, in particular, we've talked about heavy maintenance a number of quarters here recently. So that's definitely a factor more in some regions than others. I mean, there's always going to be some maintenance in our system industry as well. So I think there have been some heavier periods though that have had some impact. And then you mentioned secondary products. I think the ones that really come to mind there are those related to pet chem, so things like propylene and naphtha. And Gary just talked about it. As we're seeing pet chem start to improve expect those values to improve as well, and that's going to have some positive impact on capture."
},
{
"speaker": "Ryan Todd",
"content": "Great. And then maybe one follow-up on some of your earlier comments on sustainable aviation fuel. As we think about -- I mean the message over the last couple of years late into this, I think there was clearly an expectation that the market -- the SAF market was going to be undersupplied which was going to be good for you guys. There's been a lot of moving pieces in that. Do you still view the market over the next 12 to 24 months as undersupplied? And then as you think about you're probably one of the few domestic producers that can qualify to sell into Europe. How do you think about the potential optionality of being able to sell into Europe versus kind of domestic markets and pricing here?"
},
{
"speaker": "Eric Fisher",
"content": "Yes, this is Eric. I think our view is consistent that the market is physically undersupplied, given the ramp in mandates that is occurring over the next year to 5 years. You’re absolutely correct. Europe will be the most attractive market, and we do have capability of supplying into that market. That will be one of our primary outlets as we start up. But I think the policies are always, as I mentioned before, we’re waiting for a lot of clarification there. The mandate in Europe is very clear how that will be implemented is waiting on a lot of clarity on guidance for import codes and what duties are affecting it, all these kind of details that make – finishing the contract difficult, but we see that as all solvable between now and the end of the year for January 1 compliance. And I think in the U.S., the IRA clearly favors staff over RD from a credit standpoint. Again, we're waiting for clarity on that and as well as a lot of our customers and blenders are waiting for clarity so that we can get the contract language perfected. But all of that is moving forward, and we’re confident that’s going to get solved contractually especially once we get clarity on this policy guidance."
},
{
"speaker": "Operator",
"content": "The next question is coming from Neil Mehta of Goldman Sachs."
},
{
"speaker": "Neil Mehta",
"content": "The first question is just around operating expenses. It's always been a hallmark of Valero is your ability to keep that OpEx low per barrel. Just your perspective on how some of those moving pieces as we move into the next couple of years and how you're thinking about it even geographically as well."
},
{
"speaker": "Greg Bram",
"content": "Neil, it's Greg. So we keep those expenses under control. It's one of the things we focus on every day. A couple of parts, I think, that are probably notable. Energy costs have been low natural gas driving that. That's been a help. And so it looks like those prices will move back towards kind of middle of the cycle kind of range here, at least that's what folks are thinking, but that's been helpful. Inflation has made it a bit harder. We've seen the effects of that on both maintenance costs, catalyst chemicals, those kinds of things. We work hard with our partners to try to make sure we keep those costs competitive. And so as inflation moderates, we'd expect to see some of that improve as well. Those are probably the two biggest parts to think about and really the things we focus on every day."
},
{
"speaker": "Neil Mehta",
"content": "Yes. Yes. Understood on the energy side. And then the other one is on just on the Port Arthur coker. I think when you FID-ed, you talked about $325 million of EBITDA. And then you talked about it actually run rating closer to $400 million. How do you think -- as you think about that project specifically about, one, the current economics and then how those economics could evolve as you think about the path back to mid-cycle?"
},
{
"speaker": "Greg Bram",
"content": "Yes, Neil, I think we still see that project giving us the returns consistent with what we showed at FID. The current market is a little different than where we started. We got real good benefits earlier this year when we did the turnaround on the old coker and we expected to see some strong value there. So I don’t think anything has changed in our view. And then again, obviously, that project is hinged on being able to run a lot of heavy sour crude and upgraded to light products. And so as those sour differentials move around, that’s going to give us a chance to capture some more value."
},
{
"speaker": "Operator",
"content": "The next question is coming from Matthew Blair of TPH."
},
{
"speaker": "Matthew Blair",
"content": "If I heard correctly, I think the $4.7 million ethanol volume guidance for Q4 might be an all-time record. And just coming at a time when ethanol margins are really crumbling on paper. So could you help us reconcile that? Is that a function of increasing net export opportunities or maybe there's the lag we should be thinking about on the ethanol indicator?"
},
{
"speaker": "Eric Fisher",
"content": "Yes, it's Eric. We have increased our ethanol production capability this year. Most of this year has been pretty positive for that expanded capability. We have also expanded our export markets. Again, talking about policy, there's interest in U.S. ethanol, especially a lot of our ISCC qualified ethanol in Europe. We also see that because of U.S. corn being the most attractive feedstock in the U.S. with the largest carryout, one of the largest harvest we've ever seen, it is giving a lot of opportunity for ethanol exports. So that's what we're seeing as increased demand. We're seeing new markets for E10 in the world, and we see Brazil is increasing its ethanol mandate as well as the SaaS mandate beginning in '25. So we've grown our capacity in anticipation of a lot of this expanded interest globally in ethanol."
},
{
"speaker": "Matthew Blair",
"content": "Sounds good. And then there's been more chatter lately about just increasing global tariffs and exports are a big part of the outlet for U.S. refiners. So when you hear about the potential for just [indiscernible] increases in tariffs, what do you think, is that a concern going forward?"
},
{
"speaker": "Richard Walsh",
"content": "This is Rich Walsh. I’ll take an effort to add that. I mean, when you look at those tariffs, a lot of times, they’re really focused around manufactured goods. Most countries don’t want to increase their cost of energy that they’re trying to take in. So when you think about targets for tariffs, they normally don’t really wrap around energy. And so I don’t know that we see the concerns on that."
},
{
"speaker": "Operator",
"content": "The next question is coming from Jason Gabelman of TD Cowen."
},
{
"speaker": "Jason Gabelman",
"content": "I wanted to circle back on the financial framework, and you provided some helpful comments about the return of capital metrics being a firm target. And I'm wondering how you think about using the balance sheet in a downturn. You have this $4 billion kind of target for cash for the balance sheet. Is that what you want headed into a downturn so you could lean on the balance sheet a bit more should the market weaken?"
},
{
"speaker": "Jason Fraser",
"content": "Yes. This is Jason. I'll be glad to share some of our thoughts about cash. And our targeted cash balance will depend on the environment we're in, but in a normalized environment, we like to keep a cash balance between $4 billion to $5 billion as a guideline. And as you know, cash to move around a lot in any quarter due to things like working capital, but we're not going to hoard cash. So I think directionally, you should expect our cash balance to trend down a little from here. I'd also like to note, if it wasn't for the positive impact from working capital this quarter, we would have drawn cash by over $200 million. We also had strong buybacks for the quarter of $565 million without leaning on the balance sheet. But to answer your question more directly, yes, you're right, that $4 billion gives us a lot more room and flexibility in the downturn to continue our approach to buybacks. So I think that's correct. It's a big factor in coming out with a $4 billion number."
},
{
"speaker": "Jason Gabelman",
"content": "Great. And then the other just on the market. We've noticed a pretty strong product exports for gasoline and diesel, out of the U.S., and it's coming as fracs have fallen a bit here the past months. And so it seems like prices are needing to fall to clear the U.S. market and keep U.S. inventories kind of at healthy levels. Is that a fair interpretation of what's going on in the market where there's kind of a push from the U.S. on product exports rather than a pull from international sources on those products?"
},
{
"speaker": "Gary Simmons",
"content": "Well, it's a good question. It would appear that what you're saying is correct. But in the face of that, gasoline inventories are really pretty low. We're $10 million below where we were last year. You are below the 5-year average. So the inventories wouldn't indicate a need to push. It would almost seem like it's more of a pull, and we're getting an export premium, and that's why the barrels are flowing."
},
{
"speaker": "Jason Gabelman",
"content": "Okay. And when you say you're getting an export premium, you're able to sell to international markets at a higher price than what you're selling at on, say, the U.S. Gulf Coast?"
},
{
"speaker": "Gary Simmons",
"content": "Yes, we are."
},
{
"speaker": "Operator",
"content": "Thank you. At this time, I would like to turn the floor back over to Mr. Bhullar for closing comments."
},
{
"speaker": "Homer Bhullar",
"content": "Thank you, Donna. We appreciate everyone joining us today. As always, please feel free to contact the IR team if you have any additional questions. Have a great day, everyone. Thank you."
},
{
"speaker": "Operator",
"content": "Ladies and gentlemen, this concludes today's event. You may disconnect your lines or log off at this time, and enjoy the rest of your day."
}
] |
vlo | 2,024 | 2 | [
{
"speaker": "Operator",
"content": "Greetings. Welcome to Valero Energy Corp.'s Second Quarter 2024 Earnings Call. At this time, all participants are in a listen-only mode. A question-and-answer session will follow the formal presentation. [Operator Instructions] Please note, this conference is being recorded. I will now turn the conference over to Homer Bhullar, Vice President, Investor Relations and Finance. Thank you. You may begin."
},
{
"speaker": "Homer Bhullar",
"content": "Good morning, everyone, and welcome to Valero Energy Corporation's second quarter 2024 earnings conference call. With me today are Lane Riggs, our CEO and President; Jason Fraser, our Executive Vice President and CFO; and Gary Simmons, our Executive Vice President and COO and several other members of Valero's senior management team. If you have not received the earnings release and would like a copy, you can find one on our website at investorvalero.com. Also attached to the earnings release are tables that provide additional financial information on our business segments and reconciliations and disclosures for adjusted financial metrics mentioned on this call. If you have any questions after reviewing these tables, please feel free to contact our investor relations team after the call. I would now like to direct your attention to the forward-looking statement disclaimer contained in the press release. In summary, it says that statements in the press release and on this conference call that state the company's or management's expectations or predictions of the future are forward-looking statements intended to be covered by the safe harbor provisions under federal securities laws. There are many factors that could cause actual results to differ from our expectations including those we've described in our earnings release and filings with the SEC. Now I'll turn the call over to Lane for opening remarks."
},
{
"speaker": "Lane Riggs",
"content": "Thank you, Homer, and good morning, everyone. We are happy to report strong financial results for the second quarter. Our refineries operated well and achieved 94% throughput capacity utilization. We saw continued strength in our U.S. wholesale system with sales exceeding 1 million barrels per day in the second quarter. We also saw a good contribution from our renewable diesel and ethanol segments. On the strategic front, our growth projects are progressing on schedule. The Diamond Green Diesel sustainable aviation fuel project in Port Arthur is still expected to be operational in the fourth quarter. At which point, DGD is expected to become one of the largest manufacturers of SAF in the world. And we continue to pursue short-cycle, high-return optimization projects around our existing refining assets. On the financial side, we remain committed to shareholder returns with a year-to-date payout of 80%. And last week, we announced a quarterly cash dividend on our common stock of $1.07 per share. Looking ahead, limited announced capacity additions beyond 2025 should support long-term refining fundamentals. In closing, our team's simple strategy of pursuing excellence in operation return-driven discipline on growth projects and a demonstrated commitment to shareholder returns has underpinned our success and positions us well for the future. So with that, Homer, I'll hand the call back to you."
},
{
"speaker": "Homer Bhullar",
"content": "Thanks, Lane. For the second quarter of 2024, net income attributable to Valero stockholders was $880 million or $2.71 per share compared to $1.9 billion or $5.40 per share for the second quarter of 2023. The Refining segment reported $1.2 billion of operating income for the second quarter of 2024 compared to $2.4 billion for the second quarter of 2023. Refining throughput volumes in the second quarter of 2024 averaged 3 million barrels per day. Throughput capacity utilization was 94% in the second quarter of 2024. Refining cash operating expenses were $4.45 per barrel in the second quarter of 2024. Renewable Diesel segment operating income was $112 million for the second quarter of 2024 compared to $440 million for the second quarter of 2023. The renewable diesel sales volumes averaged 3.5 million gallons per day in the second quarter of 2024, which was 908,000 gallons per day lower than the second quarter of 2023. Operating income was lower than the second quarter of 2023, due to lower sales volumes resulting from planned maintenance activities and lower renewable diesel margin in the second quarter of 2024. The Ethanol segment reported $105 million of operating income for the second quarter of 2024 compared to $127 million for the second quarter of 2023. Ethanol production volumes averaged 4.5 million gallons per day in the second quarter of 2024, which was 31,000 gallons per day higher than the second quarter of 2023. For the second quarter of 2024, G&A expenses were $203 million, net interest expense was $140 million, depreciation and amortization expense of $696 million and income tax expense was $277 million. The effective tax rate was 23%. Net cash provided by operating activities was $2.5 billion in the second quarter of 2024. Included in this amount was a $789 million favorable change in working capital and $83 million of adjusted net cash provided by operating activities associated with the other joint venture member share of DGD. Excluding these items, adjusted net cash provided by operating activities was $1.6 billion in the second quarter of 2024. Regarding investing activities, we made $420 million of capital investments in the second quarter of 2024, of which $329 million was for sustaining the business, including costs for turnarounds, catalysts and regulatory compliance and the balance was for growing the business. Excluding capital investments attributable to other joint venture member share of DGD and other variable interest entities, capital investments attributable to Valero were $360 million in the second quarter of 2024. Moving to financing activities, we returned $1.4 billion to our stockholders in the second quarter of 2024, of which $347 million was paid as dividends and $1 billion was for the purchase of approximately 6.6 million shares of common stock, resulting in a payout ratio of 87% for the quarter. Year-to-date, we have returned $2.8 billion to our stockholders in the form of dividends and buybacks, resulting in a payout ratio of 80%, well above our minimum commitment of 40% to 50%. With respect to our balance sheet, we ended the quarter with $8.4 billion of total debt, $2.4 billion of finance lease obligations and $5.2 billion of cash and cash equivalents. The debt-to-capitalization ratio, net of cash and cash equivalents was 16% as of June 30, 2024. And we ended the quarter well capitalized with $5.3 billion of available liquidity, excluding cash. Turning to guidance. We still expect capital investments attributable to Valero for 2024 to be approximately $2 billion, which includes expenditures for turnarounds, catalysts regulatory compliance and joint venture investments. About $1.6 billion of that is allocated to sustaining the business and the balance to growth with approximately half of the growth capital towards our low carbon fuels businesses and half towards refining projects. For modeling our third quarter operations, we expect refining throughput volumes to fall within the following ranges: Gulf Coast at 1.77 million to 1.82 million barrels per day; Mid-Continent at 405,000 to 425,000 barrels per day; West Coast at 235,000 to 255,000 barrels per day and North Atlantic at 390,000 to 410,000 barrels per day. We expect refining cash operating expenses in the third quarter to be approximately $4.70 per barrel. With respect to the Renewable Diesel segment, we expect sales volumes to be approximately 1.2 billion gallons in 2024. Operating expenses in 2024 should be $0.45 per gallon, which includes $0.18 per gallon for non-cash costs such as depreciation and amortization. Our Ethanol segment is expected to produce 4.6 million gallons per day in the third quarter. Operating expenses should average $0.40 per gallon, which includes $0.05 per gallon for non-cash costs such as depreciation and amortization. For the third quarter, net interest expense should be about $140 million and total depreciation and amortization expense should be approximately $690 million. For 2024, we expect G&A expenses to be approximately $975 million. That concludes our opening remarks. Before we open the call to questions, please limit each turn in the Q&A to two questions to ensure other callers have time to ask their questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Our first question is from John Royall with JPMorgan."
},
{
"speaker": "John Royall",
"content": "One of my questions were on the refining macro side and more specifically, your views on supply and demand. The U.S. system ran pretty hard through 2Q. We built some inventories on both the gasoline and the diesel side. What are you seeing on the demand side in both the U.S. and globally? And how do you view the overall supply/demand balance today?"
},
{
"speaker": "Gary Simmons",
"content": "John, this is Gary. I think in the U.S., for the most part, the economy has been fairly resilient and the market fundamentals look pretty similar to what we've been looking at the past couple of years. If you look at our wholesale data, four-week average, our gasoline sales are up about 0.5%. There tends to be a lot of noise in the weekly DOE data. But year-to-date, DOE data would suggest a slight decline in gasoline demand less than 1%. You look at vehicles mile travel, they're up 1.4%, which would again indicate a slight increase in demand for gasoline. I guess the way we're looking at it is, we'd say, year-over-year, gasoline demand in the U.S. is flat. On the diesel side, we're actually showing a pretty good step change in our system on diesel sales, four-week average diesel sales in our system are up 10%. Again, don't necessarily believe that's representative of the broader markets. If you look at year-to-date, diesel sales and the DOE data, it would suggest a decline in diesel demand about 100,000 barrels a day. Directionally, I think that makes sense to us with a little weaker freight numbers early in the year. You didn't really have any help from weather, a little less demand from the upstream sector. However, a lot of that has been offset with the increase in jet demand. So about half of that offset with an increase in jet demand. So maybe distillate demand down slightly. In the U.S., we would say gasoline demand flat year-over-year, distillate demand down slightly. I think the bigger impact has really been for the overall North Atlantic Basin. Certainly, in the North Atlantic Basin, we saw regions with slowing economic activity that negatively impacted, especially demand for diesel. And then it looks like some of the new capacity that came on in the Middle East really never made it to nameplate capacity until early this year. So we saw a bit of a step change in refining runs in the Middle East with a lot of that product making its way into Europe. So some of that early in the year was masked with some of the drone strikes on Russian refining capacity. But the combination of higher refinery runs in the Middle East, a little sluggish economic activity in parts of the Atlantic basin allowed restocking of inventories in the region. So with that, we've obviously seen refinery margins weaken some. We haven't had any type of major weather event take down refining capacity like we've seen the past few years. Of course, we're right in the middle of hurricane season so you still have that potential. So with refinery runs up in the North Atlantic basin lined with a little softer diesel demand, you've seen that restocking. We've gone from well below the five-year average total light product inventory to trending more to the bottom end of the five-year average range. As inventories tend to trend towards the five-year average, you would expect to see margin environment closer to a mid-cycle type margin environment. That's kind of what we're seeing. It does feel as the market has found a bit of a bottom consultant data indicates at least earlier this week, hydroskimming margins in Europe and the Far East were negative, cracking margins in the Far East negative. And if that's correct, and we found the bottom, it is what historically been a mid-cycle type refining margin environment, that's -- it's actually pretty bullish refining going forward. As we move into the third quarter, we'll see -- start to see a little lower utilization, mainly turnarounds affecting refinery utilization. Most of the consultant data actually shows year-over-year demand growth was more weighted to the back end of the year. So hopefully, we see a little bit better demand. Some of the freight indices are starting to turn. Market in Europe looks actually pretty strong, which has closed the arb to send gasoline from Europe to the United States, open the arb to send U.S. Gulf Coast diesel to Europe. So I think you'll see some tightening of supply-demand balances in the near-term. And then longer term, we see very little new refining capacity additions with continued demand growth, which should be bullish margins in the long-term."
},
{
"speaker": "John Royall",
"content": "And then my second question is on capital returns. You had another very strong quarter in this quarter, I think you're above 80% of CFO. How do you think about the cadence on the buyback going forward from here? And any thought on leading into the balance sheet for capital returns?"
},
{
"speaker": "Jason Fraser",
"content": "John, this is Jason. I might just ask Homer to answer that one for you."
},
{
"speaker": "Homer Bhullar",
"content": "Sure. So, John, we haven't really had to lean into the balance sheet for shareholder returns. I mean, in fact, if you look back to 2020, we've been able to fund all of our uses of cash, including over $6.5 billion of capital investments. We've paid down over $4 billion of debt and over $17 billion of shareholder returns over that period all through cash flow from operations. In fact, we've actually built cash since 2020. So I think consistent with what we've been guiding to, given the strength in our balance sheet and our current cash position, we continue to lean into buybacks with a payout ratio at 87% for the second quarter and 80% year-to-date. Again, all funded within cash flow despite a lower margin environment. So I think looking forward in periods where the balance sheet is strong as it is now, we've got sustaining CapEx, the dividend and strategic CapEx covered, you can reasonably think about 40% to 50% as a floor and continue to expect any excess free cash flow go towards share buybacks."
},
{
"speaker": "Operator",
"content": "Our next question is from Doug Leggate with Wolfe Research."
},
{
"speaker": "Douglas Leggate",
"content": "Gary, I appreciate all your comments about the macro, but I'm afraid I'm going to ask another one, if you don't mind. Everything you've said makes an enormous amount of sense except for the fact that it seems that globally on a net basis, we're now back to a net surplus in terms of refinery additions compared to right before COVID. And obviously, Dangote is part of that, but we've had whiting come back online and utilization it seems it's now running pretty well. So I'm just curious as to how you think that cleans up. Do we need another turnaround capital event, like a turnaround cycle to see some of those closures? Or do you see it differently?"
},
{
"speaker": "Gary Simmons",
"content": "No, I think we see it the same way. I think you'll see some improvement in economic activity, which will improve diesel demand. And then for us, you've had the impact of Dangote and [Despoc] starting to be absorbed in the market. Offsetting that, there are 600,000 barrels a day of announced refinery closures. We're not sure when the timing of those will actually occur. But as you start to see more refinery rationalization occur, I don't again tighten up the supply-demand balances longer term."
},
{
"speaker": "Douglas Leggate",
"content": "My follow-up is kind of related to that because, I mean, you guys are -- there's no question you guys are and will probably continue to be the cost leader in terms of your system, best-in-class in the U.S. for sure. The issue we're trying to figure out is where the vulnerabilities are across the U.S. in terms of the marginal refinery. And I guess for you guys, we're curious what's going on in the West Coast because just last week, we had the lowest margin since COVID on the West Coast and Benicia is obviously out there. We thought it was going to do better because of TMX. So can you maybe help us understand what is the role of Benicia in the portfolio and what do you see in the West Coast dynamics currently?"
},
{
"speaker": "Lane Riggs",
"content": "Doug, this is Lane. I'll start and then I'll let Gary follow-up on the TMX question. When you think about our portfolio, the West Coast clearly is the highest cost region we operate in. It's just by virtue of everything that goes on in the West Coast, it's the most expensive to operate with. And historically, the way it works there is you have marginal economics and then the balances would be such that you'd have an allergen, you would sort of experienced a period of higher margins, and then it would go back. So it's really almost a call option on West Coast spreads. And it is a harder place to operate is a more expensive place to operate. And so when you look across the U.S., I mean, I would expect that's probably one of the places that you would ultimately see some refinery closures in this shakes out. And then I'll let Gary."
},
{
"speaker": "Gary Simmons",
"content": "Yes. The only thing I'd add to that is we did have the view that with some of the refinery conversions to make renewable fuels that you would see, especially gasoline pretty tight. But if you look from April to the end of June, imports -- gasoline imports into the West Coast were up 70,000 barrels a day. And I think that, combined with a little softer demand is why you're seeing that margin environment on the West Coast that we're seeing today. As far as TMX, TMX started up beginning of May. They didn't load the first cargo out until the end of May. We didn't load our first cargo out until June. So really, any impact you're going to see from TMX wasn't reflected in our second quarter results. You won't start to see that until third quarter."
},
{
"speaker": "Operator",
"content": "Our next question is from Roger Read with Wells Fargo."
},
{
"speaker": "Roger Read",
"content": "Maybe you take a slightly different direction here. Policy wise, at the end of June, the Supreme Court took out Chevron deference and there's a lot of ways to interpret that and some of the other things going on politically with the election. But I was just curious if you had any thoughts about -- on the policy front on that, I guess, you call it judicial front, how that might affect any parts as we think about some of the CAFE standard stuff and then has been mentioned the challenges in getting permits to do things on the expansion side?"
},
{
"speaker": "Richard Walsh",
"content": "This is Rich Walsh. And so, hey, you never get a great legal question like this on our earnings call. So this is exciting. And so I'm going to try not to get too wonky here, but I just -- with Chevron deference, right, the -- under that program, the courts were required to give agencies complete deference as to their interpretations to their own authority. And so it made it really difficult for the judiciary to kind of rein in the administrative state. And so what you see the Supreme Court doing is they really basically restored a meaningful judicial review over this. So that now judges are required to use their best reading of the statute. And while the agencies have historically viewed that they're entitled to this deference and the agencies generally believe they've got the right reading of the statute. I think everybody is going to kind of come to the realization that the range of interpretation that's going to be acceptable is not is not going to be as wide. And you're clearly going to have judges who are empowered now to kind of look at the statute and not just defer to the agency on it. So as a practical matter of how that works is I think you're going to see less agency overreach in terms of how they interpret it and you're certainly going to see less political swings in the agencies in terms of how they often shift back and forth depending on the administration. And then I think if you kind of pair that together with major questions doctrine and you're really looking at kind of trying to -- I think what the court is trying to do is put policy back in the hands of the legislator back in the hands of Congress and not let it be really policy driven at the administrative level. And so -- and just as a practical matter, we've seen that already happen. The Supreme Court sent back nine cases already asking the lower courts to review their decisions in light of not giving deference to the agency. So when you talk about our existing litigations, we really don't talk about the litigation specifically, but I would say you've seen some pretty extreme interpretations here, in particular, the administration taking the position that they, without congressional mandate can go in and mandate electrification of vehicles. That's hard to see how that -- how the courts give them deference on that question. And it's certainly hard to see how that's not already covered under the major questions doctor in the West Virginia case. So I feel like I'm getting a little wonky here. So let me just kind of wrap that up with that thought."
},
{
"speaker": "Roger Read",
"content": "And yes, it is one of those types of topics. So the only follow-up we really had on that, and I think you kind of answered it as the timing to have impacts of this could be like, what the next 12 to 24 months? Or does it take longer?"
},
{
"speaker": "Richard Walsh",
"content": "Well, there's already a California waiver case queued up in front of the Supreme Court on a [certain] petition. Now it was -- the DC circuit dismissed that one based on a standing type issue, but they really were trying to avoid, I think, addressing the underlying question. So it will be -- there's a number of cases coming up. There's a CAFE case that's already been argued in front of the DC circuit that specifically queued up. So I think these changes will happen quicker than people traditionally expect from the judiciary."
},
{
"speaker": "Operator",
"content": "Our next question is from Ryan Todd with Piper Sandler."
},
{
"speaker": "Ryan Todd",
"content": "Maybe one back on refining supply/demand. Clearly, part of the issue in the second quarter here has been supply driven. The system has been running really, really well with high utilization rates. Are you seeing -- just curious if you look at the consumer, are you seeing run cuts across any parts of the globe that you can see have an impact on the supply side. And as you look at your third quarter guidance, it implies lower throughput versus 2Q, is that maintenance? Is there some commercial activity there? Just curious as you see kind of how you see dynamics on the supply side here in the third quarter as a possible tailwind for margins?"
},
{
"speaker": "Greg Bram",
"content": "Ryan, this is Greg. I'll talk about our system. So you do see that our throughput guidance considers planned maintenance activity we have in the quarter. So particularly if you take a look at like the North Atlantic, you see that there. Otherwise, I would just say for our system, we're optimizing our refineries in light of these market conditions, just like we always do. So, some of that might be reflected in the guidance as well. But you can definitely see where the planned maintenance activity is having an impact."
},
{
"speaker": "Ryan Todd",
"content": "And then maybe on a broader question. I mean, you've argued for generally tight global refining markets and probably higher for longer type of mid-cycle margins. Has anything from the 2024 margin environment that we've seen this year change this view? Or do you still view that kind of as consistent with the outlook going forward?"
},
{
"speaker": "Lane Riggs",
"content": "This is Lane. I think if you sort of listen to Gary's opening comments and you think about our -- what we have said is that we do believe going forward, you're going to have a higher margin environment. You're seeing -- we're seeing refinery make cuts what at least we would have historically thought was a mid-cycle and so that -- which is an interesting thing to say, well, there are refineries out there that are seeing marginal economics in the -- historically mid-cycle economic environment. And so that would tell you, we don't know where the lows are. You're telling let's indicate that the call on refining is because of that, there's some thrown that have -- that are cutting in this space. So again, it just reinforces our view that you have a higher margin for our capital and higher mid-cycle going forward."
},
{
"speaker": "Operator",
"content": "Our next question is from Manav Gupta with UBS."
},
{
"speaker": "Manav Gupta",
"content": "My first question is your outlook on the Gulf Coast heavy sour differential looks like OPEC will start adding volumes somewhere in the fourth quarter and then continue to do that in 2025, and then also there is a bigger refining asset in that area, which uses a lot of that crude, which will be hopefully closing down in early 2025. So your outlook -- medium-term outlook for the heavy sour differential on the Gulf Coast."
},
{
"speaker": "Gary Simmons",
"content": "Manav, this is Gary. So I think in the short-term, we've seen heavy sour differentials move a little wider. That was mainly a Mid-Continent refiner that's had a complete power outage that's decreased the demand for Canadian heavy. As we move through the third quarter, you'll see a turnaround activity in the Mid-Continent, especially also decreased demand for Canadian heavy, which is supportive of the differentials. And then longer term, I think the two things you pointed towards, for meaningful, sustainable wider heavy sour differentials, you really need more OPEC production back on the market. We're unsure exactly when that occurs. But yes, our view has been late this year, early next year, you start to see more OPEC barrels on the market, which will create wider heavy sour differentials. The other thing I'd point to is even with where the differentials were in the second quarter, we saw a significant economic uplift by running heavy sour crudes in the second quarter even with where the differential were."
},
{
"speaker": "Manav Gupta",
"content": "My follow-up here is, as you're approaching your completion on the SAF unit, are there any preliminary estimates we should think about how much of an uplift could this change going from early to SAF provide to you guys?"
},
{
"speaker": "Eric Fisher",
"content": "Manav, this is Eric. We were not going to give out like specifics like that. I would say you can look at the various programs, the state programs, the federal tax credits around whether it's BTC or PTC and then the mandate in the EU and the U.K. all kind of give you an indicator of what that uplift will be Argus has got a quote that you can look at. What we would say is that there is a premium of SAF over RD, and it's all going to be give us a margin that will be stronger than RD. And our outlook is that we'll meet the economics of our projects. So all of that looks pretty positive."
},
{
"speaker": "Operator",
"content": "Our next question is from Theresa Chen with Barclays."
},
{
"speaker": "Theresa Chen",
"content": "I wanted to go back to one of Gary's comments earlier on demand across your footprint, the 10% year-over-year uptick on the diesel side, which is not representative of the broader market. Can you give some color on how you've been able to take market share what seems to be on a continued basis at this point?"
},
{
"speaker": "Gary Simmons",
"content": "Well, I guess I'd just say our wholesale team has done a great job for us on growing our market share. And then some of that has also been due to some of the refinery rationalization that took place, especially during the COVID period. It's allowed us to grow our market share as well."
},
{
"speaker": "Theresa Chen",
"content": "And following up on the renewable fuel economics, Eric, can you provide an update on your outlook for the different subsidy prices over the near to medium-term, especially with the election around the corner?"
},
{
"speaker": "Eric Fisher",
"content": "Yes, that's something everyone is trying to figure out and it's a really difficult dart to throw these days. I think one of the things we look at is, the RIN market still looks oversupplied to us. So as we kind of get into the back end of '24, it looks like the RIN market is long, the California LCFS market will remain long and therefore, we think with fat prices starting to increase, we see compression in RD margins in the back half of '24. The policy things that are coming up, LCFS might expand with California. They're still saying that's going to be a 2025 change. The RIN update for 2026 got pushed to March of '25. But with all the expectations that Ag has on the RFS volumes, we expect that will probably be some sort of increase. So I think longer term in sort of the next one to two years, we see a lot of tailwind for DGD in terms of credit prices. Specific to our platform, we are obviously diversifying into SAF. That's going to be a diversification away from RD with -- that includes a premium to RD. So that looks pretty strong. And then the other thing that will be interesting because this is being looked at now is, are we going to have a BTC or PTC transition January 1. And as we've said in the past, the RIN and the BTC have a relationship that previously, when we discussed the BTC going away, we expected the RIN to increase to keep the biodiesel producer at breakeven. So when you think about a BTC to PTC transition where the PTC is less than $1, there is some view that the RIN will have to pick up the difference in order to keep the biodiesel blender breakeven. So you have a little bit of a discussion of the market and the credits look long but the relationship between BTC, PTC and the RIN has always been somewhat of a factor of rebalancing the market. How fast that happens, how soon that happens, the timing of that, given the elections, those are all kind of up in the air. But I think structurally, as you look forward, all of this looks pretty good for DGD."
},
{
"speaker": "Operator",
"content": "Our next question is from Paul Cheng with Scotiabank."
},
{
"speaker": "Paul Cheng",
"content": "I think this is for Gary. Gary, can I go back into your comment. First low in May and so now just two months. So where you can see, do you think the impact on the West Coast market from the TMX is now fully retracted in the marketplace? Or the thing over the several months that we do have solution indication to the crude defense in that market? Secondly, maybe this is either for Gary or for Lane. As the market normalizes, how does it impact the way how your refining operations run in terms of the sustainable maximum run rate crude yield or product yield, whatever that you can give some comments that would be great."
},
{
"speaker": "Gary Simmons",
"content": "Yes. I'll start with TMX, Paul. Yes, I think that it took a little while for the West Coast market to respond to TMX. If you look though at where ANS was trading prior to the TMX start-up, and kind of where September is trading relative to Brent, ANS has come off in the $1.50 to $2 range, which is in line with what we thought the impact TMX would have on West Coast crude costs. I just don't think you'll see that show up until more third quarter."
},
{
"speaker": "Lane Riggs",
"content": "I'll take a shot at the second one. Paul, this is Lane. I don't really see as the world sort of settled on some other places that impacts our operations. We always take signals from the market. We focus on being reliable. We focus on execution. We don't move turnarounds and do things like that based on whether we think the markets good now, not later. Our idea is operational excellence means that we wake up every day, we try to -- where we will execute in a way there were the best operator that we can be, which we think we are the best operator out there. And so we don't really profoundly see any change based on necessarily some sort of different refining outlook."
},
{
"speaker": "Operator",
"content": "Our next question is from Joe Laetsch with Morgan Stanley."
},
{
"speaker": "Joseph Laetsch",
"content": "So on the refining side and on the export side, specifically, would you mind just giving us an update on Mexico? And if I remember right, I think there was a new terminal opening there this year as well."
},
{
"speaker": "Gary Simmons",
"content": "Yes. So this is Gary. I would tell you our volumes to Mexico were down a little bit. We've been fairly consistently sending about 100,000 barrels a day in the second quarter that was more like 87,000 barrels a day. For us, it's just another knob we have in optimizing our Gulf Coast system. And with where PEMEX was pricing the barrels, we had better alternatives. It's not a shift. Moving forward, we do think you'll see some growth in our Mexico volumes. Our terminal that we'll utilize an Altamira will start up before the end of the year. It will allow us to be more competitive in the Northern Mexico market and allow us to continue to grow our volumes there."
},
{
"speaker": "Joseph Laetsch",
"content": "And then shifting over to RD. So I know you talked about this a little bit earlier and feedstock costs have been higher over the past couple of months, but could you just talk about a little bit more about what you're seeing on the feedstock cost side as well as availability here with some of the new start-ups?"
},
{
"speaker": "Eric Fisher",
"content": "Yes. We have noticed that there is growing competition for waste oils, we're still the largest importer of foreign waste oils. So if we look at that they were used -- if I compare it to last year, there was a pretty good arb of foreign feedstocks over domestic feedstocks being more advantaged. What we see that is that's largely incorporated and now domestic feedstocks look to be the most attractive from a cost standpoint. From a CI standpoint, those are still all the most advantaged feedstocks for RD, but we do see overall particularly waste oil feedstocks starting to increase. So I would say it looks like feedstock prices have bottomed out here in the second quarter. They're starting to trend up a little bit in the third quarter, largely attributed to some of the start-ups that we see in California."
},
{
"speaker": "Operator",
"content": "Our next question is from Neil Mehta with Goldman Sachs."
},
{
"speaker": "Neil Mehta",
"content": "Staying on refining, I just love your guys perspective on the coking market, especially in light of Port Arthur coming online, which was a really good asset. And just your perspective on fuel oil and the opportunity around how of coking and how that those margins can start to normalize over time? What's the sequence of events that we'll get back to tap?"
},
{
"speaker": "Greg Bram",
"content": "Neil, this is Greg. So we still see good value in coking margins. Gary talked about where the heavy sour crude market has been. That's with our coker online and with the industry running the way it has. So I don't think that we see something that's a big step change going forward. As Gary mentioned, as you put -- as you get some more medium sour, heavy crude into the market later this year that should enhance that value. But right now, it's still a strong opportunity for us still beats our other modes of operation and something we're looking to maximize."
},
{
"speaker": "Neil Mehta",
"content": "And then the follow-up is around Asia and specifically around China, as we look at oil demand data, one of the things that disappointed our model has been Chinese domestic demand. Do you see it -- as you look at the data, and that's a part of the contribution to some of the softness in PADD 5 and in the Asian refining margin lift in the absence of strong Chinese demand?"
},
{
"speaker": "Gary Simmons",
"content": "Neil, this is Gary. We don't have a lot of visibility into the markets in the Far East. But I would tell you, certainly, what you read is in China, especially diesel demand is down. We see as much as 10% a lot less construction activity there. But for the most part, it looks like they've adjusted refinery runs to say somewhat balanced on exports. Now we would say exports are up slightly. But for the most part, they've adjusted refinery runs to balance demand, and we haven't seen a significant step change in their exports."
},
{
"speaker": "Operator",
"content": "Our next question is from Jason Gabelman with TD Cowen."
},
{
"speaker": "Jason Gabelman",
"content": "I wanted to go back to the wholesale channel growth. And it's been pretty consistent over the past few years. And I'm wondering, if you can provide some sort of earnings estimate in terms of an uplift from selling through that channel relative to maybe some pre-COVID period or other baseline you have available and if you expect that growth to continue?"
},
{
"speaker": "Gary Simmons",
"content": "Yes. The only comment, we don't really give a lot of detail around our wholesale margins. Obviously, the growth is because that's our most -- the positive netback for our Gulf Coast system and our U.S. system, and that's why we continue to push it to grow. So that should be reflected in capture rates going forward, but we don't really give a lot of detail on what those margins are."
},
{
"speaker": "Jason Gabelman",
"content": "Can you provide on a volumetric basis, how much it's grown and how much more you think you could push to that channel?"
},
{
"speaker": "Gary Simmons",
"content": "Yes, I can, roughly. I mean, you look three years ago, we were fairly consistently in the 850,000 barrel range and now over 1 million barrels a day. So somewhere in the neighborhood of 150,000 barrels a day of growth in wholesale is what I'd tell you over the last few years."
},
{
"speaker": "Homer Bhullar",
"content": "Jason, there's a page, I think Page 24 in the deck, which goes all the way back to 2012 for more color."
},
{
"speaker": "Jason Gabelman",
"content": "And then just specifically on results in refining. I think co-products were a pretty decent headwind to capture. I'm wondering how much that shaved off capture rates in 2Q and if you're seeing any reversal of those headwinds going into 3Q, especially as crude has started to fall?"
},
{
"speaker": "Greg Bram",
"content": "Yes, Jason, this is Greg. You're right. That was a headwind. I don't know if I have the exact amount. And that will come and go over time, certainly was working against us in the second quarter."
},
{
"speaker": "Operator",
"content": "Our next question is from Matthew Blair with Tudor, Pickering & Holt."
},
{
"speaker": "Matthew Blair",
"content": "Maybe just sticking on capture. I think it makes sense that your capture was lower quarter-over-quarter just due to those challenges in the co-products, at the same time, I believe that the Q2 capture was the lowest absolute number in like five or year years. So has anything changed structurally on your capture compared to even just like last year?"
},
{
"speaker": "Greg Bram",
"content": "So this is Greg. Yes, there were a few things going on in the second quarter that I think had some impact specific to this period. One, we always talk about the seasonal RVP change in gasoline and how that can have a negative impact on margin capture as you pull the butane out of the gasoline that you were able to do in the winter time. So certainly, that was a piece. We also saw crude market backwardation fairly strong in second quarter, which impacts crude cost, the acquisition cost for crude. Yes, it was probably $0.80 to $0.90 a barrel relative to prior quarter and even looking back at some of the other periods in time. We talked about the co-products, naphtha propylene in particular. And I think the other thing maybe worth noting that is a bit unique to the second quarter, we always pride ourselves on being able to go secure some of those opportunity feedstocks that we can run in our system, particularly in our Gulf Coast system with all the flexibility we have there. And I would just tell you in the second quarter, just the way the market played out, there just wasn't a lot of that opportunity to be had, not that we weren't looking for it. It's just the way kind of the market shaped up. And so that's a bit unique from what we've seen in the past. And I would expect we'd see those kind of opportunities when we look forward going in future periods."
},
{
"speaker": "Matthew Blair",
"content": "And then on the ethanol side, if I could ask, how sustainable do you think this recent uptick in ethanol margins is? And also, is there an update on the Summit carbon capture project? When do you expect that to start up and benefit your ethanol plants?"
},
{
"speaker": "Eric Fisher",
"content": "Sure. On the ethanol side, this increased margin is really a result of cheap natural gas prices as well as cheap corn. If you look at all of the carryout numbers for this year, with Brazil having a record crop, the U.S. having a record crop forecasted, the carryout is going to be pretty large. That means we're still carrying a fairly large inventory of corn from last year. The harvest that's coming up is going to be another large inventory. So we -- so I see corn fairly cheap barring weather event between now and harvest or something dramatic in Brazil. So I think the -- I'm positive on the ethanol outlook for the next -- for this -- the rest of this year and into next year. After that, it's always harvest to harvest of what the next outlook will look like after that. As far as Summit, that's not our project. That's really a question for Summit. They just got their approval in Iowa. We still view carbon sequestration as a supportive strategy for ethanol, but that's -- we're just a shipper on that project. So if and when that gets put in the ground where we'll happily hook up to it and provide volume into that system, but we don't really have a whole lot of insight into the project itself."
},
{
"speaker": "Operator",
"content": "We have reached the end of our question-and-answer session. I would like to turn the conference back over to Homer for closing remarks."
},
{
"speaker": "Homer Bhullar",
"content": "Great. Thank you. I appreciate everyone joining us today. As always, feel free to contact the IR team if you have any additional questions. Thank you, and have a great week."
},
{
"speaker": "Operator",
"content": "Thank you. This will conclude today's conference. You may disconnect your lines at this time and thank you for your participation."
}
] |
vlo | 2,024 | 1 | [
{
"speaker": "Operator",
"content": "Greetings, and welcome to the Valero Energy Corp. First Quarter 2024 Earnings Conference. [Operator Instructions] As a reminder, this conference is being recorded. It is now my pleasure to introduce your host, Homer Bhullar, Vice President, Investor Relations and Finance. Thank you. Please go ahead."
},
{
"speaker": "Homer Bhullar",
"content": "Good morning, everyone, and welcome to Valero Energy Corporation's First Quarter 2024 Earnings Conference Call. With me today are Lane Riggs, our CEO and President; Jason Fraser, our Executive Vice President and CFO; Gary Simmons, our Executive Vice President and COO; and several other members of Valero's senior management team."
},
{
"speaker": "",
"content": "If you have not received the earnings release and would like a copy, you can find one on our website at investorvalero.com. Also attached to the earnings release are tables that provide additional financial information on our business segments and reconciliations and disclosures for adjusted financial metrics mentioned on this call."
},
{
"speaker": "",
"content": "If you have any questions after reviewing these tables, please feel free to contact our Investor Relations team after the call."
},
{
"speaker": "",
"content": "I would now like to direct your attention to the forward-looking statement disclaimer contained in the press release. In summary, it says that statements in the press release and on this conference call that state the company's or management's expectations or predictions of the future are forward-looking statements intended to be covered by the safe harbor provisions under federal securities laws. There are many factors that could cause actual results to differ from our expectations, including those we've described in our earnings release and filings with the SEC."
},
{
"speaker": "",
"content": "Now I'll turn the call over to Lane for opening remarks."
},
{
"speaker": "Lane Riggs",
"content": "Thank you, Homer, and good morning, everyone. We are pleased to report strong financial results for the first quarter despite heavy planned maintenance across our refining system. Our team's ability to optimize and maximize throughput while undertaking maintenance activities illustrates the benefits from our long-standing commitment to safe and reliable operations."
},
{
"speaker": "",
"content": "Refining margins remain supported by tight product balances with supply constrained by seasonally heavy refining turnarounds and geopolitical events. Product demand was strong across our wholesale system with diesel demand higher and gasoline demand about the same as last year."
},
{
"speaker": "",
"content": "We continue to execute strategic projects and enhance earnings capability of our business and expand our long-term competitive advantage. DGD sustainable aviation fuel or SAF project at Port Arthur is progressing ahead of schedule and is now expected to be operational in the fourth quarter of 2024."
},
{
"speaker": "",
"content": "With the completion of this project, Diamond Green Diesel is expected to become one of the largest manufacturers of SAF in the world. In addition, we are pursuing shorter cash cycle projects that optimize and capitalize on opportunities and improve margins around our existing refining assets. These projects are focused on increasing feedstock flexibility, optimizing the value of our product mix and maximizing utilization of existing conversion capacity."
},
{
"speaker": "",
"content": "On the financial side, we were paid the $167 million outstanding principal amount of our 1.2% senior notes that matured on March 15. And in January, we increased the quarterly cash dividend on our common stock from $1.02 per share to $1.07 per share."
},
{
"speaker": "",
"content": "Looking ahead, we expect refining margins to remain supported by tight product balances and seasonably low product inventories ahead of the driving season. Longer term, product demand is expected to exceed supply even with the startup of new refineries this year and the limited announced capacity additions beyond 2025."
},
{
"speaker": "",
"content": "In closing, we remain focused on things that have been in the hallmark of our strategy, maintaining operating excellence, executing our projects well, disciplined around our capital investments and our commitment to shareholder returns."
},
{
"speaker": "",
"content": "So with that, Homer, I'll hand the call back to you."
},
{
"speaker": "Homer Bhullar",
"content": "Thanks, Lane. For the first quarter of 2024, net income attributable to Valero stockholders was $1.2 billion or $3.75 per share compared to $3.1 billion or $8.29 per share for the first quarter of 2023."
},
{
"speaker": "",
"content": "First quarter 2024 adjusted net income attributable to Valero stockholders was $1.3 billion or $3.82 per share compared to $3.1 billion or $8.27 per share for the first quarter of 2023. The refining segment reported $1.7 billion of operating income for the first quarter of 2024 compared to $4.1 billion for the first quarter of 2023."
},
{
"speaker": "",
"content": "Refining throughput volumes in the first quarter of 2024 averaged 2.8 million barrels per day. Throughput capacity utilization was 87% in the first quarter of 2024. Refining cash operating expenses were $4.71 per barrel in the first quarter of 2024 lower than guidance of $5.10 per barrel, primarily attributed to lower energy costs and higher throughput."
},
{
"speaker": "",
"content": "Renewable Diesel segment operating income was $190 million for the first quarter of 2024 compared to $205 million for the first quarter of 2023. Renewable diesel sales volumes averaged 3.7 million gallons per day in the first quarter of 2024, which was 741,000 gallons per day higher than the first quarter of 2023."
},
{
"speaker": "",
"content": "The higher sales volumes in the first quarter of 2024 were due to the impact of additional volumes from the DGD Port Arthur plant which started up in the fourth quarter of 2022 and was in the process of ramping up rates in the first quarter of 2023."
},
{
"speaker": "",
"content": "Operating income was lower than the first quarter of 2023 due to lower renewable diesel margin in the first quarter of 2024. The ethanol segment reported $10 million of operating income for the first quarter of 2024 compared to $39 million for the first quarter of 2023."
},
{
"speaker": "",
"content": "Adjusted operating income was $39 million for the first quarter of 2024. Ethanol production volumes averaged 4.5 million gallons per day in the first quarter of 2024, which was 283,000 gallons per day higher than the first quarter of 2023."
},
{
"speaker": "",
"content": "For the first quarter of 2024, G&A expenses were $258 million, net interest expense was $140 million, depreciation and amortization expense was $695 million and income tax expense was $353 million. The effective tax rate was 21%. Net cash provided by operating activities was $1.8 billion in the first quarter of 2024. Included in this amount was $160 million unfavorable impact from working capital and $122 million of adjusted net cash provided by operating activities associated with the other joint venture member share of DGD."
},
{
"speaker": "",
"content": "Excluding these items, adjusted net cash provided by operating activities was $1.9 billion in the first quarter of 2024. Regarding investing activities, we made $661 million of capital investments in the first quarter of 2024, of which $563 million was for sustaining the business, including costs for turnarounds, catalysts and regulatory compliance and the balance was for growing the business."
},
{
"speaker": "",
"content": "Excluding capital investments attributable to the other joint venture member share of DGD and other variable interest entities, capital investments attributable to Valero were $619 million in the first quarter of 2024."
},
{
"speaker": "",
"content": "Moving to financing activities. We returned $1.4 billion to our stockholders in the first quarter of 2024, of which $356 million was paid as dividends and $1 billion was for the purchase of approximately 6.6 million shares of common stock resulting in a payout ratio of 74% for the quarter. Through share repurchases, we have reduced our share count by over 20% since year-end 2021."
},
{
"speaker": "",
"content": "With respect to our balance sheet, as Lane mentioned, we repaid the $167 million outstanding principal amount of our 1.2% senior notes that matured on March 15. We ended the quarter with $8.5 billion of total debt, $2.4 billion of finance lease obligations and $4.9 billion of cash and cash equivalents."
},
{
"speaker": "",
"content": "The debt-to-capitalization ratio, net of cash and cash equivalents was 17% as of March 31, 2024. And we ended the quarter well capitalized with $5.3 billion of available liquidity, excluding cash."
},
{
"speaker": "",
"content": "Turning to guidance. We still expect capital investments attributable to Valero for 2024 to be approximately $2 billion, which includes expenditures for turnarounds, catalysts, regulatory compliance and joint venture investments. About $1.6 billion of that is allocated to sustaining the business and the balance to growth with approximately half of the growth capital towards our low carbon fuels businesses and half towards refining projects."
},
{
"speaker": "For modeling our second quarter operations, we expect refining throughput volumes to fall within the following ranges",
"content": "Gulf Coast at 1.79 million to 1.84 million barrels per day. Mid-Continent at 410,000 to 430,000 barrels per day. West Coast at 245,000 to 265,000 barrels per day and North Atlantic at 430,000 to 450,000 barrels per day."
},
{
"speaker": "",
"content": "We expect refining cash operating expenses in the second quarter to be approximately $4.55 per barrel. With respect to the renewable diesel segment, we expect sales volumes to be approximately 1.2 billion gallons in 2024. Operating expenses in 2024 should be $0.45 per gallon, which includes $0.18 per gallon for noncash costs such as depreciation and amortization."
},
{
"speaker": "",
"content": "Our Ethanol segment is expected to produce 4.5 million gallons per day in the second quarter. Operating expenses should average $0.38 per gallon, which includes $0.05 per gallon for noncash costs such as depreciation and amortization."
},
{
"speaker": "",
"content": "For the second quarter, net interest expense should be about $140 million and total depreciation and amortization expense should be approximately $710 million. For 2024, we expect G&A expenses to be approximately $975 million."
},
{
"speaker": "",
"content": "That concludes our opening remarks. [Operator Instructions]."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Today's first question is coming from Theresa Chen of Barclays."
},
{
"speaker": "Theresa Chen",
"content": "I want to get a sense of your product supply and demand outlook from here, maybe talking on Lane's earlier comments. And specifically, what is happening with respect to diesel and jet margins from the recent pullback? And where do you think we'll go from the here?"
},
{
"speaker": "Gary Simmons",
"content": "It's Gary. I can -- I'll give you some insight as to what we're seeing in the market today and then some thoughts on your final question. Overall, we continue to see strong light product demand. In our system, we've seen gasoline sales trending at levels equal to last year. Diesel sales in our system are actually trending about 2% higher than last year."
},
{
"speaker": "",
"content": "So I think when we look at all the data, we would expect gasoline demand to be flat to slightly up from last year. Vehicle models travel data is encouraging, would indicate we could see some gasoline demand surprise to the upside."
},
{
"speaker": "",
"content": "Diesel demand flat to slightly down compared to last year. However, again, some of the freight indices appear to be turning and indicate we could start seeing better demand. And then jet fuel demand up year-over-year."
},
{
"speaker": "",
"content": "I think that isn't really consistent with the sell-off in distillates like you're seeing. And I think some of that's just attributable to the fact that the market appears to be reacting to headlines. So in particular, you have the drone attacks in Russia, diesel gets very strong."
},
{
"speaker": "",
"content": "But then there's a lag in the supply chain. So the physical markets aren't really seeing that interruption in diesel. In fact, Russian exports following the drone attacks was actually higher. And so now we're finally getting to the point where Russian exports are starting to fall off, but the markets have kind of dismissed that, and we've sold off pretty hard."
},
{
"speaker": "",
"content": "I think diesel is too weak. And the 2 things I would point to on diesel being too weak, hydroskimming margins in Europe are negative, cracking margins in Singapore are negative and unless something significant has happened on the demand side that we don't see, we need that capacity to run, which would indicate margins are going to have to get stronger from here on."
},
{
"speaker": "Theresa Chen",
"content": "Really helpful. And maybe following up on the point about Russia, and I appreciate you going through the dynamics on the diesel exports and such. Maybe looking at the naptha side of things. So if the naptha export starts to fall off as well, what does that imply for octane economics? And in light of maybe more naphtha from some of the new refining capacity added, like what is the net impact and the translation to gasoline margins as a result?"
},
{
"speaker": "Gary Simmons",
"content": "Yes. So I think in order to see any meaningful changes in the price of naphtha or discount to gasoline, you really need to see pet-chem demand pick back up for naphtha and a lot of that is just tied to crude flat price. As long as crude flat price is high, it's hard for naphtha to compete as a feedstock into pet-chems."
},
{
"speaker": "",
"content": "And so when that happens, then naphtha is trying to find a home into gasoline, which creates strong octane in order to be able to get it blended into the gasoline pool."
},
{
"speaker": "Operator",
"content": "The next question is coming from Neil Mehta of Goldman Sachs."
},
{
"speaker": "Neil Mehta",
"content": "Another really strong quarter. And I wanted to ask about the cash flow payout as you're well above the numbers that you've targeted as the floor and so I guess the $1 billion of repurchase level, do we view that as a sustainable run rate? And how do you think about how investors should anchor to a payout guidance?"
},
{
"speaker": "Jason Fraser",
"content": "Neil, this is Jason. I'm going to ask Homer to address that question."
},
{
"speaker": "Homer Bhullar",
"content": "Yes, Neil, I think given the strength of our balance sheet in the first quarter and the fact that we're not really looking to build more cash, we had a pretty strong payout at 74%. And you'll remember, last quarter was 73%, which ended the year at 60%. So I think you can think of the 40% to 50% range as a long-term through-cycle commitment."
},
{
"speaker": "",
"content": "But in periods where fundamentals are strong, balance sheet is good, like it is now, and sustaining growth CapEx and the dividend is covered, you can think of that as a floor. So the 40% to 50% as a floor and I think reasonably expect any excess cash flow to continue to go towards buybacks."
},
{
"speaker": "Neil Mehta",
"content": "Okay. That's helpful, Homer. And then follow-up is just on DGD. There was a pull forward of the SAF projects. So it looks like project is tracking well for '24 start-up. So just how -- once it comes into service, what's the back of the envelope of how we should think about the incremental economics? And what type of premium margins do you think you could sustain on SAF barrels?"
},
{
"speaker": "Eric Fisher",
"content": "Yes, this is Eric. The project -- like you said, the project construction is going well. Start-up will be in the fourth quarter. As far as what we see in uplift, I think if you look to see what the state and federal tax program benefits are, there's a lot of credits that have been stated in the IRA, whether it's 45Z or BTC or PTC. And then in Europe, you've got the Argus quote that I'll kind of give you a good feel of what that product is going to be worth."
},
{
"speaker": "",
"content": "We've got strong interest in sales, and we do not see a problem moving it at returns that are going to meet our project return threshold."
},
{
"speaker": "Operator",
"content": "The next question is coming from Roger Read of Wells Fargo."
},
{
"speaker": "Roger Read",
"content": "Yes. Probably to come back on some of the macro stuff here. Crude differentials, we've got some, I guess, discipline out of OPEC, we've got TMX starting up, I guess, almost any day now, we have some tightness from some other places that typically have exported heavier crudes to the Gulf Coast. So just curious what you're seeing on the crude, call it, availability front and expectations on differentials?"
},
{
"speaker": "Gary Simmons",
"content": "Yes, Roger, this is Gary. I think we saw crude differentials move a little bit wider in the first quarter, which we expected and that was mainly just driven by demand with heavy turnaround season in the U.S. Gulf Coast. Demand was off a little bit and allowed the differentials to widen."
},
{
"speaker": "",
"content": "But we believe that the differentials will be relatively tight through most of the year until you get the OPEC production back on the market. At least the consultant supply-demand balances would indicate maybe third or fourth quarter of this year you'll start to see OPEC production ramp back up. I would tell you, we're not having any trouble in terms of availability of feedstock, it's just more narrow differentials than what we would like."
},
{
"speaker": "Roger Read",
"content": "Fair enough. And then to follow up on your earlier comments about the structure of the diesel market, the need for cracks to go up. This time last year, we saw gasoline, for a little while, move above -- gasoline cracks move above diesel cracks, we have that seasonally again. But is there any reason that you would lean into a max gasoline over a max diesel or a blended sort of outlook relative to what you've been doing over the last couple of years here?"
},
{
"speaker": "Gary Simmons",
"content": "No. I think a lot of that gets driven by availability of intermediate feedstocks, VGO. In a tight VGO market, then you're kind of forced more to swing either gasoline or diesel. So far, availability of VGO has been okay. We've been able to fill all the conversion units, but we'll have to see how that goes moving forward."
},
{
"speaker": "Operator",
"content": "The next question is coming from Manav Gupta of UBS."
},
{
"speaker": "Manav Gupta",
"content": "Congrats on a strong quarter again, guys. My first question here is the bear thesis on refining somewhere was [indiscernible] and it looks like it's not played out these assets from what we read and hear, one of them doesn't have enough hydrogen, the other doesn't even have an FCC. So most likely will not be providing products to the market, maybe even year-end 2024."
},
{
"speaker": "",
"content": "But my point is, even if they do start providing the products to the market somewhere in 2025, are these the last 2 ones that you are aware of or there's a big wave coming after this? So I'm trying to understand is, even if these 2 come on, they don't really change the global supply dynamics. So after this, again, we could see the market tightening up again. So if you could help us out there?"
},
{
"speaker": "Gary Simmons",
"content": "Yes. So we see it exactly like you've described. This year was the year where you had kind of a peak in terms of new capacity additions. And then from this point forward, you get to where global petroleum demand outpaces new refinery capacity additions significantly, and we see several years of tightness."
},
{
"speaker": "Manav Gupta",
"content": "Perfect. The other point is that we generally see big projects get delayed, cost overruns, you are somewhere unique. Your projects get announced and the actual start date keeps moving forward from the announcement, which is absolutely unique to you. And I'm just trying to understand like -- how are you doing this? And I'm hoping I get an answer which is more than we have the best people because we already know that. So help us understand how are you pulling forward your projects?"
},
{
"speaker": "Lane Riggs",
"content": "Manav, it's Lane. That's what I was going to say. But it speaks to the culture. Our culture is very much about high discipline, high accountability and teamwork. We make sure we get the right people into the right jobs and hold them accountable and making sure that they're -- and when I say the right people, they have to be people who are, a, competent; and b, they're willing to work with the other team members who may not necessarily be under them or adjacent to them and ultimately working on behalf of Valero."
},
{
"speaker": "",
"content": "And we have a high level of visibility with upper-level management because we're a pretty flat organization. So we all know the status of the projects. We all understand where we are in the development cycle and anything -- once the project starts. But I mean it's not like there's -- ultimately, it's about alignment, competency and accountability and that's really the secret sauce. You just got to execute."
},
{
"speaker": "Operator",
"content": "The next question is coming from Ryan Todd of Piper Sandler."
},
{
"speaker": "Ryan Todd",
"content": "Maybe a follow-up a little bit on some of the crude mix questions from earlier. I mean with TMX, there's a lot of focus on what the impact is going to be, particularly on complex Mid-Con refineries that are going to have to run more light sweet crude going forward."
},
{
"speaker": "",
"content": "But in some ways, it's similar to what's happened across the broader refining system that's been running more and more light crude across a system that's not always optimized for this. I mean can you talk about what you think this might mean for the optimization of the global refining system with more light sweet crude, what sort of impact does this have on utilization or optimization or general supply as we think about broader market?"
},
{
"speaker": "Gary Simmons",
"content": "Yes. So this is Gary. So globally, TMX doesn't have that much of an impact. It's just rebalancing the barrels. I think you see some of the heavier barrels from South America that were going to the West Coast won't travel there and they'll probably go more to the Far East and some more TMX barrels starting to go to the West Coast."
},
{
"speaker": "",
"content": "So globally, not a big impact. We definitely see that hard-to-see differentials will come in because for a period of time here, we'll have the logistics to completely clear Western Canadian production and that could cause some switching of Mid-Continent refiners that they back off on some of the heavies and go to a lighter diet."
},
{
"speaker": "",
"content": "And yes, to your -- basically to your comment, certainly in the Gulf Coast as we try to run a lighter diet that's resulted in lower overall utilization because we hit light limits on the crude units."
},
{
"speaker": "Ryan Todd",
"content": "And that's probably something that's happening on a broader sets across the system with general global crude mix being lighter, right?"
},
{
"speaker": "Gary Simmons",
"content": "Yes. I think overall, the average crude gravity is up about 1.5 numbers, which certainly results in lower utilization because especially most new capacity all was designed for medium and heavy sour crudes."
},
{
"speaker": "Ryan Todd",
"content": "Maybe switching gears to Diamond Green Diesel. I mean as you think about the broader -- obviously, we've been through a soft spot here on renewable diesel margin with RINs and LCFS pricing low. As you think about the outlook into the back part of this year and into 2025, can you maybe walk through how you view some of the moving pieces that could tighten up that market and improve kind of the relative profitability of whether it's renewable diesel or then eventually SAF in 2025?"
},
{
"speaker": "Gary Simmons",
"content": "Yes. I think the rest of this year, it's really going to be a question of what some of the other startups look like. We've seen in the news, a lot of announcements of slowdowns, project delays, even some shutdowns. If that capacity comes off-line or slows down, how does that balance versus some of the projects that are starting up in the overall D4 RIN balance at the end of the year?"
},
{
"speaker": "",
"content": "It's a little difficult to throw a dart and know exactly how that's going to end. What we can see is veg oil, whether it's BD or RD is negative. Ag products all look very long right now. We do see -- we were expecting more competition on waste oils. We haven't seen as much of that as we thought we would considering the announced start-ups. So how that balances out for the rest of the year, the thing there is we don't see any change in the RVO obligations. So it's still a question of how much capacity is going into a fixed credit bank in a fixed obligation."
},
{
"speaker": "",
"content": "And so longer term, if you look at '25, I would think the long-term outlook of RD is still positive because you look at the number of LCFS programs that are still being contemplated by legislation this year, the ramps in Canada and the U.K. continue to be strong. The SAF mandates that are kicking in, in 2025 in Europe, the U.K. are going to create demand."
},
{
"speaker": "",
"content": "And for us, diversification of your product away from California and your ability to diversify your product slate into SAF are going to be very beneficial to DGD. So I still like the longer-term outlook of '25 and beyond. '24 is a little hard to predict. I think it's still -- it probably still stays long in the D4s, net-net. So it might continue to be sort of a tough year."
},
{
"speaker": "",
"content": "We think the second quarter from a margin standpoint looks a little better from price lag standpoint, but the back half is still hard to tell with all the moving pieces. But long term, I think you still see a positive outlook, sort of '25 and beyond."
},
{
"speaker": "Operator",
"content": "The next question is coming from John Royall of JPMorgan."
},
{
"speaker": "John Royall",
"content": "So my first question is on turnarounds, I guess, for Valero and maybe in terms of expectations for the broader industry. Given you and others had a heavy turnaround quarter in the spring, should we expect a lighter fall season and maybe that global supply won't come on as expected, but we could see more supply in the second half coming out of the U.S. because it just lower turnaround than usual?"
},
{
"speaker": "Greg Bram",
"content": "John, this is Greg Bram. I'll talk about our turnaround activity. Particularly, in the first quarter, we had a pretty heavy turnaround load. You can really see that when you look at our throughput, particularly the Gulf Coast through being much lower. It's just reflective of the work that we had going on."
},
{
"speaker": "",
"content": "Looking forward, as you know, we've always got turnaround activity going on in our system to varying degrees. The first quarter tends to be the heaviest period, other periods of the year will be lighter, and that's just kind of driven by what we see from a margin standpoint. And there are certain times of the year like the holiday season where you're tending not to try to go into that kind of work that's very intensive."
},
{
"speaker": "",
"content": "As far as different periods of time, I won't speak so much to our plans. We have the same information others see about industry turnarounds. It looks like the fourth quarter will be kind of more in the typical range of outages, but it's early to tell. A lot of things will change between now and when we get to the fall season and so we'll see where that lands. But people at least are indicating something that looks like the more typical turnaround level of activity."
},
{
"speaker": "John Royall",
"content": "Great. And then I just had a follow-up on Neil's question on returns of capital and probably for Jason or Homer. You're essentially at a full free cash flow payout now. That's what we saw in the first quarter and Homer's comments suggested that -- that's the expectation going forward."
},
{
"speaker": "",
"content": "I know you've characterized the 40% to 50% of the floor, but is there any thought to changing that framework given that you have your balance sheet where you want it and you seem to be kind of in this new era on returns of capital that don't seem to be kind of peeling back to the old way of looking at things?"
},
{
"speaker": "Jason Fraser",
"content": "Well, this is Jason. Yes, I can take a stab at that. I mean, we do think about that. And really, we ask you to look more at our actions rather than that statement and -- because we've been above it in the majority of time over the past several years. But we also view that more as a long-term indication through the cycle."
},
{
"speaker": "",
"content": "I know we talk about sometimes that's a target and it is, but we don't see any problem with being above it over a consistent period of time, and you should expect us to kind of behave as you said, the last couple of quarters are probably the best indication of the future is how we're going to behave with regard to cash."
},
{
"speaker": "Operator",
"content": "The next question is coming from Jo Laetsch of Morgan Stanley."
},
{
"speaker": "Joseph Laetsch",
"content": "Congrats on a strong quarter. So I wanted to go back to SAF. Are you seeing enough demand from customers to potentially support an additional project? And then if so, would this -- would any potential announcement come after the first facility is online? Just trying to think about timing overall."
},
{
"speaker": "Eric Fisher",
"content": "Yes. I think the -- what we're seeing in terms of the commercial interest exceeds our current capacity with the first project. As we've said, we're doing engineering on the second project. In terms of timing, that's always for us, that's always an issue that we're not going to talk about that until we've decided internally on committing to that."
},
{
"speaker": "",
"content": "But what I'd say from a macro view, you could clearly -- the units are cookie cutters of each other. The project is nearly identical, the execution time and all of that is going to be very similar. So it's not a technically challenging project or something that would be difficult to fund. It's a question of how we see this market develop and when we decide internally is when we would say something externally."
},
{
"speaker": "Joseph Laetsch",
"content": "Great. Yes, that makes sense. And then I was hoping to go back and dig into your comments on Asia refining dynamics earlier, just given the decline in margins that we've seen over the past couple of months. Do you think we're close to a floor over there? And then we've also seen China exports tick up in recent months, how do you think that's been impacting U.S. margins?"
},
{
"speaker": "Gary Simmons",
"content": "Yes. So I think my comment there, when you have cracking margins in Singapore negative and you have hydroskimming margins in Europe negative, it kind of tells you we've hit a floor, we need the capacity to run and I think you'll see margins start to tick back up."
},
{
"speaker": "Operator",
"content": "The next question is coming from Paul Cheng of Scotia."
},
{
"speaker": "Paul Cheng",
"content": "The first question, I think, is either for Gary or for Lane. Peer mix start up, and so that's going to bring the WCS, which is mostly the main mix in [indiscernible] heavy oil with really heavy [indiscernible] barrels and [indiscernible]. So when that happens, will your system be able to convert all your -- if the price is right, can your system convert all your heavy intake and the medium intake into using a some form of combination of WCS plus some light barrel or that is not as simple? And also whether the industry will be able to, say, eliminate all the import from the heavy barrel from, say, [indiscernible] from the Middle East, replacing with WCS? That's the first question."
},
{
"speaker": "Gary Simmons",
"content": "Yes, Paul, this is Gary. I think what we anticipate there's a lot of coking capacity on the West Coast. I'll just use our Benicia refinery as an example. Benicia was really designed to run A&S. And we think with the barrels that are coming off TMX both the heavies and the lights, you'll be able to blend those together to form something that looks a lot like A&S. And we would expect most West Coast refiners will be doing something similar to that."
},
{
"speaker": "Paul Cheng",
"content": "Okay. And second question then, Gary, can you give us some maybe your [ comments ] that what you see in the Mexican market for both gasoline and diesel?"
},
{
"speaker": "Gary Simmons",
"content": "Yes. So our sales in Mexico have been consistent with historic levels. We're selling just over 100,000 barrels a day. We expect demand in Mexico remains very strong. We would expect to see that kind of ramp up later this year when we get our marine terminal in Altamira up and running, that will make us more competitive in the north and allow us to continue to grow volumes in Mexico."
},
{
"speaker": "Paul Cheng",
"content": "Gary, do you have an export number you can share in the first quarter."
},
{
"speaker": "Gary Simmons",
"content": "Yes. So we did 103,000 barrels a day of gasoline exports. We did 153,000 barrels of diesel exports and 25,000 barrels a day of jet exports. The diesel number in the first quarter was down year-over-year, quarter-over-quarter, and I wouldn't read that as lack of demand. That was really a result of the heavy turnaround activity and just we didn't have barrels available for export."
},
{
"speaker": "Operator",
"content": "The next question is coming from Matthew Blair of Tudor, Pickering, Holt."
},
{
"speaker": "Matthew Blair",
"content": "Could you talk about your M&A appetite for refining assets? I think it's been about a decade since you did a major deal. Has anything changed regarding your overall outlook on M&A?"
},
{
"speaker": "Lane Riggs",
"content": "This is Lane. Not really. I mean we always look at everything. I mean if you look at the most prompt sort of big deal that's out there [indiscernible] we sorted as a corporation decided not to engage in that. For whatever reason, whoever the successful buyer they can sort everything out wants to liquidate some of the assets, we'll certainly look at them at that time."
},
{
"speaker": "",
"content": "But in terms of philosophy, we look at everything, but we also, as a company, because we have done so much buying refineries and merging and acquiring, we understand the full cost to make a refinery run it and certainly at the level that we expect. And so ultimately, that goes into the to our valuation models."
},
{
"speaker": "Operator",
"content": "The next question is coming from Jason Gabelman of TD Cowen."
},
{
"speaker": "Jason Gabelman",
"content": "I had 2 market-based questions. The first, just wanted to get a sense of what you're seeing on the West Coast as we move into the summer now that another asset will be permanently shut down there? Are you seeing ratable exports coming from overseas product-wise into that market or do you expect kind of heightened volatility and elevated prices there?"
},
{
"speaker": "Gary Simmons",
"content": "Yes. So this is Gary. I would tell you, in the first quarter, we saw a little lower demand, at least in our system, California for gasoline, which I think was related to weather. We've seen demand kind of return to normal patterns. And it's very difficult to just speculate and put barrels on the water to import the California market."
},
{
"speaker": "",
"content": "So we don't think a lot of people are doing that, and you need to see the market react before you would go ahead and put barrels on the water for import into California. So we think there will be a lot of volatility and it really is all dependent on how refineries on the West Coast run throughout the driving season."
},
{
"speaker": "Jason Gabelman",
"content": "Got it. And then my second question, just going back to the commentary around the global lighting crude slate. And you had previously made a comment that crude gravity over the past few years has gone up 3 to 4 points and that's maybe reduced global capacity available by 3 to 4 percentage points. Can you just comment on that dynamic?"
},
{
"speaker": "Gary Simmons",
"content": "I don't know that I can quantify that. Certainly, that is our view that as the crude gravity goes higher, there's a lot of refining capacity around the world that was designed for a heavier gravity crude diet. It causes some derate crude units, but quantifying it. I don't know that I can do that. I don't know, Greg, if you have?"
},
{
"speaker": "Greg Bram",
"content": "I don't have any rules of thumb either."
},
{
"speaker": "Operator",
"content": "At this time, I would like to turn the floor back over to Mr. Bhullar for closing comments."
},
{
"speaker": "Homer Bhullar",
"content": "Thank you, Donna. Appreciate everyone joining us. Obviously, please feel free to contact the IR team if you have any follow-up questions. Thank you, everyone, and have a great day."
},
{
"speaker": "Operator",
"content": "Ladies and gentlemen, thank you for your participation. This concludes today's event. You may disconnect your lines at this time or log off the webcast, and enjoy the rest of your day."
}
] |
vlto | 2,024 | 4 | [
{
"speaker": "Operator",
"content": "Please standby. Your program is about to begin. [Operator Instructions] My name is Margo and I will be your conference operator this morning. At this time, I’d like to welcome everyone to Veralto Corporation's Fourth Quarter 2024 Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions] I will now turn the call over to Ryan Taylor, Vice President of Investor Relations. Mr. Taylor, you may begin your conference."
},
{
"speaker": "Ryan Taylor",
"content": "Good morning, everyone. Thanks for joining us on the call. With me today are Jennifer Honeycutt, our President and Chief Executive Officer; and Sameer Ralhan, our Senior Vice President and Chief Financial Officer. Today's call is simultaneously being webcast. A replay of the webcast will be available on the Investors section of our website later today under the heading Events and Presentations. A replay of this call will be available until February 19. Yesterday, we issued our fourth quarter and full year 2024 news release, earnings presentation and supplemental materials, including information required by the SEC relating to adjusted or non-GAAP financial measures. In addition, we also issued our 2025 full year and first quarter guidance. These materials are available in the Investors section of our website, www.veralto.com under the heading Quarterly Earnings. Reconciliations of all non-GAAP measures are also provided in the appendix of the webcast slides. Unless otherwise noted, all references to variances are on a year-over-year basis. During the call, we will make forward-looking statements within the meaning of the federal securities laws, including statements regarding events or developments that we believe or anticipate will or may occur in the future. These forward-looking statements are subject to a number of risks and uncertainties, including those set forth in our SEC filings. Actual results may differ materially from our forward-looking statements. These forward-looking statements speak only as of the date that they are made and we do not assume any obligation to update any forward-looking statements, except as required by law. And with that, I'll turn the call over to Jennifer."
},
{
"speaker": "Jennifer Honeycutt",
"content": "Thank you, Ryan and thank you all for joining our call today. I’ll begin with a look back at our 2024 accomplishments, followed by a recap of our fourth quarter performance. From there I will then take you through a detailed analysis of our Q4 results and 2025 guidance. Reflecting on 2024, I am proud of our team for their strong execution in our first full year, as a public company to grow our business, strengthen our portfolio and deliver attractive value creation for all stakeholders. In doing so, three notable accomplishments stand out. First, we delivered on our financial commitments. Second, we increased our growth investments. And third, we demonstrated a disciplined approach to capital allocation, executing strategic actions to improve our portfolio and increase our dividend in conjunction with our earnings growth. Let me expand on each of these. Beginning with our financial performance for the year, we delivered core sales growth, adjusted operating profit margin expansion and adjusted earnings per share growth above our initial guidance. This outcome demonstrates the durability of our businesses fortified by the Veralto Enterprise System. Our simplification of VES and focus on leveraging high impact tools drove sales growth and margin expansion throughout the year. Our results reflect the benefits gained from our team's engagement in focused time and events and leverage of VES growth tools to enhance commercial architecture, improved funnel management and increased lead generation. Our VES focus combined with increased investments in sales, marketing, and R&D enabled us to capitalize on strengthening demand as the year progressed. This resulted in steady sequential Improvement in volume growth, partly attributable to new customer wins and increased market penetration. Across both segments, we delivered mid-single-digit core sales growth in the second half of 2024. On the strength of this growth and strong underlying margin expansion, we accelerated investments to drive future value creation. Specifically, we expanded our direct sales force, augmented our marketing efforts and accelerated innovation in verticals and regions with high return opportunities. We enhanced our talent through new hires and internal development programs and we increased our investment in innovation with our full year R&D expense up 40 basis points year-over-year to about 5% of sales. Our focus on innovation led to several new product and technology launches across our businesses throughout 2024. PQI led the way with digital offerings in packaging and color and a steady cadence of next-gen technology launches in marketing and coding. Videojet has now launched more than a dozen new products over the past two years. Its latest breakthrough, the 7920 UV Laser Marking System launched in the fourth quarter. This laser enhances usability, adaptability and consistency in coding operations and was met with immediate enthusiasm and demand from customers. We shipped our first unit shortly after the product launched in November and continue to see strong demands here in Q1. The UV Laser is optimized for high-quality, permanent coding, bunch of lighter weight flexible films made from mono-material plastics. These flexible films are among the fastest growing substrates in the packaging industry, due to their high levels of recyclability, further supporting our customers’ sustainability goals. We are excited about this new UV Laser Technology, along with many other products and solutions we brought to the market last year. In addition to delivering our financial commitments and increasing our growth investments, our third key accomplishment last year was executing disciplined capital allocation. In 2024, we took steps to improve our portfolio across both segments. This activity ramped in the fourth quarter as we acquired TraceGains, our first acquisition of size, invested in minority stake in Axine Water Technologies and signed an agreement to sell Advanced Vision Technology or AVT, a print inspection product line in our PQI segment with approximately $40 million in annual sales. As we talked about on our Q3 call, TraceGains was acquired early in the fourth quarter. It is a leading provider of cloud-based software solutions that enable connected data and digital workflow management for consumer brands. TraceGains’ digital solutions help customers innovate new recipes faster and significantly reduces time to market for new products. Additionally, it helps increased transparency to ingredient inputs for food & beverage safety. The acquisition of TraceGains in combination with our Esko, business strategically expands our digital offering and provides us the opportunity to deliver greater value to consumer brands as they digitize critical workflows with connected data across new product development, compliance and packaging. The integration of TraceGains is going well. Our integration team is executing on all fronts. The customer response has been very positive and the team at TraceGains has quickly embraced VES. TraceGains’ fourth quarter core sales growth exceeded 20% year-over-year and importantly, we are on track with our growth investments. Late in the fourth quarter Esko entered into an agreement to sell its AVT product line. This sale is expected to be completed in the first quarter of 2025. This divestiture is another example of our stewardship of the portfolio. With Esko’s focus on providing source-to-shelf, digital workflow solutions for our CPG customers, we believe new ownership of AVT will provide the necessary focus to drive its growth and innovation. In combination, acquiring TraceGains and divesting AVT enhances our packaging and color portfolio. Both deals are immediately accretive to PQI’s core growth rate, gross margin and recurring revenue. In Water Quality, we have also taken actions to improve our portfolio. As previously discussed, since we're also spin-off, we have strategically exited thee product lines that were not aligned with our long-term value creation strategy. In the fourth quarter, we made a minority investment in Axine, a provider of electrochemical oxidation technology, used to destroy contaminants in water including PFAS. Our Water Quality team has a long proven track record of developing and commercializing technologies that help customers detect and destroy emerging contaminants. A key part of our growth strategy in Water Quality is developing fit-for-purpose solutions to help our customers meet complex challenges. We believe Axine’s electrochemical oxidation technology provides a promising solution for difficult-to-treat organic contaminants and that our commercial partnership with Axine will accelerate technology adoption over time. Overall, we are pleased with the progress we made in curating our portfolio in 2024. Moving forward, we expect acquisition growth to be a key value creation lever. The pipelines for both segments are full and active and we continue to be disciplined in our approach to capital allocation. Looking now at 2025, we are starting off the year with an improved portfolio, positive trends in our end-markets and a stronger financial position. Demand across our key end-markets has strengthened compared to this time last year highlighted by strong demand for industrial water treatment in North America and improved demand in consumer packaged goods markets globally. For the full year 2025, we are targeting low to mid-single-digit core sales growth with strong incremental margins, solid, earnings growth and strong cash generation and we believe the durability of our businesses, fortified by the Veralto Enterprise System, our competitive advantages that enable us to consistently grow and improve even in dynamic macro environments. Looking at our financial results for the full year 2024, total sales grew 3.4% year-over-year to just under 5.2 billion, an all-time high. We delivered 3.7% core sales growth with 80 points of adjusted operating profit margin expansion. And adjusted earnings per share grew 11% to $3.54 per share. Notably, we exceeded our initial guidance on all three of these metrics and we generated $820 million of free cash flow further strengthening our financial position. We ended the year with $1.1 billion of cash on hand and net leverage at 1.2 times. Overall, I'm pleased with the growth in margin expansion we delivered in 2024. Every operating company across both segments contributed core sales growth with positive volume. Our Water Quality team delivered 3.9% core sales growth with 50 basis points of adjusted operating profit margin expansion. They set all-time highs with annual sales of over $3 billion and adjusted operating profit margin of 25%. And our PQI team delivered 3.3% core sales growth with 160 basis points of adjusted operating profit margin expansion. They also reached all-time highs with over $2 billion in sales and adjusted operating profit margin of 27%. I'm proud of our teams across the world for their strong commercial and operational execution in support of our customers. We capped off a strong 2024 with solid fourth quarter results. Core sales grew 4.6%, led by volume growth with both segments growing core sales by more than 4%. Adjusted earnings per share grew 9%, year-over-year to $0.95. And free cash flow generation was strong at $263 million in the fourth quarter, further strengthening our financial position. Looking at core sales growth by geography and end-market for the fourth quarter, growth across the enterprise was broad-based across key verticals and regions. And our commercial teams executed well, leveraging our VES growth tools and investments made earlier in the year. North America and Western Europe, which comprise about 70% of our total sales grew nearly 6%. And high growth markets grew low-single-digits year-over-year. In North America, core sales grew 5.8% within both segments. In Water Quality, we continue to capitalize on strong demand for our Chemical Water Treatment Solutions, which grew high-single-digits in North America. From an Industrial end-market perspective, this growth was broad-based with the strongest growth in food & beverage, chemical processing and power generation. We also continue to see strong growth for Trojan's UV systems at municipalities in North. America, primarily related to water reuse. We're also continue to benefit from strong secular drivers in water conservation, reclamation and reuse.as we help our customers achieve their sustainability goals. Over the long term, we expect the secular trends to drive continued growth opportunities, given the scarcity of water today, coupled with more frequent, severe weather events and increasing water usage from industry, such a datacenters, which consume large quantities of water for cooling. It also includes traditional industries, ranging from power generation to food & beverage processing. Both our Water Treatment and Analytics businesses are poised to benefit from increased industrial activity in North America. At PQI, core sales in North America also grew 5.8% in Q4 with mid-single-digit growth in both packaging and color and marking and coding. PQI’s growth in North America was largely driven by strong growth in equipment sales. This reflects the combination of improving end-market demand from CPG customers and market penetration from our strategic initiatives. Specifically, in North America, Videojet focused on new customer wins, differentiated new product launches and VES-driven commercial excellence. In Western Europe, we saw continued momentum with core sales growth of 5.8% year-over-year led by 7.3% growth in Water Quality sales and 4.4% growth in PQI. The sales growth in Western Europe was largely driven by strong commercial execution by our Water Analytics team. Additionally, we drove growth across PQI in both our marking and coding and packaging and color businesses. In high growth markets, core sales increased 1.5% in the fourth quarter, led by Latin America and India. In China PQI continued to drive solid year-over-year core sales growth. However, similar to our third quarter performance, PQI’s growth in China was offset by lower sales in Water Quality. This is primarily due to ongoing soft demand for Water Analytics, and a lower level of UV System installations for chip processing, which were exceptionally strong in the fourth quarter of 2023. Total company sales into China in Q4 were in line with our quarterly average for the year. We continue to view demand for our products in China as stable at low levels and do not expect China sales to grow in 2025. Overall, we delivered solid fourth quarter financial results, on the back of strong commercial execution, while continuing to invest in future value creation. At this time, I'll turn the call over to Sameer to provide details on our fourth quarter results and 2025 guidance."
},
{
"speaker": "Sameer Ralhan",
"content": "Thanks, Jennifer, and good morning, everyone. I'll begin with our consolidated results for the fourth quarter. Total sales grew 4.4% on a year-over-year basis to over $1.3 billion. Currency was a 50 basis points headwind year-over-year and acquisitions contributed 30 basis points of growth, primarily driven by TraceGains. Core sales grew 4.6%. Our core sales growth was primarily driven by volume, which grew 3.1% year-over-year. Price contributed 1.5% growth this quarter, in line with historical levels. Our recurring revenue grew mid-single-digits year-over-year and comprised 59% of our total sales. The percentage of recurring revenue is in line with 2023 levels. However, it is down sequentially, primarily due to high-single-digit, sequential growth in non-recurring revenue, specifically, Water Testing Instrumentation and Marking and Coding Equipment. Gross profit increased 7% year-over-year to $801 million. Gross profit margin improved 170 basis points year-over-year to 159.6%, primarily driven by pricing. Adjusted operating profit increased 5% year-over-year and adjusted operating profit margin was flat year- over-year at 23.8%. As Jennifer mentioned, in the fourth quarter, we continue to increase investments in our direct sales and marketing efforts on both a year-over-year and sequential basis. On a year-over-year basis, R&D as a percent of sales increased 70 basis points or $12 million to 5.1%. In addition, our cost optimization investments in this quarter increased by about $7 million on sequential basis. These investments are aligned with our strategic growth plans. Looking at EPS for Q4, adjusted earnings per share grew 9% year-over-year to $0.95 per share. As compared to our guidance, adjusted EPS came in stronger, primarily due to lower corporate expenses and a lower tax rate. These benefits more than offset a headwind from currency. As compared to our guidance expectations, strengthening of the US dollar during the quarter resulted in about 2% or approximately $25 million headwind to sales, primarily due to translation of foreign currencies. This led to a headwind of about $7 million to adjusted operating profit or $0.02 to adjusted earnings per share, as compared to our guidance assumptions. In the fourth quarter, we generated robust free cash flow of $263 million or 116% conversion of GAAP net income. Moving on, I'll cover the segment highlights, starting with Water Quality. Our Water Quality segment delivered $811 million of sales, up 3.7% on a year-over-year basis. Currency was a 60 basis points headwind. Divestitures reduced total sales by 60 basis points versus the prior period. Core sales grew 4.9% year-over-year. Water Quality’s core sales growth was led by volume, which grew 3.3%. Pricing contributed 1.6% growth year-over-year. Water Quality’s volume growth was driven by strong demand for Water Treatment Solutions in our industrial end-markets and UV Treatment Systems in municipal end-markets. We also saw a good volume growth in sales of analytical instruments, reagents and chemistries to municipalities Recurring sales grew mid-single-digits and equipment growth was up low-single-digits year-over-year. Adjusted operating profit increased 2% year-over-year to $207 million and adjusted operating profit margin was 25.5%, marking Water Quality’s highest quarterly margin performance this year. Moving to the next page, sales in our PQI segment grew 5.4% year-over-year to $534 million in the fourth quarter. Currency was a 30 basis points headwind and acquisitions contributed 1.6% growth in the quarter. Core sales grew 4.1%, with volume up 2.9%. Price increases contributed 1.3% to the year-over-year growth in core sales. PQI’s recurring revenue grew high-single-digits year-over-year, with positive momentum across the portfolio. PQI’s equipment sales grew low-single-digits, primarily driven by marking and coding systems. On a sequential basis, equipment sales were up mid-single-digits, driven largely by marking and coding equipment. Breaking this down by business, marking and coding core sales grew mid-single-digits, driven by growth in both consumables and equipment, a strongest growth both in food & beverage applications within our CPG customer base. In our packaging and color business, core sales grew mid-single-digits year-over-year led by growth in both recurring software and subscription revenue. PQI's, adjusted operating profit was $133 million in the fourth quarter, up $10 million over the prior resulting in adjusted operating profit margin of 24.9%. That represents a 60 basis points improvement in adjusted operating profit margin over the prior year period. The margin expansion was primarily due to favorable currency benefit as the Argentine peso devaluation in Q4 2023 did not repeat. This benefit was partially offset by increased investments in sales, marketing, and R&D, along with a higher mix of equipment sales and dilution from the TraceGains acquisition. For the full year, PQI delivered 3.3% core sales growth and 160 basis points of adjusted operating profit margin expansion. Overall, it was a very good year for PQI as we continue to see positive momentum in our commercial execution and end-market environment as we enter 2025. Turning now to our balance sheet and cash flow. In Q4, we generated $285 million of cash from operations. We invested $22 million in capital expenditures. Free cash flow was $263 million in the quarter or 116% conversion of GAAP net income. At the end of the fourth quarter, gross debt was $2.6 billion and cash on hand was $1.1 billion. Net debt was $1.5 billion, resulting in net leverage of 1.2 times. As Jennifer shared, early in the fourth quarter, we acquired TraceGains at a gross purchase price of $350 million. The deal was funded with cash on hand. We also invested approximately $15 million to establish a minority interest in Axine Water Technologies. Even after these investments, our financial position is strong and we continue to have flexibility in how we deploy capital. To that point, in the fourth quarter, our Board of Directors approved a 22% increase in our quarterly dividend. This is consistent with our approach to increase the dividend as we grow our earnings. Over the long term however, our bias remains to create long-term shareholder value through M&A. We have an attractive pipeline of opportunities in both Water Quality and PQI. We remain disciplined in our approach as we continue to deploy capital to create long-term shareholder value. Turning now to our guidance for 2025 beginning with our expectations for the full year. We are targeting core sales growth in the low to mid-single-digit range on a year-over-year basis. At the midpoint of our guidance, we are assuming core sales growth, consistent with the full year 2024. This assumes pricing in the range of 100 to 200 basis points, consistent with our historical range. We expect net acquisitions and divestitures to be neutral to growth as potential sales contribution from TraceGains is largely offset by the impact of the AVT divestiture. Our full year guidance assumes that currency rates as of December 31st 2024 prevail for the remainder of the year. Based on this assumption, currency is approximately 2% headwind to total sales on a year-over-year basis. This falls through roughly in line with our adjusted operating profit margin resulting in operating profit, dollar headwind of approximately $25 million. This represents an $0.08 headwind to adjusted earnings per share. Our guidance assumes corporate expense at a full annual runrate between $100 million to $105 million. Looking at adjusted operating profit margin, we're targeting 25 to 50 basis points of improvement in 2025. This assumes margin expansion at both segments and total company incremental margins around 40%. Our adjusted EPS guidance for the full year 2025 is in the range of $3.60 per share to $3.70 per share. This assumes an effective tax rate of approximately 23%. Excluding the $0.08 per share currency headwind, our adjusted EPS guidance represents about 5% year-over-year growth at the midpoint and about 7% growth at the high end of the range and we are targeting free cash flow conversion between 90% to 100% of GAAP net income. This assumes CapEx in the range of 1% to 1.5% of sales and a modest working capital investment to support our growth. Looking now at Q1 2025, we expect core sales to grow in low to mid-single-digit range across both segments. Currency translation is expected to be approximately 2% year-over-year headwind to sales. We anticipate adjusted operating profit margin in the range of 24% to 24.5%. And our Q1 2025 guidance for adjusted EPS is $0.84 to $0. 88 per share. This assumes a $0.02 currency headwind. That concludes my prepared remarks. At this point, I'll turn the call back over to Jennifer for closing remarks."
},
{
"speaker": "Jennifer Honeycutt",
"content": "Thanks, Sameer. In summary, we capped off the strong first year as a public company. In 2024, we delivered on our commitments, invested in our future and improved our portfolio. We entered 2025 with a more positive outlook on our end-markets and momentum throughout the enterprise. Longer-term, we are confident that the essential need for our technology solutions and the strong thematic growth drivers across our end-markets will provide steady durable growth. And we will continue to leverage the power of the Veralto Enterprise System to drive, continuous improvement and bolster our agility through dynamic macro environments. Our financial position remains strong and we continue to evaluate additional strategic opportunities within our disciplined capital allocation framework of market, company, and valuation. We are excited about the bright future ahead for Veralto and the opportunities in front of us to help customers solve some of the world's biggest challenges in delivering clean water, safe food and trusted essential goods. That concludes our prepared remarks. And at this time, we're happy to take your questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] We'll take our very first question from Andy Kaplowitz from Citigroup. Please go ahead."
},
{
"speaker": "Natalia Bak",
"content": "Hi, good morning. This is Natalia Bak on behalf of Andy Kaplowitz."
},
{
"speaker": "Sameer Ralhan",
"content": "Hi Natalia."
},
{
"speaker": "Natalia Bak",
"content": "First question I want to ask is, if you could break down or give more color into how you're thinking about your segments in terms of margin expansion? Do they both grow in that 25 to 50 plus range? And TraceGains weighing you down a bit more in PQI?"
},
{
"speaker": "Sameer Ralhan",
"content": "Hey Natalia. This is Sameer. Yeah, I think the - as you kind of think about the margin expansion, it's very similar. In fact, I wish we just can take a step back and look at our overall company guide and how the segments are going to be contributing, for both the segments you should look at the core growth in a very similar place, low-single-digits to make-single-digit and also from the margin expansion perspective, pretty similar contribution coming from both the segments."
},
{
"speaker": "Natalia Bak",
"content": "All right. That’s helpful. And then, second question I wanted to ask is, just curious about the progression of DDR. What specific initiatives have you implemented under VES to drive composition fees and enhanced margin? And how has it been evolving since you went public? Where do you see the most opportunity for further margin expansion in 2025? And how are you balancing those increasing growth investments for both improving margin performance?"
},
{
"speaker": "Jennifer Honeycutt",
"content": "Thanks for the question Natalia. I think we feel very good about how we have honed our VES toolset. Certainly, we had a big push in 2024 really to drive growth in commercial execution, but we also drove considerable amounts of margin expansion in just good factory discipline. So, the things that we did in bringing the VES toolset over from Danaher post spin or to really narrow the focus and drive a greater depth of application and competency in the use of those tools. There are 5 or 6 tools that sit in our fundamentals and those fundamentals are relevant to everyone, whether you sit in a function or you sit in an operating company. And so, we feel good about both our deployment there for a commercial application, accelerate new product development and factory focused optimization."
},
{
"speaker": "Natalia Bak",
"content": "All right. That's helpful. Thank you so much."
},
{
"speaker": "Operator",
"content": "Our next question comes from Deane Dray with RBC Capital Markets. Please go ahead."
},
{
"speaker": "Deane Dray",
"content": "Thank you. Good morning to everyone."
},
{
"speaker": "Sameer Ralhan",
"content": "Good morning."
},
{
"speaker": "Jennifer Honeycutt",
"content": "Hey Deane."
},
{
"speaker": "Deane Dray",
"content": "Good morning. Hey, you all know I have covered the Danaher for so many years. So whenever I hear about growth investments done at year end, that’s really read out of the Danaher playbook. Because it's a good sign you're getting – you are doing it from a position of strength. There's a way to jumpstart the New Year. So, I'm assuming that applies to you all. And if I look at the margin past couple of quarters sequentially down a bit. Is it fair to say that that's the impact of the growth investments? Can you size that impact and anything about the benefits and am I thinking about it at the right way?"
},
{
"speaker": "Jennifer Honeycutt",
"content": "Yeah. Thanks, Deane. As you know, some of us here in the room have spent nearly a lifetime at Danaher. And so the playbook there is very familiar. I think it’s right, we took the opportunity here on the back of strong growth to continue to reinvest in the business in areas that we think will set us up for a good 2025. So, that's spot on and maybe I'll turn it over to Sameer to talk about the rest of your question."
},
{
"speaker": "Sameer Ralhan",
"content": "Thanks, Jennifer. Yeah, Deane, if you kind of look the sequential margin right, the first one is really TraceGains. Roughly 70 basis points dilutive to the PQI margins, right? But it really sets up really well in 2025 as you kind of look to driving the growth in PQI. The second one is actually, great, as you kind of think about the net equipment sales coming back, so the mix of the equipment in PQI, was little higher similarly in the Water Quality, as well. Again, as the installed base grows, as you know, our future recurring revenue grows. So it’s just great to have that. And last for the point that you kind of made Deane, really as you're kind of think about the investments in R&D, commercial, cost optimization, these things are all as you outlined very intentional, very deliberate actions to make sure that we hit the ground running in 2025. So, I think, as Jennifer also said, playbook is very similar. But our focus is long-term value creation, and if you kind of zoom out for our full year 2025, we delivered 80 basis points in the full year, while ramping up as a full year in the First full year as a public company, while investing in sales and marketing, while investing in R&D, all those things really positioning us, really well as we kind of start 2025. So we feel good about the margin expansion."
},
{
"speaker": "Deane Dray",
"content": "It’s really helpful and I appreciate all those specifics. And the second question, you might - I might be tempted to ask about TraceGains, because that's, kind of the marquee first deal. But I'm actually more interested in talking about the investment in Axine. This electrochemical oxidation technology looks really promising. We’ve spoken with Axine before. They are established. And it looks like it could have good application for on-site PFAS destruction because they’ve already proven the technology in other complex molecules. So, look it’s still early. I get that. I'm most interested in the strategy here of using M&A as a proxy for R&D, because you can make a really smart investment for $15 million with potentially significant payoff down the road. Because your funnel have more candidates – investment candidates like this because pound-for-pound, that’s a great way to be spending your capital."
},
{
"speaker": "Jennifer Honeycutt",
"content": "Yeah, thanks for the question Deane. Look, I - we have a number of different levers to pull relative to capital allocation and we look at all sorts of modalities there to create long-term shareholder value. I think we feel good about our level of investment in Axine just relative to proving out the technology, making sure that it matures in the right way relative to the markets that we serve. And we've got a very competent and capable science and technology team that's constantly canvasing the market for good opportunities to engage with other partners, be that in a minority investment or be that outright acquisition. So, I think everything's on the table there."
},
{
"speaker": "Deane Dray",
"content": "Really appreciate it. Thank you."
},
{
"speaker": "Sameer Ralhan",
"content": "Thanks, Deane."
},
{
"speaker": "Operator",
"content": "And our next question comes from Mike Halloran with Baird. Please go ahead."
},
{
"speaker": "Mike Halloran",
"content": "Hey morning, everyone."
},
{
"speaker": "Jennifer Honeycutt",
"content": "Morning. Mike"
},
{
"speaker": "Mike Halloran",
"content": "Let’s just start with end-markets and kind of a loose start. What's changed as we sit here today versus the last time we talked, because I think 3Q earnings? It sounds like you're pretty constructive coming into the year. It's just kind of continuation the trends you're seeing then? Or is there anything new that you think has developed over this period of time?"
},
{
"speaker": "Jennifer Honeycutt",
"content": "I think it's largely a continuation of what we seen Mike. We've talked a lot about the strength in our Industrial Water businesses, given the number of very thirsty industries, datacenters, power generation and so on. That continues. We're seeing good steady growth in Analytics, as well, particularly in the US, and in Europe on the back of the secular drivers that require clean water for the population that they serve. And then, I think on the PQI side, we see the continued recovery in the strength of CPG markets. We saw actually the sixth consecutive quarter of mid-single-digits to high-single-digit recurring revenue. We know that that recurring revenue always precedes sort of equipment growth. And now we've seen three consecutive quarters of year-over-year growth and equipment sales with in fact, equipment sales coming in better than expected here in the fourth quarter. So we think we're set up well, given the macro and we enter the year here with continued momentum."
},
{
"speaker": "Mike Halloran",
"content": "I appreciate that. And then, when you think about the foundation for the guide for the year, I understand all the moving pieces. You gave a lot of color. Just two quick questions related to that. One, is the cadencing through the year expected to be kind of consistent with normal seasonality? And two, is the assumption that things just kind of hold trend as we sit here today? Or is there any improvement or decel assumed in what your end-markets look like?"
},
{
"speaker": "Sameer Ralhan",
"content": "Hey Mike. Yeah, from the guide perspective, as kind of look at the top line of the growth side, it's going to be pretty consistent as Jennifer just said, right? Yeah, from the CPG markets perspective, on a water perspective, you're seeing some good trends. Feel really good about as we're going to enter 2025. Those trends are continuing. So overall, from a seasonality perspective, as you know, we don't have a whole lot of seasonality maybe on the equipment side, instrument side, we see a little more pull through in Q4 as people are kind of managing the budgets. But overall, not a whole lot of seasonality in our business. So, but coming into 2025, we feel pretty good about the trends continuing and then – and the numbers."
},
{
"speaker": "Mike Halloran",
"content": "Great. Really appreciate everyone. Thank you."
},
{
"speaker": "Sameer Ralhan",
"content": "Thanks Mike."
},
{
"speaker": "Operator",
"content": "We'll take our next question from Nathan Jones from Stifel. Please go ahead."
},
{
"speaker": "Nathan Jones",
"content": "Good morning, everyone."
},
{
"speaker": "Jennifer Honeycutt",
"content": "Good morning, Nathan."
},
{
"speaker": "Nathan Jones",
"content": "Couple questions - I got a couple questions around margins. When comparing the margin expansion in ’24 with ’25, ramped up R&D investments to 40 basis points. So without that ‘24 would have been up like 120 basis points in the guidance for ‘25 on similar revenue growth is ‘25 to 50. But maybe you can just give us some more color on where you got that extra margin expansion in, so that maybe you're not anticipating in 2025? I'll stop there."
},
{
"speaker": "Sameer Ralhan",
"content": "Yeah, Nathan, I'll start off with that. As you kind of look at it from like 24 to 25, right, of course in the 24 the margin expansion was pretty broad based really as Jennifer said all the way from the factory floor down to the commercial operations and functions. Get offsets a little bit by TraceGains and some of the investments that we continue to make. As we move into 2025, from a price cost differential perspective, we still expect to be positive. I mean, as positive of 2024. We expect that to continue. R&D will be in a very similar level, Nathan. Roughly 5% of the sales, so that trend will we expect to continue in 2025 and that's sort of stuff is really some really targeted investments on the commercial side really into sales and marketing as we continue to drive the growth. So that's kind of like how it’s kind of panning out the 25 to 50 basis points. Still going to be pretty much - pretty broad-based, pretty across the board."
},
{
"speaker": "Nathan Jones",
"content": "Thanks for that. And I guess I'll ask one on incremental margins. Jennifer, you talked about 40% incremental margins in 2025. Eight years probably, it relatively of a small change at low to mid-single-digit growth, but I think originally when the business spun out, you guys had talked about 30% to 35% incremental margins. Just wondering if you can comment on is that’s structurally high now or is it a one-off this year. And if it is structurally higher, what's driven that?"
},
{
"speaker": "Sameer Ralhan",
"content": "Yeah, Nathan, if you kind of look at 30% to 35%, right, that's a long-term view. We expect to make the right investments in the sales, marketing, R&D to continue to position the business for future growth as well, right. 2024, we feel really good about what the teams have been able to deliver. We are north of 45%, close to 50% on the fall through. For 2024, given the kind of investments that we have laid out and have visibility into what we're going to be doing in 2025, we feel pretty good about delivering 40%. All right? So the year the year-over-year depending on some of the Investments things will change, but I think if you think about a long-term value creation frame 30% 35% is a good one to keep."
},
{
"speaker": "Nathan Jones",
"content": "Great. Thanks for taking my question."
},
{
"speaker": "Sameer Ralhan",
"content": "Thanks, Nathan."
},
{
"speaker": "Operator",
"content": "Thank you. And next, we'll go to Saree Boroditsky with Jefferies. Please. Go ahead."
},
{
"speaker": "Unidentified Analyst",
"content": "Good morning. This is James on for Saree. Thanks for taking questions this morning."
},
{
"speaker": "Sameer Ralhan",
"content": "Good morning, James."
},
{
"speaker": "Unidentified Analyst",
"content": "I want to kind of touch on – good morning. I wanted to touch on the CPG market little bit more. I mean, you talked about like continued threshold recovery path here over the last several quarters. So can you provide a little more color on the recovery path like how far are we from like the normalization in our industry? And like what percentage of - like revenue is still missing from the like, last, like normal like date of CPG market?"
},
{
"speaker": "Jennifer Honeycutt",
"content": "Yeah, I mean, I think the way we look at the recovery of CPG market is, mothball manufacturing lines will be turned back on and those will require spare parts, consumables, that then is followed by equipment upgrades. We are not yet at the point where we're seeing line expansions per se and new builds. So that would be another sort of extension of the recovery. But given the fact that we've seen six consecutive quarters of mid to high-single-digit recurring revenue growth, which means those lines are coming back on and using ink and solvent spare parts, filters and so on and we've seen three consecutive quarters of year-over-year growth in equipment sales. It suggests that we're well into the recovery with the prospect of new builds still ahead of us should that happen."
},
{
"speaker": "Unidentified Analyst",
"content": "Got it. Great. Thanks for the color. And I guess, I wanted to understand the like portfolio optimization like initiative a little bit better here. So like how much are left to do here? Like what are some spaces that you can still do and how will like this initiative affect the top-line and potentially margin, like in 2025?"
},
{
"speaker": "Jennifer Honeycutt",
"content": "Yeah, the way we think about this is that every product line has to earn its right to be in the portfolio. And I think as an independent enterprise, we are tasked with being good stewards of the portfolio in terms of making sure that products that are part of the portfolio and services are at or better than the fleet average and where we've got product lines that are below the fleet average in terms of core growth and operating profit we'll look to make changes there. Now, those changes may be additional investments to get them on the right track. It may be that we attenuate them over time and it may be that we divest them outright. But I think it's safe to assume that we're always looking to improve our portfolio and moving the portfolio towards nominally higher growth rates and increasing margins."
},
{
"speaker": "Unidentified Analyst",
"content": "Great. Thanks for the color. I will visit there."
},
{
"speaker": "Operator",
"content": "Thank you. And we'll next go to Andrew Buscaglia with BNP. Please go ahead."
},
{
"speaker": "Andrew Buscaglia",
"content": "Hi, good morning, everyone."
},
{
"speaker": "Jennifer Honeycutt",
"content": "Morning, Andrew."
},
{
"speaker": "Andrew Buscaglia",
"content": "So I want to ask you a high-level question. You guys had a great year and the stock also had a pretty good year, but it sort of broke down the stock that is towards the end of the year on concerns around a Trump Administration. What that means for your stock I think? And you've got a couple months to think about it now. So I am wondering at first, it was concerns around what it means for Water Quality, but then it kind of morphed into is this good or bad for PQI and you can hear different arguments on both sides. I was wondering, what are your latest thoughts for both segments under this administration."
},
{
"speaker": "Jennifer Honeycutt",
"content": "Yeah. We are certainly operating in a fairly dynamic environment, but from a portfolio standpoint, 85% of our sales are tied to water, food, and essential goods. It's never been out of style to protect public health and safety and regulations to help us do that. But these are issues that are important to everyone, regardless of the political affiliation. So I would say sort of on the water side, because we are endemic to the operation environment of discharging clean water and cleaning up industrial water, waste water and so on, I think we feel like that is still going to be a need, as long as we've got people on the planet, they're going to need clean water. On the PQI side, a lot of what we are focused on there is securing the inherent safety of the food supply chain, right? And, we have a need to or consumer product brands have a need to ensure that what they are distributing to their consumers. You know that the ingredients, the formularies and so on are safe, a traceable, and can be recalled in the event that there's some sort of public health or safety issue. So, we think even in the current environment, we've got strength in both of these businesses. These products and services not only provide essential public health and safety information. But in many cases, the products and services we provide, provide economic benefits to customers, as well. So, again, this is not a CapEx-intensive set of businesses. We are focused on the daily operations and the essential need of our products and services there are we believe going to remain"
},
{
"speaker": "Andrew Buscaglia",
"content": "Yeah. Okay. And maybe along those lines, with tariffs is part of your guidance implied some disruption around tariffs and can you comment around the latest - your latest thoughts around China, Mexico and, and Canadian tariffs, how that might impact you?"
},
{
"speaker": "Sameer Ralhan",
"content": "Yeah, Andrew, in the guidance, we have not reflected any sort of a sustained impact from the tariffs. Look, it's a very fluid and dynamic situation. But if you kind of step back, we procure our materials from globally. We have a global manufacturing footprint. And over the years through the supply chain disruptions and things that have happened, we feel pretty good about the changes that the operations have made over the last four, five years. So really positioned and fortify our supply chain. So feel pretty good. We are keeping an eye on, just like you guys on the things that are coming out, but overall, we feel pretty good. But if you say, hey, there's a sustained level of tariff changes, that's not baked into the guide."
},
{
"speaker": "Andrew Buscaglia",
"content": "Okay. All right. Thank you."
},
{
"speaker": "Sameer Ralhan",
"content": "Thanks, Andrew."
},
{
"speaker": "Operator",
"content": "Thank you. We'll take our next question from John McNulty with BMO Capital Markets. Please go ahead."
},
{
"speaker": "John McNulty",
"content": "Yeah, good morning. Thanks for taking my question. Maybe just a couple on the water side. So, you highlighted some of the growth that you were seeing were was really in the food & beverage and on the power side. Those striking is relatively stable markets. So is the bulk of that share gain and if so, I guess, can you help us to understand kind of what drove that? Was it some of the investments you've been making in North America or are there other things that we should be thinking about?"
},
{
"speaker": "Jennifer Honeycutt",
"content": "Yeah, I mean, I think, we participate in a well-diversified set of markets with respect to our water business and the two that you cite there are certainly the strong growing industrial markets that we experienced in 2024. But the reality is these shift over time and we have good agility in pivoting our sales force to where the growth is coming from. Generally we've been up year-over-year in most of our markets and we continue to feel good about industrial production and the need for our products and services, particularly as reshoring comes back to the US and so on."
},
{
"speaker": "John McNulty",
"content": "Got it. Fair enough. And then, maybe just one question on the datacenter side. There's some growing excitement around directed chip cooling. There's also just an increase in general use. I guess, can you speak to whether you're agnostic as to how datacenters cool going forward and some of the growth that you're seeing in terms of the opportunities from the datacenter side?"
},
{
"speaker": "Jennifer Honeycutt",
"content": "Yeah, I mean, I think the predominant focus here for us is our water cooled applications, right? But I would say that we have a very strong science and technology team on the ground that's regularly canvasing the customer base to understand sort of paint points and technology changes. I would say our mid-single-digit growth algorithm is really not tied to sort of single industry here. It's going to be broad-based and we believe that the growth in datacenters and power generation actually needed to run those centers will continue to be a potential - have potential to be a meaningful growth driver certainly throughout our treatment business."
},
{
"speaker": "John McNulty",
"content": "Great. Thanks very much for the color."
},
{
"speaker": "Operator",
"content": "And next we're going to go to Andrew Krill with Deutsche Bank. Please go ahead."
},
{
"speaker": "Andrew Krill",
"content": "Hi, thanks. Good morning, everyone. Looking at free cash flow, I know the guidance 90% to 100% is a little below your medium-term target of 100% and extra working capital was cited. So just, should we be thinking that’s kind of a one-time 2025 event? And that in 2026, we get back that 100% or so? And are there any other factors you could call out for this year on what’s CPG below 100%?"
},
{
"speaker": "Sameer Ralhan",
"content": "Yeah. Hey, Andrew this - if you kind of look at the free cash flow conversion, yes, we had a pretty solid year in 2024 with a 98% conversion of GAAP net income. As you kind of move into 2025, there are really two things because of which we guided a little bit below. And one of the reasons is on the CapEx site, as you know historically, we’ve been at least for the last three years, we’ve been – CapEx is kind of like close to 1% of revenue. We've guided towards 1% to 1.5% that's a gain mostly tied to some of the growth investments that we are making in our sort of physical asset base. In 2025, some it’s just a good stewardship of the asset base. So as we kind of just looking at the CapEx going to 1% to 1.5% of revenue that's impact of only 4% on the free cash flow conversion. And the other one that we built in is, given the pretty dynamic world macro that we are living in just from the working capital perspective, we modeled it a little bit higher working capital just to support the business and manage all the supply chain things from the tariffs that we are seeing. Those are two – really the two things as things normalize for 2025, of course we expect it to back up."
},
{
"speaker": "Andrew Krill",
"content": "Okay. That makes perfect sense. That is a good segue. Following up on tariffs, have you dialed what your sourcing is maybe for COGS from China, Mexico and Canada? And would any of those particular paint points where are you not in regions or regions sales? I believe some of that like Trojan have – has pretty meaningful cam exposure or just any help or quantification there would be great. Thank you."
},
{
"speaker": "Jennifer Honeycutt",
"content": "Yeah, thanks for the question, Andrew. We started several years ago, full decade certainly to source raw materials and semi-finished goods globally. We got a diversified number of manufacturing locations and we've diversified the supply chain accordingly. Certainly VES provides us the tools to proactively deal with countermeasures for different scenarios. And obviously, we're focused on controlling what we control. Relative to exposure, our primary exposure in Canada is Trojan as you appropriately cited, which is headquartered in Ontario. We have taken actions there to localize consumables and spare parts for Trojan in the US to derisk any supply chain disruption that we would see. It also gives us an opportunity to provide more agility in serving customers. I mean, I think the way to think about this is, is all told Trojan’s annual sales in the US are less than 5% of our total - for all those sales annually. So, we, we think we're well positioned to sort of weather the storm here. And we've got VES on our side to respond with agility and rigor."
},
{
"speaker": "Andrew Krill",
"content": "Great. And just real quick on China, because I think it is 78% of sales it’s a bit bigger than some peers. Is that fair that’s mostly in region for region or that would be like headquarter imbalance?"
},
{
"speaker": "Jennifer Honeycutt",
"content": "Yeah, we've spent actually a longer period of time diversifying our supply chain around what we have in China. We have a good deal of in China for China. We certainly wouldn't be disrupted by any tariff changes. But again, we have spent the last several years diversifying that supply chain as well, and think we're well, positioned to be able to address any headwinds that we might see there."
},
{
"speaker": "Andrew Krill",
"content": "Great. Thank you very much."
},
{
"speaker": "Operator",
"content": "And we'll take our last question from Brian Lee with Goldman Sachs."
},
{
"speaker": "Brian Lee",
"content": "Hey, good morning, everyone. Thanks for squeezing me in. Just wanted to go back to a couple of margin questions I guess, first off, on, on the PQI side, the 350 basis point margin contraction sequentially. I know part of that seems to be the higher mix of equipment sales. When we kind of back into it, it doesn’t seem to explain the entire bridge. Can you kind of deconstruct the 350 basis points for us across different moving sectors?"
},
{
"speaker": "Sameer Ralhan",
"content": "Hey, Brian. This is Sameer. Yeah, as I kind of outlined earlier right, the first one of course is a TraceGains. That's almost 70 basis points dilutive to PQI on a sequential basis. The next one as we kind of talked about some of the cost optimizations actions we took in my prepared remarks I highlighted $7 million higher on a sequential basis. Majority of that is in PQI. That’s 120-ish kind of basis points, little more than that for PQI. And I would say the third one is, as you kind of think about the R&D sequentially up as well as tied to the investments you are making to drive the future growth in the business. On a sequential basis, majority of the jump is actually tied to PQI, as well. And then last one you add is the higher mix of equipment sales which again really help us expand the installed base for our future recurring revenue. So those are the four things, you add them up, you kind of balance out the 300 basis points gap that you laid out."
},
{
"speaker": "Brian Lee",
"content": "Yeah, I guess, fare to assume some of those factors do spillover to the early part. I guess, if I look at the Q1 guide, it implies margins are going to be down a few tens of BPS year-on-year despite the low-single-digit growth. I know some of that is FX, but then your full year guide implies margin growth through the year off of Q1 with the same FX assumption. So, maybe just kind of walk through the margin cadence, what’s happening in Q1 that doesn’t repeat through the rest of the year? What margin gains are you seeing start to play out off of the back of Q1. Thank you."
},
{
"speaker": "Sameer Ralhan",
"content": "Yeah. No, I think it's going to move from Q4 to Q1, Brian. Not a whole lot of these things are spilling over, right? Look R&D on a sequential basis that should be consistent at higher level. And I would save cost optimization stuff, there's nothing is spilling over into Q1. Really as you kind of look at from anything that's moving from this year to next is TraceGains is going to be as we highlighted, it’s going to be a little bit of dilutive upfront as we continue to drive it's 20% growth business. So we have to make the right investments to make sure we are capitalizing on that. Those investments will be and then the mix, the trends we that we are seeing in the higher mix of equipment sales and PQI continues maybe a little bit of impact from that. But nothing, nothing more than that that’s kind of moving on or spilling over from Q4 to Q1."
},
{
"speaker": "Operator",
"content": "Thank you. And at this time, I'll turn the call back over to Mr. Taylor for final remarks."
},
{
"speaker": "Ryan Taylor",
"content": "Thanks, Margo, and thanks everyone for joining us on the call. We appreciate the interest and engagement. As usual, we'll be around for follow-up questions. Just reach out to me if you'd like to ask anything to follow-up on the quarter or the guide for 20025. Thank you so much. And that concludes our call. We'll talk to you next time."
},
{
"speaker": "Operator",
"content": "Thank you and this does conclude today's program. Thank you for your participation. You may disconnect at any time."
}
] |
vlto | 2,024 | 3 | [
{
"speaker": "Operator",
"content": "Please standby. Your program is about to begin. [Operator Instructions] My name is Shelby and I will be your conference operator this morning. At this time, I would like to welcome everyone to Veralto Corporation's Third Quarter 2024 Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions] I will now turn the call over to Ryan Taylor, Vice President of Investor Relations. Mr. Taylor, you may begin your conference."
},
{
"speaker": "Ryan Taylor",
"content": "Good morning, everyone. Thanks for joining us on the call. With me today are Jennifer Honeycutt, our President and Chief Executive Officer; and Sameer Ralhan, our Senior Vice President and Chief Financial Officer. Today's call is simultaneously being webcast. A replay of the webcast will be available on the Investors section of our website later today under the heading Events and Presentations. A replay of this call will be available until November 9. Yesterday, we issued our third quarter news release earnings presentation and supplemental materials, including information required by the SEC related to adjusted or non-GAAP financial measures. Our Form 10-Q was also filed yesterday. These materials are available in the Investors section of our website, www.veralto.com under the heading Quarterly Earnings. Reconciliations of all non-GAAP measures are also provided in the appendix of the webcast slides. Unless otherwise noted, all references to variances are on a year-over-year basis. During the call, we will make forward-looking statements within the meaning of the federal securities laws, including statements regarding events or developments that we believe or anticipate will or may occur in the future. These forward-looking statements are subject to various risks and uncertainties, including those set forth in our SEC filings. Actual results may differ materially from our forward-looking statements. These forward-looking statements speak only as of the date that they are made and we do not assume any obligation to update any forward-looking statements, except as required by law. And with that, I'll turn the call over to Jennifer."
},
{
"speaker": "Jennifer Honeycutt",
"content": "Thank you, Ryan and thank you all for joining our call today. It has been just over 1 year since we became an independent public company. In that time, I am proud of what our team of 16,000 associates has accomplished to establish a track record of consistent performance, profitable growth and investments for the future. These accomplishments are a testament to our talented team and continuous improvement culture powered by the Veralto Enterprise System. VES enables us to differentiate in the marketplace and is deeply ingrained in our culture. It is the driving force of our daily operations as we strive to deliver results with top talent, continually improve for enduring impact and unlock ingenuity for customer success, all while serving humanity with purpose and integrity. During the past year, we simplified the VES toolkit to focus on the fundamentals bolstered by growth tools, operational excellence and high-impact leadership development. This has fortified our execution and enabled us to better capitalize on durable thematic growth drivers across both business segments. Approximately 85% of our sales support the delivery of clean water, safe food and trusted essential goods. Our customers value our products and solutions because they support critical aspects of daily operations where the risk of failure is high. Our businesses are well-established leaders in their industries with earned authority, large installed bases and intimate customer relationships. These factors, along with our high level of recurring revenue and broad service networks create incredibly durable growth and help insulate us from economic cycles. Our third quarter performance underscores the power of VES and the durability of our businesses. Our teams across the world executed well and delivered another quarter of strong performance with mid-single-digit core sales growth, robust margin expansion and strong cash generation. And we continue to increase our investments in sales, marketing and innovation to support future value creation. In addition to these organic investments, we have cultivated a pipeline of inorganic opportunities for both segments aligned to our strategy, purpose and disciplined M&A criteria. Early in the fourth quarter, we completed the acquisition of TraceGains, a leading provider of software solutions that enable consumer brands to meet increasingly stringent compliance regulations for food and beverage safety and traceability. Its cloud-based solutions and large network connect consumer brands with ingredient manufacturers. This enables consumer brands to develop new products more efficiently while also monitoring quality and compliance. TraceGains serves a fast-growing market segment and has grown its top line by 20% compound annual growth rate over the past 3 years. This year, TraceGains expect sales to exceed $30 million with more than 95% on a recurring basis and a gross margin of approximately 80%. The financial profile and recurring revenue business model of TraceGains meets our disciplined acquisition criteria and strengthens our PQI segment. TraceGains is highly complementary to our PQI brands and connect digital workflows for our CPG customers across new product development, compliance and packaging. We now can streamline processes for consumer brands from source to shelf to relieve pain points as they work to accelerate time to market. Synergies with Esko's global customer base, direct sales channel and the application of VES represent key value creation levers that we believe will accelerate TraceGains' growth, expand its market presence and improve its operating efficiency. We believe Veralto is the ideal new home for TraceGains and we're excited to welcome TraceGains' associates to our team. Moving forward, we continue to evaluate additional strategic opportunities that align with our commitment to deliver clean water, safe food and trusted essential goods and position us to seize emerging market opportunities with attractive long-term value creation potential. Now, looking specifically at our consolidated Q3 financial results. We delivered 4.6% core sales growth with volume contributing 2.8% growth and pricing contributing 1.8%. Our growth was broad-based across key end markets and regions, highlighted by continued strong demand for industrial water treatment in North America and gradual recovery across consumer packaged goods markets globally. We expanded adjusted operating margin by 170 basis points year-over-year to 24%. Adjusted earnings per share grew 19% year-over-year to $0.89 and we generated $215 million of free cash flow, further strengthening our financial position. Looking at core sales growth by geography in the third quarter, sales across all 3 major regions grew in the mid-single digits. In North America which represents nearly half of our total company sales, core sales grew 5.5%, with growth across both segments, led by 7% growth in Water Quality. In Water Quality, we continue to capitalize on strong demand for chemical water treatment solutions which grew high single digits in North America. From an industrial market perspective, this growth was broad-based with the strongest growth in food and beverage and chemical processing. We also continue to see strong growth for UV systems at municipalities in North America. In water treatment, we're partnering with customers to help them achieve their sustainability goals related to water conservation, reclamation and reuse. In our water treatment businesses, we are well positioned to benefit from onshoring or reshoring activity in North America. This includes technology investments such as data centers which consume large quantities of water for cooling. At our PQI segment, core sales in North America grew 2.5% in Q3 with packaging color sales up mid-single digits and marking and coding sales up low-single digits. In Western Europe, core sales grew just over 4% year-over-year with both Water Quality and PQI growing near the company average. The sales growth in Western Europe was concentrated in water analytics and marking and coding. Note that our total company growth in Western Europe included an approximately 50 basis point headwind related to the strategic portfolio actions in our Water Quality segment that we mentioned on prior earnings calls. In high-growth markets, core sales grew 4.5% in the third quarter. We continue to see strong growth in Latin America with core sales up about 10%, led by water analytics, water treatment and marking and coding. Latin America now represents about 10% of our total company sales and we are investing for growth in this region. Within high-growth markets, the growth in Latin America more than offset a modest 3% decline of sales into China. Overall, we delivered terrific third quarter financial results on the back of strong commercial and operational execution. And on the strength of our third quarter performance, we raised our full year adjusted EPS guidance. At this time, I'll turn the call over to Sameer to provide details on our third quarter results and guidance for the balance of the year."
},
{
"speaker": "Sameer Ralhan",
"content": "Thanks, Jennifer and good morning, everyone. I'll begin with our consolidated results for the third quarter. Net sales grew 4.7% on a year-over-year basis to just over $1.3 billion. Core sales grew 4.6%. Currency was a modest benefit in the quarter. Our core sales growth was driven by increased volume at 2.8% with positive volume growth across both segments, led by PQI. This marks the second consecutive quarter in which volume grew across both the segments. Price contributed 1.8% growth in this quarter, in line with historical levels. Our recurring revenue grew mid-single digits year-over-year and comprised 61% of our total sales. We expanded margins at both segments through pricing, improved productivity and cost optimization. Gross profit increased 8% year-over-year to $783 million. Gross profit margin improved 200 basis points year-over-year to 59.6%, reflecting the benefits of pricing as well as improved productivity and reduced manufacturing costs. Adjusted operating profit increased 13% year-over-year and adjusted operating profit margin expanded 170 basis points to 24.1%. We delivered strong margin expansion while investing in our sales and marketing efforts to drive future growth. We also increased our R&D investments with R&D as a percent of sales increasing 40 basis points over the prior year period. These investments are aligned with our strategic growth plans and we expect to continue to fund ongoing growth investments. Looking at earnings per share for Q3, adjusted earnings per share grew 19% year-over-year to $0.89. And free cash flow was $215 million or approximately 98% conversion of GAAP net income. Moving on, I'll cover the segment highlights, starting with Water Quality. Our Water Quality segment delivered $801 million of sales, up 3.6% on a year-over-year basis. Currency was a 20 basis-point headwind and divestitures had 20 basis points impact versus the prior year period. In addition, small product lines that we strategically exited in the fourth quarter of 2023 resulted in approximately 70 basis points headwind to core growth for the Water Quality segment in the third quarter. The headwind from these product line exits has annualized and will not impact our fourth quarter results. Core sales grew 4% year-over-year. Pricing contributed 2.1% and volume growth contributed 1.9% to year-over-year core sales growth. Our volume growth was driven by strong demand for water treatment solutions in our industrial end markets and UV treatment systems in municipal end markets. We also saw strong growth in sales of reagents and chemistries to municipalities. Recurring sales across Water Quality segment grew high single digits. Adjusted operating profit increased 4% year-over-year to $199 million and adjusted operating profit margin increased 10 basis points to 24.8%. Moving to the next page, our PQI segment delivered sales of $513 million in the third quarter, up 6.3% year-over-year. Currency was a 40 basis-point tailwind. Core sales grew 5.7%. Volume contributed 4.3% and price increases contributed 1.4% to the year-over-year core sales growth. PQI's recurring sales grew high single digits year-over-year with continued positive momentum across the portfolio. Recurring revenue increased to 64% of PQI sales mix in this quarter. Breaking this down by business, marking and coating sales grew mid-single digits, driven by growth in both consumables and equipment. The strongest growth was at food and beverage applications with our CPG customer base. In our packaging and color business, core sales grew high single digits year-over-year, led by growth in recurring software and subscription revenue. PQI's adjusted operating profit was $142 million in the third quarter, up $32 million over the prior year period, resulting in an adjusted operating profit margin of 27.7%. That represents a 490 basis-point improvement in adjusted operating profit margin over the prior year period. The margin expansion was driven primarily by pricing, strong operating leverage and cost optimization initiatives. As a reminder, PQI's profitability in the third quarter of 2023 was unfavorably impacted by changes in foreign currency, particularly the devaluation of the Argentine peso which did not repeat in the third quarter of 2024. Overall, it was a very strong quarter for PQI which further demonstrates the earnings power of our PQI businesses. Turning now to our balance sheet and cash flow. In Q3, we generated $224 million of cash from operations. Cash flow from operations for the third quarter reflects the biannual cash interest payments on our senior notes. We also invested $9 million in capital expenditures. Free cash flow was $215 million in the quarter or 98% conversion of GAAP net income. At the end of the third quarter, gross debt was $2.6 billion and cash on hand was $1.27 billion. Net debt was $1.37 billion, resulting in net leverage of 1.1x. As Jennifer shared, early in the fourth quarter, we acquired TraceGains at a gross purchase price of $350 million. The deal was funded with cash on hand. Pro forma for this acquisition, our financial position still remains strong and we continue to have flexibility in how we deploy capital to create long-term shareholder value with a bias towards M&A. We have an attractive pipeline of opportunities in both Water Quality and PQI. We will remain disciplined in our approach as we continue to deploy capital to create long-term shareholder value. Turning now to our guidance for the fourth quarter. We are targeting core sales growth in the low to mid-single-digit range on a year-over-year basis, consistent with the level of core growth we reported in the second and third quarter of 2024. We expect acquisitions to contribute about 60 basis points to year-over-year sales growth. Including the impact of the TraceGains acquisition, we expect adjusted operating profit margin of approximately 24% in the fourth quarter. This represents 30 basis points of improvement in adjusted operating profit margin on a year-over-year basis and is flat sequentially. And our Q4 2024 guidance for adjusted EPS is $0.86 to $0.90 per share. For the full year, we raised our adjusted EPS guidance to a range of $3.44 per share to $3.48 per share. Midpoint of our updated full year adjusted EPS guidance of $3.46 per share is up $0.05 from the prior guidance. Also at the midpoint, this represents year-over-year adjusted EPS growth of 8%. That concludes my prepared remarks. At this point, I'll turn the call back over to Jennifer for closing remarks."
},
{
"speaker": "Jennifer Honeycutt",
"content": "Thanks, Sameer. In summary, we delivered high-quality growth and margin expansion in the third quarter, further demonstrating the durability of our business, the power of VES and the talent of our team. Across the company, we are executing well and capitalizing on the secular growth drivers across both segments. Based on the strength of our third quarter results, we raised our full year adjusted EPS guidance. And at the outset of the fourth quarter, we completed the acquisition of TraceGains. Our financial position remains strong and we continue to evaluate additional strategic opportunities within our disciplined framework of market, company and valuation. As we look longer term, we remain committed to creating value through steady, durable sales growth, continuous improvement and disciplined capital allocation. That concludes our prepared remarks. And at this time, we are happy to take your questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] And we'll take our first question from Andy Kaplowitz with Citigroup."
},
{
"speaker": "Andy Kaplowitz",
"content": "Sameer, I know you want to be conservative but just looking at the Q4 guidance, you're guiding below Q3's core growth. And adjusted operating margin, even as it seems like PQI continues to recover, I know your year-over-year comp in Q4 is a bit more difficult than Q3. And I think you just said you have some minor negative TraceGains impacts in there for Q4. But any other reason why year-over-year growth in margin would be a little down in Q4 versus Q3? Is there just a bit of conservatism in the guide?"
},
{
"speaker": "Sameer Ralhan",
"content": "Andy, thanks. Look from the margin perspective, really, on a year-over-year basis, when you look at it, it's really three things that are kind of driving it. The first one is, of course, the TraceGains, the operating impact as well as some of the transaction costs, so that's roughly 30 bps of an impact that you're going to see in Q4. And then the higher corporate costs as they're getting to the run rate tied to some of the onetime costs related to first year activities as a public company. So, that's another kind of a 50 basis point Andy. So those combined are almost 80 bps of an impact on the margin in Q4 and then after that, it's really a mix of equipment sales as the printer sales, we feel really good about some of that engagement with the customers, that equipment volumes coming back, that's going to have an impact on the margin. So those are the really three things Andy which are kind of driving our view on the 24% margin for Q4."
},
{
"speaker": "Andy Kaplowitz",
"content": "And just the growth side, Sameer, like anything to sort of call out there just kind of similar to Q3?"
},
{
"speaker": "Sameer Ralhan",
"content": "Similar to Q3, look, when I think the overall sort of demand patterns are very similar on the consumer package, so good side for PQI. We feel encouraged. It's a kind of a steady recovery that we are seeing in the marketplace. And the water again, you saw the -- our commentary around the industrial end markets that we saw in North America that continues. Europe is steady. And I think China, we are all watching. It's just kind of sequentially flat is what you kind of think about from a guide perspective. And just as a reminder, on the growth side, when you kind of start looking from a year-over-year perspective Andy, Q4 was strong in China. So that's going to be a little bit of an impact, Q4 last year. So that's a little bit of an impact. But no, it's almost like a Q3 kind of a quarter."
},
{
"speaker": "Andy Kaplowitz",
"content": "Got it. And then Jennifer, can you give us a little more color into your thought process of how TraceGains is going to help drive growth through revenue synergies in PQI? Obviously, you mentioned source-to-shelf solutions. TraceGains, we know is already growing fast. But are you expecting TraceGains to allow you to take more market share with food and beverage customers in the near term and maybe that enhances your overall core growth. How do you think about that?"
},
{
"speaker": "Jennifer Honeycutt",
"content": "Yes, thanks for the question. We're really excited about TraceGains. They provide a cloud-based solution that connect the brands with ingredient manufacturers and help address increasingly stringent compliance regulations for food and beverage safety and traceability. The synergy with Esko allows us to integrate the packaging and the new product development workflows. It also helps improve data integrity and reduce time to market which are 2 critical pain points for customers. In terms of the outlook there, they've been a strong grower in terms of delivering double-digit sales growth since 2022. We would expect this momentum to continue as we think about food and beverage customers being early in their digitization journey. So with the macro of regulatory drivers, consumer safety mandates, we feel really good about bringing this business in and getting synergy with Esko to drive forward momentum and improve our growth profile there."
},
{
"speaker": "Operator",
"content": "We'll take our next question from Mike Halloran with Baird."
},
{
"speaker": "Mike Halloran",
"content": "So first one, just on the CPG side and the underlying trends you're seeing sequentially through the quarter and into 4Q here. Any change in the thought process on how the improvement is coming around on that side of things? I know the content so far has talked about a gradual improvement. Any tone change? And then maybe talk about the moving pieces behind it that give you confidence into '25?"
},
{
"speaker": "Jennifer Honeycutt",
"content": "Yes. I mean I think we continue to be encouraged by the ongoing recovery in CPG but we also see it as slow and steady. Some of our early indicators here are that we've just completed the fifth consecutive quarter of mid- to high single-digit growth in recurring revenue at PQI. And as we've mentioned in prior calls, this is an indication that lines are coming back online that they're being refurbished and now that we've seen two consecutive quarters of year-over-year growth in equipment sales, it also suggests that brand owners are upgrading their printer technology and replacing printers that are aging out. So we see continued strength here. We think it's kind of slow and gradual. We're not going to see any dramatic inflection points but we're pretty confident that what we're seeing is good, robust market recovery. And relative to the submarkets, data is a little bit mixed. Beverages are generally up, elective snacks are down but at-home food spend is still a little bit negative. It is improving sequentially. And so we are encouraged by the market indicators but still early days in the recovery and we expect to continue to execute well. I think our recent product launches and newest innovations are also gaining momentum."
},
{
"speaker": "Mike Halloran",
"content": "Helpful. Appreciate that. And then just on the packaging color side of things, now that you have TraceGains in there, broadens out the offering. When you think about that digital workflow that you're trying to accomplish, what are the gaps? What do you feel like is left to fill in and organic versus inorganic? I'm assuming more of that fill in is inorganic. But curious what's left and where you see the air pocket still in the offering?"
},
{
"speaker": "Jennifer Honeycutt",
"content": "Yes. I mean, I think it's early, as we said in the digitization journey for CPG customers. There are a lot of sort of disaggregated data flows and needs that they have to tick and tie information. And really, what we're looking to do is to make sure that we're well positioned to solve unmet customer needs and address some of those pain points. So we do see more optionality in the space, both organically and inorganically and we're excited about that in the future."
},
{
"speaker": "Operator",
"content": "We'll take our next question from Nathan Jones with Stifel."
},
{
"speaker": "Nathan Jones",
"content": "I guess I wanted to start on a comment you made in your prepared remarks, Jennifer, on having simplified the VES tool set and having that make the business better able to capitalize on durable growth trends. I wonder if you could just talk a little bit more about the kinds of things that you've done to adapt the VES system to Veralto and how you think that positions you to better capitalize and durable growth trends?"
},
{
"speaker": "Jennifer Honeycutt",
"content": "Yes. I mean I think once we came over a little over a year ago, we took a hard look at the tools in terms of which were really material to improving sort of growth and profitability profile, giving us access to markets, accelerating new product development and so on. And so the simplification was really focused around narrowing the field of tools that sit in what we call the VES Fundamentals. And these are tools, it's 5 or 6 tools that are relevant to every function and every business regardless of where you sit in the organization. And it's really a disciplined approach to good critical thinking and problem-solving and how you know that you're winning each and every day, whether you're red or green in terms of visual management and how you're correcting course along the way. We've subsequently fortified that tool set with very select growth tools, operational excellence tools and leadership tools. And so the way to think about this, Nathan, is we've narrowed the tool set to the critical view to drive discipline and focus. And we've made sure that VES is really being used by everyone, all functions, all businesses and so on. So we're excited about sort of the new simplified way of creating focus here. And I -- as I mentioned, we selectively will develop tools as and when the business needs them going forward."
},
{
"speaker": "Nathan Jones",
"content": "And then, I've got one on TraceGains. Can you talk about what the algorithm is you need to achieve out of TraceGains in terms of gross margin expansion to hit that double-digit ROI by year 6? And then I think there's some planned investments to go into that business to drive growth. Maybe just a comment on whether that should be accretive or decretive to earnings in 2025?"
},
{
"speaker": "Jennifer Honeycutt",
"content": "Yes. I think we really like the growth profile here. Obviously, they've been growing solid double digits here in recent history. We have seen them continue to invest here and we will continue to invest to fuel their growth. They are an early phase business but maybe to the numbers specifically, I'll turn that over to Sameer."
},
{
"speaker": "Sameer Ralhan",
"content": "Thanks, Jennifer. Yes Nathan, as you're going to look at from the '25 perspective, the way it stands right now as Jennifer said, given the growth that we're seeing that TraceGains and the investments that we'll continue to make to drive that growth, we expect it to be modestly dilutive. But just to put in perspective, there's a pretty small acquisition. So it's not going to -- it's going to have a minimal impact at best on '25. But we'll walk through the '25 EPS growth bridge when we come back in February and talk about '25 guide."
},
{
"speaker": "Operator",
"content": "And we'll take our next question from Deane Dray with RBC Capital Markets."
},
{
"speaker": "Deane Dray",
"content": "There's a major fast food company going through a food contamination situation. I'm not asking you to comment specifically on it but as a use case hypothetically, how does Veralto have positioned in the food chain to be able to identify and do that kind of trace work on a kind of an emergency basis?"
},
{
"speaker": "Jennifer Honeycutt",
"content": "Well, as you know, Deane, we've got a broad portfolio of solutions relative to contaminant control and detection. Most of that sits on the water side. Some of that is transferable to the food side of things. Today, most of our analytics really sits on the inorganic side of the business. We do have good technologies to bring to bear in this space. But certainly, when it comes to sort of an acute outbreak of a food-borne issue, we don't play as heavily there than we might play if it was a waterborne outbreak. So we're well positioned certainly in the water space and anything that relates to water. And we think we've got a good play here with the addition of TraceGains and we're excited about how we think about that market going forward."
},
{
"speaker": "Deane Dray",
"content": "Yes Jennifer, I'm not asking so much about the analytics around Salmonella on what the actual contaminant was but just the traceability across the food chain of what producer, there's bar codes, there's shipment data and so forth. And you're part of that chain and that's part of the traceability appeal of Veralto. Just hypothetically, how would that work?"
},
{
"speaker": "Jennifer Honeycutt",
"content": "Yes, absolutely. I mean if you're thinking about traceability and following a contaminant or a series of contaminants through the food chain and food cycle, we are well prepared to do that. TraceGains gets us to the traceability of the ingredient information, right? And for brand manufacturers, that's incredibly important in terms of where they're sourcing raw materials. But frankly, our coding and marking business will give you date codes, lot codes and traceability for how to identify where those products have gone and how to actually ring-fence quarantine them and pull them off the market. So we're well positioned here."
},
{
"speaker": "Deane Dray",
"content": "All right. That's exactly what I was looking for. So I appreciate that. And then just a follow-up for Sameer and or Jennifer. You all referenced a disciplined acquisition criteria. And as far as I know, you all haven't really laid this out and wasn't at your Investor Day. What are the hurdles that you set because the expected double-digit ROIC for TraceGains is rather extended versus -- and we get it a SaaS business, it's a different set of expectations versus industrial acquisitions? But just give us a sense of what the acquisition hurdles are as we think about prospective M&A?"
},
{
"speaker": "Sameer Ralhan",
"content": "Hey Deane, I'll take that one. From an M&A perspective, as you know, as we look at the opportunity set, it's always deeply rooted in our framework which is market company valuation. And from the financial metrics point of view, things like ROIC growth, margin, cash flow accretion are all very important as we kind of evaluate all the opportunities. It's all about striking the right balance depending on the acquisitions. What I would say is from an ROIC perspective. It depends on the complexity and the kind of deal. For example, if it's a small bolt-on that we are looking at, that will be -- we expect to be a cost of capital by year 3. And if it's a large acquisition, is a technology acquisition, for example, TraceGains is a great example for that, we'll achieve ROIC close to cost of capital by year 5 or 6 [ph]."
},
{
"speaker": "Operator",
"content": "We'll take our next question from Brian Lee with Goldman Sachs."
},
{
"speaker": "Brian Lee",
"content": "Maybe first one for Sameer. You mentioned you're seeing good strength in PQI, some of the equipment sales seem like they're going to start to flow through more meaningfully into 4Q but have some slight margin implications. Can you quantify that? And then given kind of the backlog and visibility you have on equipment volumes into, I guess, 2025, should we expect that level to maybe persist in the PQI margins for a couple more quarters?"
},
{
"speaker": "Sameer Ralhan",
"content": "Thanks, Brian. Thanks for your question. As we kind of look at the equipment side, first of all, from a growth perspective, we expect -- we feel really good about the engagement that we have with the customers right now and all the signals that the teams are getting, we expect the equipment recovery to happen over the next few quarters in 2025. So it's going to be a slow and steady kind of a gradual recovery in the equipment side. From a margin perspective, the way to quantify it is to really look at what the mix was in 2019, right but things will -- a little more normalize on where the gross margins were that kind of helps you quantify a little bit on what the impact may be. But again, things have changed quite a bit. And as Jennifer said earlier, we have simplified VES. We're attacking all these things from a VES perspective. So we'll mitigate any impact as much as we can but it is going to have a little bit of an impact on the gross margin."
},
{
"speaker": "Brian Lee",
"content": "Okay, great. That's helpful. And then, maybe just on China. You called it out as a modest headwind on growth this quarter, I think 3%. You're saying it's going to be flat sequential but you had a tougher comp from Q4 last year. Just kind of taking a step back, can you speak to sort of what you're seeing on the ground in China if this is sort of just bouncing along bottom for a little while? Is there any potential for a pickup as you see it in the near term just with some of the stimulus potentially brewing out there? Just any views on kind of the state of the state in China."
},
{
"speaker": "Jennifer Honeycutt",
"content": "Yes, thanks for the question. On an aggregate level, I think the year is playing out as we anticipated in China, really no meaningful recovery or change in sales and demand profile. To use your words, we kind of are bouncing along the bottom. We were down modestly, about 3% year-over-year. But from a segment perspective, we kind of have two different trends here in Q3. We are seeing in PQI modest recovery in both CPG and industrial markets as they reignite their manufacturing activity over there. So we are seeing modest growth there. In Water Quality, kind of a little bit of the opposite. We continue to see challenges in funding at municipal customer sites. And then certainly, from a year-over-year perspective, we had a pretty significant number of orders go out on semiconductor projects from our Trojan business last year. So they had a very strong sort of second half in 2023 that is not going to repeat here in 2024. The good news, if there is some silver lining here, is that we still see strong demand here in the U.S. for semiconductor orders and activity. So a little bit of a shift in terms of where that business is occurring. In near term, we're just not expecting really any overall improvement. It's kind of going to be more of the same."
},
{
"speaker": "Operator",
"content": "We'll take our next question from Andrew Buscaglia with BNP."
},
{
"speaker": "Andrew Buscaglia",
"content": "I just wanted to start out with Water Quality, sales very solid. Margins also good but maybe a little bit below what I was forecasting. And I'm wondering if you could kind of dig into the different -- the margin differential with analytics and treatment? It looks like treatment or analytics is lagging a little bit behind treatment. And how do you see that playing out over the next 12 months with how those progressed and maybe the margin impact?"
},
{
"speaker": "Sameer Ralhan",
"content": "Yes, I'll take that one. If you look at it from a margin perspective, right, you're right. Analytics has been growing nicely. It's a more steady business for us, as you know Andrew. But on the other hand, the treatment side, you've seen some really good growth from the industrial end markets. Analytics tends to be a little higher margin. There's not a huge delta but a slightly higher margin than the industrial and the chemical treatment kind of businesses. So that mix has a little bit of an impact but nothing sort of a major. I would say the only other thing really Andrew, is quarter-to-quarter, means impacts. We'll be making investments, as we said, as we're going to think about growth and the growth opportunities that we see for the business in 2025. We are getting up for those growth opportunities, making those investments on the sales and marketing side. That's really the impact. But beyond that, I wouldn't read too much into it."
},
{
"speaker": "Andrew Buscaglia",
"content": "Okay. And PQI has been such a great story all year. I'm wondering if a lot of these a lot of analysts like myself don't have a ton of context but in terms of understanding that CPG markets and cycles. How does this cycle feel versus past ones in terms of recovery? Because this tend to be a low single-digit business long term but you can have some big swings to the upside. So what do you -- how do you guys see that playing out this cycle?"
},
{
"speaker": "Jennifer Honeycutt",
"content": "Yes, we really like the PQI business. And I think if you look at its history over the past 20 years, we've only had sort of 3 periods of contraction. So it tends to hold up really well through various economic cycles. And what I would say in comparing this recovery to prior recoveries is prior recoveries was more of a V-shaped recovery kind of fast down and fast up. I think what we've seen sort of post pandemic is a gradual and steady progressive sequential improvement, so it's more U-shaped than V-shaped. But we continue to be encouraged by the leading indicators that we see in terms of volume of -- that's published from our top CPG customers and demand continues to consistently grow and that's also supported by the sales out that we've seen from our recurring revenue and then the two sequential quarters of equipment growth. So again, I think it's a slow and steady wins the race here. We're not going to see any huge inflection points but we're encouraged by certainly what we see in the market today."
},
{
"speaker": "Sameer Ralhan",
"content": "Shelby, we're ready for the next question."
},
{
"speaker": "Operator",
"content": "We'll take our next question from Andrew Krill with Deutsche Bank."
},
{
"speaker": "Andrew Krill",
"content": "I wanted to sort of go back to the strong Latin America growth. I was wondering if you could expand a little on like why you think this all of a sudden accelerated so much and has this been years of investment that's kind of finally coming through? And then do you think it's sustainable going forward? And maybe any color on like the margins here, if there are any different than the company average?"
},
{
"speaker": "Jennifer Honeycutt",
"content": "Yes, thank you for the question Andrew. We've been really pleased with our performance in Latin America. And we've watched this region closely over the course of the last couple of years here. We've made some commercial investments here to sort of focus the team at capturing the highest growth opportunities. And so I think what we're seeing there is the benefit of some reshoring or onshoring activity as some of the customers look to diversify their risk and insulate themselves from any sort of geographical constraints that they might see in China. But we're also starting to see some benefit from privatization of water utilities in Brazil. That's giving us some good opportunity around how we serve those customers and some changes in business model that help us serve them effectively. So, I think this is a reason for us to continue to stay focused on. As you know, we said in our prepared remarks, Latin America represents 10% of our total sales and it's growing well for us."
},
{
"speaker": "Andrew Krill",
"content": "Anything on just the margins or should we assume they're kind of similar to the company average?"
},
{
"speaker": "Sameer Ralhan",
"content": "It's very similar Andrew, I think nothing dramatically different."
},
{
"speaker": "Andrew Krill",
"content": "Got it. And then, going back to the broader M&A pipeline discussion. Just wondering if you -- as I think TraceGains came through, just is there like a theoretical limit to the number of deals you think the company can handle per year? And I guess, in terms of maybe bolt-ons, is there a number? And if you did a larger, would you expect to kind of take your foot off the gas with bolt-on?"
},
{
"speaker": "Jennifer Honeycutt",
"content": "Thanks for the question. M&A is fairly episodic. We don't necessarily control the timing here. But what we can say is we're excited about the level of activity and engagement we have for both sides of the house. Funnels for Water Quality and PQI are both very full and we continue to be heavily engaged in this area. We don't set thresholds or limits to what we can digest here by way of number of deals or size. It stands to reason that we feel well prepared to be able to execute on our M&A playbook and bring in deals of various sizes and scale as and when we find the right intersection of market company and valuation. So again, this is an area that we're excited about. We don't have any preset thresholds but we will capitalize on the opportunity as and when we're able to go after deals that meet our stringent criteria."
},
{
"speaker": "Operator",
"content": "We'll take our next question from Joe Giordano with TD Cowen."
},
{
"speaker": "Joe Giordano",
"content": "I just wanted to touch back on the margins on Water Quality. I know Sameer mentioned some of the puts and takes there. But if I look at year-on-year growth it was pretty strong. Price is pretty good. and you had some divestments which I assume are lower margin than the fleet average there. So like the leverage there, obviously, it was up 10 bps year-on-year. Can you just talk through like the lack of leverage in the quarter and like what, if anything, are kind of more onetime in the quarter that might go away if you were to keep growing at this pace?"
},
{
"speaker": "Sameer Ralhan",
"content": "Yes, Joe, I'll take that one. If you look at from a margin perspective, right, on the Water Quality side, we talked a little bit of the puts and takes but still the fall-through is close to 30%. So as you kind of think about from a long-term growth algorithm perspective in the 30%, 35%, so they're pretty close. And that's also, as we said, we are making investments in the sales and marketing side in that business as we're going to think about how we orient ourselves to capture the future growth. And then when we move to PQI, the fall through has been really good. It's a little over 100%. And even if you pro forma for the onetime, I think there's only one thing that you can think about onetime item and that was in 2023, Q3, the Argentine peso impact. Even if you pro forma on that, the fall through in PQI has been close to 80%. So net-net at the company level, we are a 60% kind of a fall through. So overall fall-through has been good. And as we kind of move into the '24, I kind of laid out some of the puts and takes on the margin side. So there's nothing one-off items kind of thing here, Joe, that are impacting the margins."
},
{
"speaker": "Joe Giordano",
"content": "Okay. And then on CapEx, like can you talk about the long-term needs of the organization? It's still -- it's extremely light kind of percentage of sales and even if I was to apply all the CapEx to just Water Quality, it's still pretty low. So what should that kind of balance out as a percentage? And then just add one quick one on TraceGains afterwards."
},
{
"speaker": "Sameer Ralhan",
"content": "Yes. I mean if you look at the CapEx side, it's really -- we are not a very capital-intensive business, as you know, right? It's a pretty asset-light model. The strength of the business is driving the values really through -- on the R&D side and the commercial side. That's where you see the investments and then the impact on the P&L side. But from a CapEx, 1% to 2% is how you should think about that. It really comes down to the projects, depending on how they're going to pan out from a timing perspective. But 1% to 2% is the right way to thinking about the CapEx for us. We're running a little light this year."
},
{
"speaker": "Joe Giordano",
"content": "Okay. And then just last on TraceGains. You mentioned the combination with Esko. I'm just curious, like from a customer standpoint, how does this work? Like are you -- are these independent offerings that are being pitched separately? Or are you going to be able to get TraceGains through the Esko platform like I'm just curious as to what the customer experience is to have that whole totality of the -- from source to shelf?"
},
{
"speaker": "Jennifer Honeycutt",
"content": "Yes, thanks for the question. I think the way to think about this is we will serve customers in the way that they want to be served. One thing that we do see is Esko has got great strength at the enterprise level and TraceGains has got great strength kind of at the mid-market level. The cross-pollination of the two will catalyze sort of expanded share of wallet, I think, at customers and give them more solutions to their sort of digital integration challenges that they're working with today. So it will vary by region. It will vary by customer but we feel good about the combination of the two going forward."
},
{
"speaker": "Operator",
"content": "We'll take our next question from Damian Karas with UBS."
},
{
"speaker": "Damian Karas",
"content": "Sameer, sorry if I missed this, did you quantify how much of a headwind the Water Quality product exits were to the third quarter sales?"
},
{
"speaker": "Sameer Ralhan",
"content": "I'm sorry, Damian, can you repeat that?"
},
{
"speaker": "Damian Karas",
"content": "The Water Quality product exits."
},
{
"speaker": "Sameer Ralhan",
"content": "It's roughly 70 basis points on the growth side, Damian."
},
{
"speaker": "Damian Karas",
"content": "70 to the segment, 50 to the total company 50 bps; that's helpful. I wanted to ask you guys, so there's some updated regulations requiring a lower threshold for lead and copper in drinking water systems that were finalized earlier in the month. Just curious if you think that, that's something that could have a meaningful impact on your business? I mean, is there a good way to kind of think about that? I think there's 10 years to meet the requirement. Would you expect implementation to happen sooner rather than later? Or is that the type of change that everyone kind of just waits until the last minute to address?"
},
{
"speaker": "Jennifer Honeycutt",
"content": "So Damian, the way to think about this is our analytics business is 4 to 5x the menu of anyone else in the market. We've got the broadest portfolio with decades of innovation in this space. We are already well positioned with our technologies associated with detecting lead and copper. So unless there is an increase in frequency of testing which there may be on the margin, just to validate, we would expect this to just be business that we get in the normal course of running the business. So, I wouldn't think about this as a huge opportunity for increased sales. There may be a period of time of sort of marginal increase in testing, just to verify what you've got in place. But we're already well positioned here with our existing technologies."
},
{
"speaker": "Operator",
"content": "We'll take our last question from Brad Hewitt with Wolfe Research."
},
{
"speaker": "Brad Hewitt",
"content": "So as we think about the M&A pipeline more broadly, how should we think about the distribution of the funnel as it relates to the time required to get to 10% ROIC? Would you expect the majority of targets are kind of more in the 4- to 5-year time frame you get to that 10% ROIC rather than the 6 years for TraceGains?"
},
{
"speaker": "Sameer Ralhan",
"content": "Yes, it's a pretty broad range, right? As we kind of talked earlier, the pipelines are pretty full on both sides of Water Quality and PQI but it's really a mosaic of opportunities as you're going to think about, Brad, some of our technology investments which are going to be on the longer side. And at the same time, there are a bunch of bolt-ons and the larger transactions as well. So bolt-on should be on the quicker -- on the closer side, it's a pretty broad range. I wouldn't say it's skewed one way or the other."
},
{
"speaker": "Brad Hewitt",
"content": "Okay, that's helpful. And then, curious how important entry multiples are in your decision-making process for M&A? And how do you think about the triangulation between entry multiples and what that implies for business quality versus the path to 10% ROIC?"
},
{
"speaker": "Sameer Ralhan",
"content": "Look it's really about value creation, Brad. It's the input, as you said, the entry multiple and what we can do with the business, how we can fuel the growth or drive the margin expansion to the application of VES. So it's a combination of all those things. I would say our focus is ultimately doing transactions, adding things to our portfolio which drives long-term value creation. So, everything kind of starts from that."
},
{
"speaker": "Ryan Taylor",
"content": "Thanks, Brad and thanks, everybody, for joining the call. This is Ryan Taylor. We are at the hour time, so we're going to conclude the call for this time. I'll be available for any follow-ups. Please reach out to me if you have any further questions. We really appreciate the engagement and support and joining our call today and we'll talk to you next time."
},
{
"speaker": "Operator",
"content": "That concludes today's teleconference. Thank you for your participation. You may now disconnect."
}
] |
vlto | 2,024 | 2 | [
{
"speaker": "Operator",
"content": "My name is Leo, and I will be your conference operator this morning. At this time, I would like to welcome everyone to Veralto Corporation's Second Quarter 2024 Conference Call. All lines have been placed on mute to prevent any background noise. After the speakers' remarks, there will be a question-and-answer session. [Operator Instructions] I will now turn the call over to Ryan Taylor, Vice President of Investor Relations. Mr. Taylor, you may begin your conference."
},
{
"speaker": "Ryan Taylor",
"content": "Good morning, everyone, and thanks for joining us on the call. With me today are Jennifer Honeycutt, our President and Chief Executive Officer; and Sameer Ralhan, our Senior Vice President and Chief Financial Officer. Today's call is simultaneously being webcast. A replay of the webcast will be available on the Investors section of our website later today under the heading Events & Presentations. A replay of this call will be available until August 9. Before we begin, I'd like to highlight a few recent disclosures. On July 24, we issued our 2024 sustainability report. That report can be viewed on our main website under Sustainability or on our Investor website under Corporate Governance. Yesterday, we issued our second quarter news release, earnings presentation, and supplemental materials, including information required by the SEC relating to adjusted or non-GAAP financial measures. Additionally, our Form 10-Q was filed yesterday. These materials are available in the Investors section of our website under the heading Quarterly Earnings. Reconciliations of all non-GAAP measures are provided in the appendix of the webcast slides. Unless otherwise noted, all references to variances are on a year-over-year basis. During the call, we will make forward-looking statements within the meaning of the federal securities laws, including statements regarding events or developments that we believe or anticipate will or may occur in the future. These forward-looking statements are subject to a number of risks and uncertainties, including those set forth in our SEC filings. Actual results may differ materially from forward-looking statements. These forward-looking statements speak only as of the date that they are made and we do not assume any obligation to update any forward-looking statements, except as required by law. With that, I'll turn the call over to Jennifer."
},
{
"speaker": "Jennifer Honeycutt",
"content": "Thank you, Ryan, and thank you all for joining our call today. I want to start this call by recognizing the engine behind our strong second quarter results, our more than 16,000 associates around the world. Their strong execution and support of our customers drove our growth and improved profitability during the quarter. Nine months into our journey as an independent company, we are hitting our stride and delivering winning outcomes for our stakeholders. A key catalyst has been increased rigor in deploying the Veralto Enterprise System. As I've shared before, VES is a key competitive advantage for Veralto. It drives continuous improvement, accelerates innovation, and enables us to win in our markets. Every day, at all levels of our enterprise, our teams leverage VES to solve problems rapidly and drive sustainable improvements. Our increased rigor in deploying VES has helped drive growth, expand margins, and ensure that we deliver on commitments. Our second quarter results demonstrate the benefit of this increased rigor, while also highlighting the durability of our businesses. We delivered core sales growth across both segments, led by better-than-expected positive volume and price increases in line with historical levels. We expanded margins at both segments through strong operating leverage, improved productivity, and cost optimization. Based on our strong execution in the second quarter and an incrementally more positive view of our end markets, we have raised our full year adjusted EPS guidance. From an end market perspective, we are capitalizing on secular growth drivers across our industrial and municipal markets in Water Quality. In water analytics, our commercial initiatives are accelerating volume growth and market penetration, particularly in consumables. And in water treatment, we continue to see strong growth, driven by our customers' water conservation, reclaim, and reuse initiatives. On that front, ChemTreat was recently recognized as Industrial Supplies & Services Supplier of the Year by one of the largest global beverage companies. ChemTreat is playing an integral role in helping this customer achieve its sustainability targets through wastewater projects that support the reclamation of hundreds of millions of gallons of water annually. In PQI, we are encouraged by ongoing recovery in consumer packaged goods markets and improved sentiment from brand owners and packaging converters. In our marking and coding business, recurring revenue grew mid-single digits for the fourth consecutive quarter. Notably, sales of marking and coding equipment accelerated during the quarter and grew on a year-over-year basis, with good traction on new product launches. One of those new products is Videojet's 2380 large character inkjet printer, which launched in early April and is off to an impressive start. This printer is designed for use on sustainable packaging materials, such as corrugated cardboard and other porous materials. Second quarter sales of the 2380 printer exceeded our expectations and we continue to build momentum through a robust sales funnel. In our packaging and color business, second quarter bookings were strong, driven in part by the success of new software launches unveiled at recent trade shows and industry events. At the Drupa Trade Show, our Esko, Pantone, and X-Rite teams jointly showcased their latest innovations and highlighted our seamless packaging workflow software and hardware solutions. At the event, Esko unveiled its S2 platform, a multi-tenant cloud-native platform that provides cloud computing, data sharing, and artificial intelligence. All Esko applications connect to this platform, giving all key stakeholders in the value chain access to live data and identical information wherever they are in the world. This integrated ecosystem will empower customers to compress workflows, harness cloud technology and artificial intelligence to accelerate speed-to-market with vital integrated color accuracy. This new technology helps our customers save time, reduce waste, and ensure brand fidelity. These workflow improvements help our customers minimize the environmental impact across their supply chains and achieve their sustainability objectives, while providing safe foods and trusted essential goods to their customers. This is a great example of the alignment between our product innovation and our purpose. Our work at Veralto is inspired by our unifying purpose, Safeguarding the World's Most Vital Resources. We live in a world with big challenges and Veralto plays a significant role in solving many of them. Helping customers ensure clean water, safe foods, and trusted essential goods for billions of people across the globe motivates all of us at Veralto each and every day. It inspires our associates who are drawn to Veralto because of the role our products and solutions play in helping preserve the planet, how we care for and invest in our people, and our efforts to minimize the environmental impact of our own operations. And it's easy to be inspired by the work that we do at Veralto. In 2023, our team helped ensure 3.4 billion people around the world had access to clean water for daily use, treat and recycle 13 trillion gallons of water, save 81 billion gallons of water, and ensure product authenticity and safety by helping customers mark and code over 10 billion products every day. In addition to these positive and enduring contributions, I want to highlight two important commitments featured in this year's Sustainability Report. First, in support of our commitment to minimize the environmental impact of our own operations, we disclosed our 2023 Scope 1 and Scope 2 greenhouse gas emissions and committed to a 54.6% reduction goal by 2033. Second, in support of our commitment to drive a responsible supply chain, we set an initial target to have 40% of our supplier base certified through the EcoVadis program. EcoVadis is one of the leading sustainability rating agencies and will help us measure, assess, and improve the impact of our supply chain on the world. The role our products play in preserving the planet and the targets we have committed to achieve embody the culture and are made possible by our people. Our people are the most important part of our strategy and we invest heavily to recruit, develop, and retain the most talented and diverse team possible. Our 2024 Sustainability Report published earlier this week contains more details about our commitment and ability to deliver positive, enduring impact, and drive sustainable outcomes for the benefit of humanity. Now turning to our Q2 financial results. Before getting into the details, it's important to highlight a key underlying strength of Veralto, and that is the durability of our businesses. Approximately 85% of our sales are related to water, food, and essential goods. These are large attractive markets with steady growth, driven by strong secular trends. Our customers in these markets have an essential need for our products and solutions to support critical aspects of their daily operations where the risk of failure is high. Our durability is further bolstered by a razor-razorblade model, which drives a high level of recurring revenue, further catalyzed by VES. The CEO kaizen events we kicked off in Q1 are a strong proof point. These events, which focused on value-accretive growth, have already had a positive impact on our 2024 performance, evident in our second quarter results. On a consolidated basis, we exceeded our guidance on all fronts, with 3.8% core sales growth and 24% adjusted operating profit margin. Adjusted earnings per share was $0.85, up 6% year-over-year and $0.05 above the high end of our guidance range. And we generated $240 million of free cash flow, further strengthening our financial position. Looking at core sales growth by geography in the second quarter, sales in the North America and high-growth markets grew in the mid-single digits and sales into Western Europe were essentially flat. In North America, core sales grew over 5%, driven by both segments. In Water Quality, we continued to capitalize on strong demand for our water treatment solutions, which grew high-single digits in North America. This growth was broad-based across most industrial verticals, with the strongest growth in food and beverage, mining and power generation. We also continue to see strong growth for UV systems at municipalities in North America. In Water Treatment, we're partnering with customers to help them achieve their sustainability goals related to water conservation, reclamation, and reuse. Our water treatment businesses are also well positioned in North America to support onshoring or reshoring activity, including tech operations, such as semiconductor fabs and data centers. Relative to North America, our PQI segment grew 3.5% in Q2. Packaging and color grew mid-single digits, with marking and coding up low-single digits. In high-growth markets, core sales grew by more than 4%. We continue to see strong growth in Latin America and India. And in China, core sales grew low-single digits year-over-year. In Western Europe, core sales were essentially flat year-over-year, including 50 basis point headwind related to the strategic portfolio actions in our Water Quality segment that we mentioned on prior earnings calls. Excluding this headwind, core sales into Western Europe were up modestly. At this time, I'll turn the call over to Sameer to provide more details on our Q2 performance and our guidance."
},
{
"speaker": "Sameer Ralhan",
"content": "Thanks, Jennifer, and good morning, everyone. I'll begin with our consolidated results for the second quarter on Slide 8. Net sales grew 2.8% on a year-over-year basis to about $1.29 billion. Core sales grew 3.8%. Currency was an 80 basis points headwind or approximately $10 million. And the small divestiture of Salsnes was a modest headwind. Our core growth in this quarter was balanced, with both volume and price increases driving our growth. Price contributed 2% growth in this quarter, in line with our expectations and historical levels. Volume grew 1.8%, with positive volume growth across both Water Quality and PQI. This marks the first quarter since the second quarter of 2022 in which volume grew across both segments. Our recurring revenue grew mid-single digits year-over-year and comprised 62% of our total sales. We expanded margins at both segments through strong operational leverage, improved productivity, and cost optimization. Gross profit increased 7% year-over-year to $774 million. Gross profit margin improved 230 basis points year-over-year to 60%, reflecting the benefits of pricing, as well as improved productivity and reduced material costs. Adjusted operating profit increased 5% year-over-year and adjusted operating profit margin expanded 70 basis points to 24%. We delivered strong margin expansion, while investing in our sales and marketing efforts to drive future growth. We also increased our R&D investments, with R&D as a percent of sales increasing 20 basis points over the prior-year period. These investments are aligned with our strategic growth plans and we expect to continue to fund ongoing growth investments. Looking at EPS for second quarter, adjusted earnings per share grew 6% year-over-year to $0.85. And free cash flow was $240 million, down from the prior year, primarily due to standalone public company costs and cash tax payments, which were not incurred in the prior-year period. Moving on, I'll cover the segment highlights, starting with Water Quality on Slide 9. Our Water Quality segment delivered $777 million of sales, up 2.8% on a year-over-year basis. Currency was an 80 basis points headwind and the divestiture of Salsnes had 40 basis points impact versus the prior-year period. In addition to this divestiture, small product lines that were strategically exited in the fourth quarter of 2023 resulted in approximately 80 basis points headwind to core growth for the Water Quality segment in the second quarter. Despite this headwind, core sales grew 4% year-over-year. Pricing contributed 2.4% and volume growth contributed 1.6% to year-over-year core sales growth. Our volume growth was driven by strong demand for water treatment solutions in our industrial end markets and UV treatment systems in municipal end markets. We also saw growth in sales of lab instrumentation, reagents, and chemistries to municipalities. Recurring sales across the Water Quality segment grew mid-single digits. Adjusted operating profit increased 5.5% year-over-year to $192 million, and adjusted operating profit margin increased 70 basis points to 24.7%. The increase in profitability and margin reflects strong pricing execution, leverage on volume growth, and improved productivity. To a lesser extent, our adjusted operating profit margin also benefited from a favorable sales mix this quarter. Moving to the next page, our PQI segment delivered sales of $511 million in the second quarter, up 2.7% year-over-year. Currency was a 70 basis point headwind. Core sales grew 3.4%. Positive volume contributed 2% growth and price increases contributed 1.4% to the year-over-year core sales growth. PQI's recurring sales grew mid-single digits year-over-year for the fourth consecutive quarter with growth across the portfolio. Recurring revenue increased to 63% of PQI sales mix in the second quarter of this year. Breaking this down by business, core sales growth in our marking and coding business was in line with the segment, driven by growth in both consumables and equipment. This growth was driven by both CPG and industrial end markets. In our packaging and color business, core sales grew about 3% year-over-year, led by growth in recurring software and subscription revenue. PQI's adjusted operating profit was $141 million in the second quarter, resulting in adjusted operating profit margin of 27.6%. That represents a 100 basis points improvement in adjusted operating profit margin over the prior-year period. This was another quarter of margin improvement for PQI, driven by the strong operating leverage, particularly on the recurring revenue growth and productivity improvements. Turning now to our balance sheet and cash flow. In the second quarter, we generated $251 million of cash from operations and invested $11 million in capital expenditures. Free cash flow was $240 million in the quarter, or 118% conversion of GAAP net income. As of June 28, gross debt was $2.6 billion and cash on hand was just over $1 billion. Net debt was $1.6 billion, resulting in net leverage of 1.3 times. In summary, our financial position is strong. We have flexibility in how we deploy capital to create long-term shareholder value with a bias towards M&A. Turning now to our guidance for 2024, beginning with our updated expectations for the full year. We increased our full year guidance to reflect our strong second quarter execution and incrementally positive view of our end markets. For core sales growth, our target remains low-single digits, however, we are trending towards the high end of low-single digits. Through the first half of 2024, core sales growth was 2.8%. For the second half, we are targeting core sales growth in the low to mid-single digits range, similar to what we achieved in the second quarter. Looking at adjusted operating profit margin for the full year, we now expect to deliver approximately 75 basis points margin expansion year-over-year, which would put our full year adjusted operating profit margin at about 24%. This implies an incremental margin or fall-through of around 50%. For adjusted EPS, we raised our full year guidance range to $3.37 to $3.45 per share. At the midpoint, this represents 7% growth year-over-year and is $0.11 or about 3.5% higher than our previous guidance. And our guidance for free cash flow conversion remains in the range of 100% to 110% of GAAP net income. Looking at our guidance for Q3, we are targeting core sales growth in the low-to-mid single digits on a year-over-year basis. At the midpoint of our Q3 guidance, we are modeling a core growth rate similar to second quarter. We expect adjusted operating profit margin of approximately 23.5% in the third quarter. This represents 100 basis points of improvement in adjusted operating profit margin on a year-over-year basis. And our Q3 2024 guidance for adjusted EPS is $0.82 to $0.86 per share. At the midpoint, that represents double-digit year-over-year growth. With that, I'll hand the call back to Jennifer for closing remarks."
},
{
"speaker": "Jennifer Honeycutt",
"content": "Thanks, Sameer. In summary, we are executing well across the company with greater focus and rigor using VES, and we are capitalizing on the secular growth drivers in our key end markets. We delivered a strong second quarter across the board, with core sales growth approaching mid-single digits, continued margin expansion, and strong cash generation. Based on the strength of our execution and positive view of our end markets, we raised our full year 2024 adjusted EPS guidance. As we look longer term, we remain committed to creating value through steady, durable sales growth, continuous improvement, and disciplined capital allocation. That concludes our prepared remarks. And at this time, we are happy to take your questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Thank you. We'll take our first question from Scott Davis of Melius Research."
},
{
"speaker": "Scott Davis",
"content": "Hey. Good morning, Jennifer, Sameer, and Ryan."
},
{
"speaker": "Sameer Ralhan",
"content": "Good morning."
},
{
"speaker": "Jennifer Honeycutt",
"content": "Good morning."
},
{
"speaker": "Scott Davis",
"content": "I've got to ask -- good morning. I got to ask about the gross margins just because they've been so incredible, strong. Is -- A, I guess, is 60% the new normal or is that just more of kind of a shorter-term impact? And second, maybe I heard the word price in the context of pricing power more on this quarter and last one, too, than we would have thought in the past. And are you finding there's just more pricing power in your markets maybe than you thought you had before and that's driving that 60% gross margin. Is that a fair takeaway?"
},
{
"speaker": "Sameer Ralhan",
"content": "Yeah. Scott, let me just touch on the margin and then I'll have Jennifer just talk about the price. On the gross margin side, it's really been really in -- the increased rigor on VES really driving the execution side. Frankly, it's been lots of singles and doubles that are driving the margin here. And also, as you see, we are benefiting a little bit from the recurring revenue here, right? The mix is more towards consumables to the spares, which is impacting and helping us on the margin. The packaging and color business, as you know, that tends to be on the software side with a little higher margin. So, that's helping us. So, those things are helping us. I would say, you should expect the gross margins to come in a little bit as the growth rate equilibrates between the equipment and consumables overtime. But we feel really good about 60%, but I think once the transition happens, we'll be more in the high-50% or 59% growth range."
},
{
"speaker": "Jennifer Honeycutt",
"content": "Yeah. And I think, Scott, what you're seeing relative to price is our ability to sort of hold the value of our products in terms of commercial excellence related to VES. So the teams commercially are executing well around the world, but we have seen price normalize to historical levels, which we believe fit in the range of 100 bps to 200 bps."
},
{
"speaker": "Scott Davis",
"content": "Okay. Fair enough. And just I feel obligated to ask about M&A. I know these things are lumpy and it's hard to kind of talk about it, but any update on maybe your pipeline and your enthusiasm about the assets that are out there?"
},
{
"speaker": "Jennifer Honeycutt",
"content": "Yeah. We remain pretty convicted about our M&A approach. We've got really robust funnels for both PQI and Water Quality. We're looking at a lot of assets and we're actively engaged in our market activity here. But consistent with what we've said on prior calls, we're really going to stay close to our heritage and the disciplined capital allocation around market, company, and valuation. So we obviously like businesses that have similar operating models and secular durability, financial profiles that look like us, and certainly businesses where we think VES can add value. So we're active here. We're excited about the space. We're working hard kind of on both sides of the fence, and more to come."
},
{
"speaker": "Scott Davis",
"content": "Yeah. Best of luck. Congrats on the first two quarters here of the year."
},
{
"speaker": "Jennifer Honeycutt",
"content": "Thanks, Scott."
},
{
"speaker": "Operator",
"content": "We'll take our next question from Deane Dray of RBC Capital Markets."
},
{
"speaker": "Deane Dray",
"content": "Thank you. Good morning, everyone."
},
{
"speaker": "Jennifer Honeycutt",
"content": "Good morning, Deane."
},
{
"speaker": "Deane Dray",
"content": "Good morning. Hey, I'll echo…"
},
{
"speaker": "Sameer Ralhan",
"content": "Good morning."
},
{
"speaker": "Deane Dray",
"content": "Scott's comments, that's a clean quarter, kind of hard to find anything to quibble about. So maybe I'll start with product quality. Your primary competitor had some similar results yesterday in terms of strong aftermarket, but it looks like your printer sales are stronger. I know the 2380 sounds like that was a boost. Just can you comment on the mix and the go-forward, especially with the recovery expected in the consumer packaging goods?"
},
{
"speaker": "Jennifer Honeycutt",
"content": "Yeah. Thanks for the question, Deane. Our PQI businesses in the main are performing well. I think you see that both in terms of our marking and coding businesses. You also see it on our color and packaging side. We're not going to comment really on competitors' activity, but what we can say is, our marking and coding businesses are performing well and I think in line with the recovery of the consumer packaged goods market. So we see this fourth consecutive quarter of mid-single digit recurring revenue growth. And we also see, as you rightly point out, Q2 marking the return of growth in equipment sales. And so, this follows a nominal recovery that we see when we're coming out of a down cycle where consumables and by way of inks and solvents and spare parts and so on recover before equipment does. We're excited about the funnel that we have for equipment. And certainly, as we talk to our CPG customers, they are -- their sentiment is more positive in terms of the future outlook. From a packaging and color standpoint, we've just finished the Drupa Trade Show, where we got a lot of positive response in terms of the products being launched there, mostly around our S2 native-cloud, digital integrated solutions. This really helps reduce time-to-market for the brands. It also helps mistake-proof relative to the information that they're passing around between their functional departments. So, funnels are healthy on both sides. The market recovery in terms of CPG itself is a little bit lumpy. We do see mixed results across various CPG categories. But certainly, we're encouraged by the market indicators and I think our teams are executing well with recent product launches, and our new product innovations really are gaining momentum."
},
{
"speaker": "Deane Dray",
"content": "It's all very helpful. And just a geographic question. Just for both businesses, what was the sense of demand in China and the outlook? The expectation is that you all have a very defensive type of mix there, but will you feel any of the ongoing pressures in the economy over the next couple of quarters?"
},
{
"speaker": "Jennifer Honeycutt",
"content": "Yeah. I think, Deane, our view of China hasn't materially changed from quarter-to-quarter. I think we believe that China has stabilized related to the end markets, but we don't expect to see any meaningful recovery in China this year. I think for state-owned or state-sponsored municipalities, funding is still extraordinarily tight. So we're not seeing much money flow there. I think long term, China is anticipated to improve. It's got a large and aging population. Those folks are going to require clean water, safe food, and trusted medicines. But our China team has stepped up to the challenge here in the slower growth macro and we continue to ensure that we have a China business that's creating incremental value for Veralto."
},
{
"speaker": "Sameer Ralhan",
"content": "And then, Deane, from a guide perspective, effectively, you assume China will be sequentially flat, right? So, as you know, we were down quite a bit in the Q3 and Q4. So you're going to see a little bit of an uptake on a year-over-year basis as we kind of get into the second half, but sequentially, it's effectively flat."
},
{
"speaker": "Deane Dray",
"content": "That's real helpful. Thank you."
},
{
"speaker": "Operator",
"content": "We'll take our next question from Andrew Kaplowitz of Citigroup."
},
{
"speaker": "Andrew Kaplowitz",
"content": "Hey, good morning, everyone."
},
{
"speaker": "Sameer Ralhan",
"content": "Good morning, Andy."
},
{
"speaker": "Jennifer Honeycutt",
"content": "Good morning, Andy."
},
{
"speaker": "Andrew Kaplowitz",
"content": "Jennifer, Sameer, you raised your revenue guidance by $100 million for '24, I think, versus last quarter's forecast. So, maybe just give us a little more color into what markets are better than you expected. I know you just talked about Videojet equipment starting to accelerate. What are you baking now -- baking in now for the second half of that improvement? And then in Water Quality, is it more that water treatment is driving continued strong momentum, or are you seeing more improvement in water analytics?"
},
{
"speaker": "Jennifer Honeycutt",
"content": "Yeah. I mean, I think we see strength across the board, really. We benefit, I think, from a couple of areas here. One is just the markets that we're in and the quality of the products we bring to market being part of the essential nature of customer operations. I think the deployment of VES and the increased focus that we have as a standalone company continues to help us execute well commercially. From a macro standpoint, on where the demand is occurring, water and municipalities, particularly in US and Europe, continue to execute on project backlog in terms of improvements to their respective plants and their run rate business is steady. We do see some nice pockets of growth coming for our water treatment businesses and see some tailwind and some benefit from things like CHIPS Act in terms of build out their data centers, which are requiring an extensive amount of water in their cooling towers. And those kind of two markets really benefit our ChemTreat and our Trojan businesses, respectively. So we're seeing good sort of solid, steady, robust demand really for both water treatment and Water Quality."
},
{
"speaker": "Andrew Kaplowitz",
"content": "Very helpful. And then Jennifer, just going back to M&A, like, I know timing is always difficult, but would you expect to get something done this year? And then under what conditions would you do a larger deal where you may potentially raise equity?"
},
{
"speaker": "Jennifer Honeycutt",
"content": "Yeah. I think you are right that M&A is clearly episodic. We can't guarantee the intersection of when we will see market, company, and valuation come together. As we've mentioned in the past, we're going to stay disciplined to that approach. We have to like the market, right? It's got to be adjacent or near adjacent to where we play. The company has got to be a strong company that has secular drivers that we value under the umbrella of Safeguarding the World's Most Vital Resources, and we got to be able to get at the right price. I think right now, valuations are still a little bit inflated. So we're looking at the intersection here, but we've got to fundamentally get to all three of those variables. And all I can say is, we're working hard in this area."
},
{
"speaker": "Sameer Ralhan",
"content": "And Andy, just going to look, think about the equity side, it's just one of the components of how we think about funding any transaction. The main thing is value creation, right? Anything that can ultimately help us create long-term value, we'll look at all forms of funding, as we have kind of talked in the past. Main thing for us as we're going to think of any kind of funding is maintaining investment-grade balance sheets. That's sacrosanct for us."
},
{
"speaker": "Andrew Kaplowitz",
"content": "Appreciate the color, guys."
},
{
"speaker": "Operator",
"content": "We'll take our next question from John McNulty of BMO Capital Markets."
},
{
"speaker": "John McNulty",
"content": "Yeah. Thanks for taking my question. Maybe one on the free cash flow side. Obviously, a really strong quarter for you there and hitting kind of conversion levels that are above what you're certainly looking for the year. I guess, can you help us to think about what drove that? And if that -- if we see more things that you can kind of wring out from, whether it's a working capital side to kind of keep that level elevated for the next couple of quarters, how should we be thinking about that?"
},
{
"speaker": "Sameer Ralhan",
"content": "Yeah, John. Thanks for that. As you kind of look at the free cash flow conversion, quarter-to-quarter, it can vary. As you know, we have the bond payments that come in, in the first quarter and the third quarter. So that gets -- impacts timing of the cash payments. So I would say, when you look at the free cash flow conversion, really look at it on a full year basis. Overall, given the strength that we're seeing in the business, the execution, we feel pretty good about delivering 100% to 110% free cash flow conversion, that's off GAAP net income."
},
{
"speaker": "John McNulty",
"content": "Got it. Fair enough. And then just a question on SG&A. It took a reasonable jump up, somewhere in the 7.5% kind of range. I guess, can you help us to think about how much of that is just general labor, inflationary type trends versus the corporate side, where now you're a public company versus investment for growth? I guess, how should we be thinking about the various buckets there?"
},
{
"speaker": "Sameer Ralhan",
"content": "Yeah. I think it's -- let's take it in two buckets, right? One is -- first, on the business side, as we kind of told you, right, at the beginning of the year, we will be we -- are investing in the sales and marketing side to really drive the growth of the business, and you've seen that kind of really coming through or flowing through the numbers in the first quarter and second quarter. John, inflation is there a little bit, I think, just like everybody else. There's nothing outsized. But it's -- these are really heads that are added more on the sales and marketing side to drive the growth, and you started seeing a little bit of the impact and more in the 2025 that you're going to see. So I would say, on the business side, we are more or less in a normalized state, so to speak, and SG&A as a percent of revenues. On the corporate side, we were very judicious in how we bring the cost in. So what you're going to see is more of a run rate view of the corporate expenses in the second half of the year. So there's going to be a little uptick in the second half versus the first year that you're going to see on the corporate side, but that should normalize in the second half. So, nothing extraordinary on that front."
},
{
"speaker": "John McNulty",
"content": "Great. Thanks very much for the color."
},
{
"speaker": "Operator",
"content": "We'll take our next question from Mike Halloran of Baird."
},
{
"speaker": "Mike Halloran",
"content": "Hey, good morning, everyone."
},
{
"speaker": "Jennifer Honeycutt",
"content": "Good morning, Mike."
},
{
"speaker": "Sameer Ralhan",
"content": "Good morning, Mike."
},
{
"speaker": "Mike Halloran",
"content": "So, just some thoughts on the product rationalization side of things, some of the initiatives you're doing there. Maybe just how far along do you think you are in that journey in general? Have most of the areas been identified already, or do you think that there's more to come on that side of things?"
},
{
"speaker": "Jennifer Honeycutt",
"content": "Yeah. I think, Mike, what you've seen us do here is just pruning around the edges, right, and this is actually part of standard work that we do day-in and day-out in managing the portfolio of the businesses. It's not an -- it's not something that we look at on an episodic basis. We're looking at this all the time. So, I would say, when we see opportunities for continued portfolio evolution to get us a stronger portfolio, focused in the higher areas of growth with higher margin and recurring revenue, anything that falls materially far away from that profile is something that we'll take action on. So we feel good about the portfolio we have today. We'll continue to prune around the edges as and when we see that it's appropriate to do so."
},
{
"speaker": "Mike Halloran",
"content": "Makes sense. And then just to follow up on, I think, Andy's question earlier, when you think about the greater confidence going into the back half of the year, has anything actually changed, or is this just about starting to see the momentum into this year, first quarter, and is actually having to materialize that gives you extra confidence? In other words, has there any -- been really any change in your thinking about how these end markets are going to progress?"
},
{
"speaker": "Jennifer Honeycutt",
"content": "Well, I think we've come out of a pretty tumultuous several years following the impact of the pandemic, Mike. And we saw a lot of whiplash, right, in terms of price and volume and demand cycles and consumer spending and what they were spending on and so on. I would say that our confidence is built more as a function of an enduring steady state for our Water Quality businesses, driven by the secular drivers that we've talked about and an incrementally improving macro here for consumer products, goods markets. 85% of our revenue goes into water, food, and pharmaceuticals, and provided that those markets are steady or improving, we're going to see that benefit."
},
{
"speaker": "Mike Halloran",
"content": "Appreciate it. Thank you."
},
{
"speaker": "Jennifer Honeycutt",
"content": "Thanks, Mike."
},
{
"speaker": "Operator",
"content": "Our next question is from Brian Lee of Goldman Sachs."
},
{
"speaker": "Brian Lee",
"content": "Hey, everyone. Good morning. Thanks for taking the questions. I guess…"
},
{
"speaker": "Sameer Ralhan",
"content": "Good morning, Brian."
},
{
"speaker": "Brian Lee",
"content": "The first one on -- hey, Sameer, good morning. Sameer or maybe Jennifer, you mentioned during your prepared remarks some favorable mix, I think, in the Water Quality segment that might have helped margins. Can you elaborate any -- on that, and is that something that either you can quantify or, as you think about the next few quarters, is that expected to persist."
},
{
"speaker": "Sameer Ralhan",
"content": "Hey, Brian. Yeah. I'll take that one. The mix comment is really around consumables. We've seen a good amount of consumable uptick that's driving it. As you've seen, our recurring revenue is almost at 62% right now and that is predominantly mix and a little bit of spares and the -- some of the SaaS software side, but predominantly consumables. If you recall and go back into the history, when things are more normalized, that tends to be in the high-50s, right. So that kind of helps you dimensionalize now the transition as the volume comes back on the printer side, in PQI, instrumentation side, on the Water Quality side, it's going to be a multi-quarter journey as we kind of move. So, you're not going to see a big variation quarter-to-quarter, but that sort of 62% versus high-50s is the way to dimensionalize the change over time."
},
{
"speaker": "Brian Lee",
"content": "All right. Fair enough. That's helpful. And then I know you're talking about improving end markets kind of across the board. Jennifer made some comments around the strong backlog trends in Water Quality. Can you maybe talk a bit more specifically around -- I think you had comments in the release about strong bookings in packaging and color. Our understanding is that that's more of a short cycle business. So, where is the visibility? Are those the areas where you're seeing trends improving as well? Just kind of any commentary on the short cycle side of your business? Thank you, guys."
},
{
"speaker": "Jennifer Honeycutt",
"content": "Yeah. Relative to packaging and color, as we mentioned, we've just concluded our Drupa Trade Show. That's a trade show that runs once every four years. And given the pandemic, this is the first time that show has been conducted in eight years. So there were some really good kind of pent-up demand that we saw there. But I think our solutions and, particularly those around innovation that we're providing in the S2 cloud-native digital integration of the workflow has got the attention of a lot of brand owners, because they are under pressure to compress their development cycles and ensure the integrity of the information that they're working with, which gives every user of that system access to the same information. So we had a great showing there. The teams -- all three teams in terms of Esko, Pantone, and X-Rite really did a great job there. And I think the -- outside of the enthusiasm generated in Drupa, the recovery of the CPG markets will lend itself to new product releases and new product innovations from brand owners. So they are getting ready. They have a number of projects that they're considering in terms of new product releases and so on and so forth. And so, this is the front end of that. And I think we're well positioned to be able to help them with their solutions."
},
{
"speaker": "Brian Lee",
"content": "Okay. I appreciate the color. I'll pass it on."
},
{
"speaker": "Operator",
"content": "We'll move next to Brad Hewitt of Wolfe Research."
},
{
"speaker": "Brad Hewitt",
"content": "Hey, good morning, guys. Thanks for taking my questions."
},
{
"speaker": "Jennifer Honeycutt",
"content": "Good morning, Brad."
},
{
"speaker": "Brad Hewitt",
"content": "So, I guess, I wanted to start on the margin side of things. Your guidance implies about a 50 basis point step-down in margins in Q3 versus Q2 despite the fact that revenue, I think, should be flat to slightly up sequentially. And then also your trade show expenses should step down quarter-over-quarter. So, just curious if you can talk about kind of the drivers of the sequential margin pressure there."
},
{
"speaker": "Sameer Ralhan",
"content": "Yeah, Brad. This is Sameer. Effectively, really two things here. The first one is the mix comment that you made earlier. Our mix is pretty rich in consumables and recurring revenue right now. We have started seeing some good, encouraging signs on the equipment side. We said in the second quarter, we finally see -- saw a positive revenue growth on the equipment side. So we've modeled in kind of a decent equipment growth in the Q3 and second half of the year. So mix impact is what's kind of flowing through here. And the other one I would say is really on the corporate side. As we kind of get into the second half of the year, we are going to be getting more towards the run rate expenses on the corporate expenses. So that's impacting the margin side as well. So it's really those two things that are impacting the margin."
},
{
"speaker": "Brad Hewitt",
"content": "Okay. That's helpful. And then, I guess, going back to the long-term incremental margin framework of 30% to 35%, I know that includes kind of some reinvestment in the business. But just given the strong execution on VES since the spin, as well as the implied 50% incremental margins this year despite volume growth kind of in the 1% to 2% zone, does that give you confidence on perhaps something more like 40%-plus incrementals going forward over the medium term?"
},
{
"speaker": "Sameer Ralhan",
"content": "Yeah. No. Thanks for that. Look, I mean, it's first of all, really kudos to all our teams, all our 16,000 people that are really helping drive this kind of fall-through that you're seeing, right? Really proud of what we've been able to achieve this year. But as you kind of think about 30% to 35% is really on the -- over the longer term, right? We do want to incorporate in that long-term value creation algorithm, a healthy investment mix from the sales side, from R&D side. So I think from a long-term value framework perspective, I think still 30% to 35% is the right way to look at it. But I think -- and in the near term, really good performance and execution of the teams is driving a fall-through close to 50%."
},
{
"speaker": "Brad Hewitt",
"content": "Great. Thanks, Sameer."
},
{
"speaker": "Operator",
"content": "We'll take our next question from Nathan Jones of Stifel."
},
{
"speaker": "Nathan Jones",
"content": "Good morning, everyone."
},
{
"speaker": "Jennifer Honeycutt",
"content": "Good morning, Nathan."
},
{
"speaker": "Nathan Jones",
"content": "I guess, I'll follow up on that last question. You guys have made it pretty clear that you intend to continue to invest in growth here. Can you talk about what you think the growth rates will be in kind of investment in commercial resources, investment in sales, investment in R&D kind of over the next several years rather than just any one year to the next?"
},
{
"speaker": "Sameer Ralhan",
"content": "No. I think as you kind of think about long term, Nathan, these investments should be supportive of the mid-single digit growth framework, right? And that is 4% to 6% kind of a range, as we have kind of talked about. So as when we think about that mid-single digit growth framework, we do reflect the incremental contribution coming from these investments on the sales and marketing side, as well as on the R&D side, right? This is a technology-heavy business as you kind of think about in the commercial execution business. So those investments are key as we kind of think about long-term sustainable value creation."
},
{
"speaker": "Nathan Jones",
"content": "So, you would be looking at kind of that kind of mid-single digit growth in those investments as revenue?"
},
{
"speaker": "Sameer Ralhan",
"content": "Yeah."
},
{
"speaker": "Nathan Jones",
"content": "Now, look, the other question I had…"
},
{
"speaker": "Sameer Ralhan",
"content": "It kind of depends, right -- just to make sure, Nathan, right, it -- on average, right, this is a cumulative thing that we're looking at. Of course, the new investment should be incrementally driving higher growth from their side, but some things fall out of the portfolio, too."
},
{
"speaker": "Nathan Jones",
"content": "Got it. The other question I wanted to ask is on the recycle, reuse, reclaim market driver. I think that is likely to be a pretty considerable driver of investment from industrial water users. So I'm hoping you could talk a little bit more about where Veralto plays, kind of how much of your revenue that makes up where you think it could go to over the next five-year to 10-year kind of time frame, long-term growth rate you're expecting out of that, just because I think that's going to be a pretty good driver of incremental demand."
},
{
"speaker": "Jennifer Honeycutt",
"content": "Yeah. Thanks for the question, Nathan. We do see great demand here in recycle, reclaim, and reuse. The businesses most impacted by that certainly is our Trojan business who is well positioned there to help customers with their sustainability initiatives in this space. ChemTreat also has a play here. And certainly, if you're going to be moving water around, you're going to have to test it as well. So it does create some opportunity for our analytics businesses. But the primary beneficiary really of this opportunity would be our Trojan business. And frankly, we see this space growing probably mid-to-high single digits for the foreseeable future. Lots of industries are under pressure to achieve their sustainability targets, and we're well positioned with solutions to help them."
},
{
"speaker": "Nathan Jones",
"content": "Great. Thanks for taking my questions."
},
{
"speaker": "Operator",
"content": "Our next question is from Andrew Krill of Deutsche Bank."
},
{
"speaker": "Jennifer Honeycutt",
"content": "Good morning, Andrew."
},
{
"speaker": "Andrew Krill",
"content": "Thanks. Good morning, everyone. I wanted to circle back on margins again from a little bit more of the medium-term perspective. I know there's been a lot of discussion just that the company has meaningfully more opportunities to improve margins than might be improved -- appreciated by investors. Just can you update us any of, like, the findings you've had since the spin on that and whether you would consider explicitly quantifying those at any point? And then would you also say, is there more opportunity in one segment versus the other or do you think it's kind of similar? Thanks."
},
{
"speaker": "Sameer Ralhan",
"content": "Yeah. Andrew, thanks for that. As you kind of look at the opportunities on the margin expansion, right, this is -- the work that the teams have been doing on the procurement side, really our folks on the front lines and the shop floor, on the factory optimization, so these are lots of singles and doubles. As I said earlier in the call, it's not one or two factors that are driving this margin expansion. And that, frankly, really is the beauty of the kaizen culture, right? That's where you're going to see the margin contribution coming in. Those efforts really that the teams have been doing and execution that is happening is giving us the confidence to really up the bar on the margin expansion for the full year or we have -- instead of 50 basis points to 75 basis points, what we've said -- raised the guidance to is 75 basis point margin expansion for the full year this year. So that should get the full year pretty much close to 24% on the operating earnings margin."
},
{
"speaker": "Andrew Krill",
"content": "Okay. Great. Very helpful. And then can you give us an update on the situation in Argentina and maybe just how much contingency, if you will, you have left in your guidance for the full year? And then, I guess, depending on how that shakes out the rest of the year, how that could help or hurt PQI margins in the back half? Thanks."
},
{
"speaker": "Sameer Ralhan",
"content": "Yeah. Very brief, right, Andrew, as you kind of look at Argentina, as we said at the Q1 call, we did the Blue Chip Swap to really insulate any impact on the historical cash that really drove the impact last year. But as you kind of move into this year, effectively, our exposure is much smaller, and that's reflected in the guide."
},
{
"speaker": "Andrew Krill",
"content": "Okay. Great. Thank you."
},
{
"speaker": "Operator",
"content": "We'll take our next question from Andrew Buscaglia of BNP."
},
{
"speaker": "Jennifer Honeycutt",
"content": "Good morning, Andrew."
},
{
"speaker": "Andrew Buscaglia",
"content": "Hey, good morning, everyone."
},
{
"speaker": "Sameer Ralhan",
"content": "Good morning."
},
{
"speaker": "Andrew Buscaglia",
"content": "I'm just looking at your guidance and trying to map out the ranges. And looking at the high end, I'm wondering kind of what's contemplating or what informs the high end of your guidance? Because it's difficult to get there. So, you either need sales to accelerate for some reason or maybe you have some extra margin expansion in your back pocket. I guess, of those two or what -- what's behind that high end is my question."
},
{
"speaker": "Sameer Ralhan",
"content": "Yeah. No, thanks for that. It really comes down to how you're going to think about the CPG markets, right? CPG markets are evolving, incrementally becoming positive, but it's a pretty fast-changing views that we are seeing. So I think, as you kind of look at the guidance range, one of the big drivers is how we kind of think about the CPG markets and the impact they will have on the on the PQI topline. I would say -- if there's one thing I can say, that's one of the key things. And then on the margin side, right, I mean, there's always the raw material price versus raw material contribution we always look at. We believe we have baked in a pretty prudent view here. So, any benefit from that will be more enduring towards the high end of the range."
},
{
"speaker": "Andrew Buscaglia",
"content": "Okay. That's helpful. And yeah, I wanted to ask, any update on the PFAS regulation opportunity in terms of whether anything new around your discussions with customers or -- I know you guys are talking about product development. Just what's the latest there?"
},
{
"speaker": "Jennifer Honeycutt",
"content": "Yeah. We continue to be interested in this space. But as you know, this is an incredibly difficult and complex problem to solve. We believe that we're well positioned, given our 70-year history at Hach for democratizing tests and analytics and our long track record at Trojan for developing treatment solutions. So we continue to invest in this space and stay focused there, but real fit-for-purpose solutions that are focused on at-site or in-line testing and at-site real-time destruction of PFAS are going to be -- remain a difficult problem to solve. But we're focused on creating winning outcomes for our customers that have fit-for-purpose solutions. So, still a few years away here, but we are interested in the space, as we are with sort of all of the micro-contaminants that come into the regulation frame."
},
{
"speaker": "Andrew Buscaglia",
"content": "Okay. All right. Thank you."
},
{
"speaker": "Operator",
"content": "We'll take our next question from Joe Giordano of TD Cowen."
},
{
"speaker": "Joe Giordano",
"content": "Hey, guys."
},
{
"speaker": "Jennifer Honeycutt",
"content": "Good morning, Joe."
},
{
"speaker": "Joe Giordano",
"content": "Good morning. Thanks for taking my questions. I was interested in the industrial growth commentary. It's just we're not hearing that in a lot of places, right? Industrial data is pretty bad and most companies, we're seeing orders decline. So it was interesting and good to see that there. Can you kind of -- what's driving that? Is it new project ramps? Is it -- like, is it optimization at existing facilities? Like, what's the nature of this kind of growth there? Because it does seem somewhat unique."
},
{
"speaker": "Jennifer Honeycutt",
"content": "Yeah. I think what you're seeing here is that there's really three things that differentiate us from other industrials. We play in the end markets with really attractive and kind of non-optional secular growth drivers, right? So, when you've got a business that's 85% of our sales into food, water, and pharma, it's -- these are not elective areas of testing, right? So these are really durable markets. And as a consequence, the way our businesses have been built are durable in turn. 60% of our recurring revenue or 60% of our revenue is kind of in this recurring revenue space. It's a razor-razorblade business model with high-margin consumables. And these products and services that are deployed for our customers are essential parts of their operation. So, if they choose not to use our products or they choose not to treat and measure and monitor and so on, the cost of failure to them is high, because we're really tied to sort of product quality and public health. So the last thing I would say is, VES provides a competitive advantage for us really in terms of differentiating us relative to talent growth and continuous improvement."
},
{
"speaker": "Joe Giordano",
"content": "And then just last for me on the margins. So, we touched on this a bunch, but with gross margins at 60%, it's excellent. If I look at the spread between gross margins and EBITDA, 30% in SG&A seems a little high, like you're a newer company. Like, long term, what's like a real -- realistic level that that should normalize out at?"
},
{
"speaker": "Sameer Ralhan",
"content": "Yeah. Joe, I'll take that one. It's really the sales and marketing, right? If you -- just to take you back, effectively, when you look at the P&L, it really aligns with how we create value in the business. It's more driven by investments in R&D, it's a technology-driven business, and then on the commercial side, right? The secret sauce, what we believe and our competitive strength, is a direct business model that effectively does result in the sales and marketing that you -- impact that you see on -- in the numbers. Overall, we feel really good about our business model that is more direct, and it really drives a competitive advantage in the marketplace."
},
{
"speaker": "Joe Giordano",
"content": "Thanks, guys."
},
{
"speaker": "Operator",
"content": "And this does conclude our question-and-answer session. I'd be happy to return the conference to Ryan Taylor for closing comments."
},
{
"speaker": "Ryan Taylor",
"content": "Thank you, Leo, and thanks for everybody that joined us on the call today. We really appreciate your engagement and the discussion. Feel free to reach out to me if you have any more follow-ups. Thanks again for joining us, and we'll talk to you next quarter."
},
{
"speaker": "Operator",
"content": "This does conclude today's conference. You may now disconnect your lines, and everyone, have a great day."
}
] |
vlto | 2,024 | 1 | [
{
"speaker": "Operator",
"content": "My name is [ Shelby ], and I will be your conference operator this morning. At this time, I would like to welcome everyone to Veralto Corporation's First Quarter 2024 Conference Call [Operator Instructions] After the speaker's remarks, there will be a question-and-answer session."
},
{
"speaker": "",
"content": "[Operator Instructions]"
},
{
"speaker": "",
"content": "I will now turn the call over to Ryan Taylor, Vice President of Investor Relations. Mr. Taylor, you may begin your conference."
},
{
"speaker": "Ryan Taylor",
"content": "Good morning, everyone. Thanks for joining us on the call. With me today are Jennifer Honeycutt, our President and Chief Executive Officer; and Sameer Ralhan, our Senior Vice President and Chief Financial Officer. Today's call is simultaneously being webcast. The replay of the webcast will be available on the Investors section of our website later today under the heading Events and Presentations. A replay of this call will be available until May 8, 2024."
},
{
"speaker": "",
"content": "Before we begin, I'd like to point out that yesterday, we issued our first quarter news release, earnings presentation and supplemental materials, including information required by the SEC relating to any adjusted or non-GAAP financial measures. These materials are available in the Investors section of our website, www.veralto.com under the heading Quarterly Earnings. Reconciliations of all non-GAAP measures are provided in the appendix of the webcast slides. Unless otherwise noted, all references to variances are on a year-over-year basis."
},
{
"speaker": "",
"content": "During the call, we will make forward-looking statements within the meaning of the federal securities laws, including statements regarding events or developments that we believe or anticipate will or may occur in the future. These forward-looking statements are subject to a number of risks and uncertainties, including those set forth in our SEC filings."
},
{
"speaker": "",
"content": "Actual results may differ materially from any forward-looking statements that we make today. These forward-looking statements speak only as of the date that they are made, and we do not assume any obligation to update any forward-looking statements, except as required by law."
},
{
"speaker": "",
"content": "And with that, I'll turn the call over to Jennifer."
},
{
"speaker": "Jennifer Honeycutt",
"content": "Thank you all for joining our call today. The first quarter of 2024 marks our second consecutive quarter of solid operating execution as a stand-alone company. We are driving steady, profitable growth and continuous improvement through greater focus and accountability using VES fundamentals, basic blocking and tackling."
},
{
"speaker": "",
"content": "For Q1, we delivered 8% adjusted earnings growth year-over-year, driven by 2% core sales growth and 90 basis points of adjusted operating profit margin expansion, and we exceeded our guidance across the board. Our financial performance reflects our culture of continuous improvement and demonstrates our ability to deliver on commitments."
},
{
"speaker": "",
"content": "From an end market perspective, we are seeing healthy trends across our key verticals. In our Water Quality segment, we continue to see positive secular growth drivers across industrial markets, particularly in North America, along with steady demand at municipalities. And in our Product Quality & Innovation segment, we are seeing modest signs of recovery in consumer packaged goods markets."
},
{
"speaker": "",
"content": "Most notably, PQI's recurring revenue grew mid-single digits year-over-year for the third consecutive quarter. Equipment bookings for marking and coding started to show signs of recovery late in the first quarter, and we continue to see encouraging trends at some of our large CPG customers led by food and beverage."
},
{
"speaker": "",
"content": "Based on our first quarter results and improving market trends, we continue to expect our core sales growth rate to modestly improve sequentially throughout the year."
},
{
"speaker": "",
"content": "Looking at our full year guidance, we are on pace to deliver low single-digit core sales growth and are trending toward the high end of our adjusted operating margin range of 50 to 75 basis points of improvement over 2023. As a result, we have modestly increased our full year adjusted EPS and free cash flow conversion guidance. Sameer will cover that in more detail a bit later in the call."
},
{
"speaker": "",
"content": "Confidence in our ability to deliver on commitments is, in large part, grounded in the Veralto enterprise system. Our proven system for driving growth, operational improvements and leadership development. A core tenet of the VES is continuous improvement or Kaizen."
},
{
"speaker": "",
"content": "During March, we completed Veralto's first CEO Kaizen week as a stand-alone company. CEO Kaizen week is a long-standing tradition of our enterprise system and personally one of my favorite weeks of the year. The purpose of this year's CEO Kaizen week was to drive value-accretive growth. For one week, we immersed 12 cross-functional teams at Gemba where the real work happens across 6 businesses in 5 countries."
},
{
"speaker": "",
"content": "The Veralto executive team worked alongside associates in our operating companies to solve some of the most complex challenges and yield high-impact results. For example, this year's event included increasing customer engagement in North America and EMEA to drive incremental sales growth of Hachs consumables."
},
{
"speaker": "",
"content": "Improving the customer buying experience at Videojet to accelerate key growth initiatives and using lean conversion tools for make-to-stock products at a Hach distribution facility in North America to optimize efficiency, improve on-time delivery and meet increasing customer demand. The benefits of any Kaizen week include immediate solutions that are rapidly implemented and yield real-time results. Success is proven by sustaining these results, which we track following the Kaizen event."
},
{
"speaker": "",
"content": "From a big picture perspective, this year's CEO Kaizen week, fortified our ability to deliver on our commitments to key stakeholders and reinforce that at Veralto, we are all practitioners of continuous improvement."
},
{
"speaker": "",
"content": "Turning now to our financial results for the quarter. Core sales grew 1.8% year-over-year, led by price increases across both segments and modest volume growth in our Water Quality segment led by our industrial water treatment businesses. Notably, both segments delivered recurring sales growth in the mid-single digits year-over-year, increasing our percentage of recurring sales to 61% of total sales in the quarter. As compared to our guidance, we exceeded core sales growth expectations due to strong commercial execution and better-than-expected volume at both segments, particularly within consumables."
},
{
"speaker": "",
"content": "On the margin front, we delivered 90 basis points of adjusted operating profit margin expansion primarily through price execution, productivity improvements and cost optimization. Adjusted EPS was $0.84 per share up 8% year-over-year and $0.06 above the high end of our guidance range, and we generated over $100 million of free cash flow, further strengthening our financial position."
},
{
"speaker": "",
"content": "Looking now at core sales growth by geography for the first quarter. Sales in North America grew over 3% year-over-year with sales in high-growth markets flat and sales in Western Europe down about 1%. In North America, we continue to see strong growth in our water treatment businesses across industrial verticals, including food and beverage, chemical processing, mining and power generation."
},
{
"speaker": "",
"content": "We also continued to see strong demand for municipal customers for UV treatment systems. In Western Europe, core sales were down modestly year-over-year, primarily due to timing of UV system projects and the strategic portfolio actions in our Water Quality segment that we mentioned in our Q4 earnings call. Apart from these 2 items, core sales in Western Europe were steady year-over-year in both segments."
},
{
"speaker": "",
"content": "In high-growth markets, core sales were essentially flat year-over-year as growth in Latin America and India was offset by low single-digit decline in China as anticipated. Despite the year-over-year headwind in Q1, we believe our end market environment in China has stabilized."
},
{
"speaker": "",
"content": "That concludes my opening remarks. And at this time, I'll turn the call over to Sameer for a detailed review of our first quarter financial performance."
},
{
"speaker": "Sameer Ralhan",
"content": "Good morning, everyone. I will begin with our consolidated results for the first quarter on Slide 7. First quarter net sales grew 1.8% on a year-over-year basis to about $1.25 billion. Currency was a modest benefit, offset by the divestiture of Salsnes product line. Salsnes was a small commodity filter product line in our Water Quality segment that was divested in January."
},
{
"speaker": "",
"content": "Core sales growth in Q1 was 1.8%. Price contributed approximately 2% growth in this quarter, in line with expectations. This aggregate price increase is also in line with historical levels. Volume was down a modest 40 basis points year-over-year. This was better than we expected, primarily due to higher sales volumes of consumables and both segments during the quarter. Gross profit increased 6% year-over-year to $747 million. Gross profit margin increased 220 basis points year-over-year to 60%, reflecting the benefits of pricing as well as improved productivity and reduced material costs."
},
{
"speaker": "",
"content": "Adjusted operating profit increased 5% year-over-year. and adjusted operating profit margin expanded 90 basis points to 24.5%. We delivered strong margin expansion while investing in our sales and marketing efforts to drive future growth. We also increased our R&D investment to 4.8% of sales, up 20 basis points over the prior year period. These investments are aligned with our strategic growth plans and we expect to continue to fund ongoing growth investments."
},
{
"speaker": "",
"content": "Looking at EPS for Q1. Adjusted earnings per share grew 8% year-over-year to $0.84, and free cash flow was $102 million, down from the prior year. This decline is primarily due to cash interest payments that we did not incur last year prior to our spin-off."
},
{
"speaker": "",
"content": "Moving on, I will cover the segment highlights, starting with Water Quality on Slide 9. Our Water Quality segment delivered $749 million of sales, up 2.7% on a year-over-year basis. Currency was neutral and the divestiture of Salsnes had 10 basis point impact on sales this quarter versus the prior year period. In addition to this divestiture, we strategically exited small product lines in our Water Quality segment in the fourth quarter of 2023."
},
{
"speaker": "",
"content": "As we previously mentioned on the earnings call in February, Exiting these product lines resulted in approximately 60 basis points headwind to core growth for the segment in this quarter. Despite this headwind, core sales grew 2.8% year-over-year as compared to 11% core sales growth in the prior year period, bringing the 2-year core sales growth stack for Water Quality segment to about 7%. Pricing contributed 2.6% to core sales growth and volume was up 30 basis points year-over-year."
},
{
"speaker": "",
"content": "This is the first quarter of volume growth for Water Quality since Q1 2023. Our volume growth in this year's first quarter was driven by strong demand for our water treatment solutions in industrial end markets and UV treatment systems in municipal end markets."
},
{
"speaker": "",
"content": "Recurring sales across the segment grew mid-single digits, highlighted by increased sales of reagents and chemistries used in our analytical instruments at municipalities in North America. Adjusted operating profit increased 9% or $16 million year-over-year to $186 million. Adjusted operating profit margin increased 150 basis points RECONNECT to 24.8%. The increase in profitability reflects solid pricing execution and improved productivity. Moving to the next page."
},
{
"speaker": "",
"content": "Our PQI segment delivered sales of $497 million in the first quarter, up modestly versus the prior year period. Core sales were essentially flat on a year-over-year basis as price increases of 1.5% were largely offset by 1.3% decline in volumes."
},
{
"speaker": "",
"content": "Recurring sales grew mid-single digits with growth across the portfolio, increasing the mix of recurring sales for PQI to 63% in Q1. In Packaging and Color, sales were up low single digits year-over-year, highlighted by growth in recurring software and subscription revenue. In contrast, marketing and coding sales declined modestly, reflecting lower demand from CPG customers as compared to Q1 2023."
},
{
"speaker": "",
"content": "This decline, however, was less than what we had anticipated in our guidance. As Jennifer mentioned, we continue to see modest signs of recovery in CPG markets with consumable sales up mid-single digits year-over-year for the third consecutive quarter and equipment bookings showing pockets of improvement."
},
{
"speaker": "",
"content": "We remain cautiously optimistic that CPG volumes will improve sequentially as the year progresses. PQI adjusted operating profit was $139 million in the first quarter resulting in adjusted operating profit margin of 28%. This was a strong margin performance for PQI and demonstrates the earnings power of these businesses."
},
{
"speaker": "",
"content": "Turning now to our balance sheet and cash flow. In Q1, we generated $115 million of cash from operations and invested $13 million in capital expenditures. Free cash flow was $102 million in the quarter. Note, this included about $57 million of cash interest payments, which we did not incur in Q1 2023 prior to our spin-off."
},
{
"speaker": "",
"content": "At the end of the quarter, gross debt was $2.6 billion and cash on hand was $827 million. Net debt was $1.8 billion resulting in net leverage of 1.5x. In summary, we further strengthened our financial position during the quarter and have ample liquidity. This gives us flexibility in how we deploy our capital to create long-term shareholder value with a bias towards M&A."
},
{
"speaker": "",
"content": "Turning now to our guidance for 2024. Beginning with our updated expectations for the full year. As Jennifer mentioned, we are on track to deliver our target of low single-digit core sales growth at the enterprise level and in both segments. We're targeting 100 to 200 basis points of price, consistent with historical pre-pandemic levels. From a sequential perspective, our guidance assumes that year-over-year core sales growth increases modestly quarter-to-quarter through 2024."
},
{
"speaker": "",
"content": "Looking at adjusted operating profit margin, our target remains 50 to 75 basis points of improvement this year. Based on our Q1 performance, we are trending towards the high end of this range. Given our Q1 results and current view on margin improvement for the year, we have increased our full year adjusted EPS guidance to a range of $3.25 to $3.34 per share, up from our prior guidance range of $3.20 to $3.30 per share. In addition, we increased our free cash flow conversion guidance to a range of 100% to 110%."
},
{
"speaker": "",
"content": "Looking at our guidance for Q2, we are targeting core sales growth in low single digits on a year-over-year basis, with adjusted operating margin of approximately 23% and our Q2 2024 guidance for adjusted EPS is $0.75 to $0.80 per share."
},
{
"speaker": "",
"content": "That concludes my prepared remarks. At this time, I'll turn the call back to Jennifer for closing remarks before we open up the call for questions."
},
{
"speaker": "Jennifer Honeycutt",
"content": "In summary, as a stand-alone company, we have increased focus, discipline and accountability across all levels of the enterprise, which has elevated our level of execution. We are driving continuous improvement and investing in future growth as our end market environment gradually improves. We are off to a positive start in 2024 with solid growth and strong margin expansion in the first quarter."
},
{
"speaker": "",
"content": "Our financial position remains strong and we continue to take a disciplined approach to capital deployment with our primary focus on strategic acquisitions with attractive returns."
},
{
"speaker": "",
"content": "Looking ahead, we remain focused on driving commercial excellence, continuous improvement and disciplined capital allocation to create shareholder value while safeguarding the world's most vital resources."
},
{
"speaker": "",
"content": "That concludes our prepared remarks. I want to thank you all again for joining our call. And at this time, we're happy to take your questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions]"
},
{
"speaker": "",
"content": "We'll take our first question from Scott Davis with Melius Research.We'll take our first question from Scott Davis with Melius Research."
},
{
"speaker": "Scott Davis",
"content": "The 60% gross margin is a pretty incredible number when you really think about the mix of businesses you have. But should we think about this as kind of high watermark or would you think about it as more of a step up into a new level of entitlement? How do you guys think about it?"
},
{
"speaker": "Sameer Ralhan",
"content": "Maybe I'll take that one, Scott. Overall, as you got to look at margin perspective, some of it comes down deliver of a mix. I think it's still going to be in the 58% to 60% kind of ZIP code."
},
{
"speaker": "",
"content": "As Jennifer mentioned on the call earlier, we saw good sort of a rebound in the consumables in both sides that really helps us on the margin side, both in the Water Quality and PQI side. But as kind of equipment starts coming back at the rest of the year and the second half of the year, we should be in that 58% to 60% kind of ZIP code."
},
{
"speaker": "Scott Davis",
"content": "And just following on a little bit to a comment you made, Jennifer, on increasing accountability. I understanding has always been that the Danaher business system always drove a pretty high level of accountability. How have you tweaked it to even raise that to a different level? And what kind of changes have you made when you think about just tightening things up for the assets that you have here?"
},
{
"speaker": "Jennifer Honeycutt",
"content": "Yes. I mean I think it's always challenging to provide an equal level of focus across a very, very large enterprise like Danaher has I think a smaller, more nimble $5 billion business, obviously, allows us to focus exclusively on these businesses, whereas there were many more factors sort of previously with the life sciences and diagnostics side in Danaher."
},
{
"speaker": "",
"content": "And so some of the things that we've done here is we've just -- we've raised the level of not only expectation but visibility to how we're operating, the tools that we're using by way of VES, and we're really focusing on the critical few."
},
{
"speaker": "",
"content": "Every business is a little bit different. Their evolutionary maturity is a little bit different. And as a result, we focus on using fit-for-purpose tools in our VES toolbox to make sure that we're elevating the level of performance of each of those businesses."
},
{
"speaker": "Scott Davis",
"content": "Congrats on the quarter. Good luck this year."
},
{
"speaker": "Operator",
"content": "And we'll take our next question from Andy Kaplowitz with Citigroup."
},
{
"speaker": "Andrew Kaplowitz",
"content": "Jennifer and Sameer, how are you feeling about the PQI recovery at this point? I know you mentioned North America and Western Europe, you continue to see signs of recovery. You talked about equipment demand coming back late in the quarter. Maybe you could elaborate on that equipment trend. Have you seen follow through in that food and beverage recovery that started, I think, in Q4? And how are you factoring in China-related growth in that segment for the rest of the year?"
},
{
"speaker": "Jennifer Honeycutt",
"content": "Yes. We're really encouraged by the PQI performance here in Q1, particularly around our consumable revenue stream or recurring revenue. Is this the third sequential quarter that we've seen mid-single-digit growth there. And with regard to sort of how those markets, particularly in food and beverage, recover from a downturn, we will always see the consumable revenue stream ramp first."
},
{
"speaker": "",
"content": "And that's as a result of CPG customers coming back online that were previously mothballed they're getting those lines running, they're refurbishing equipment. And so we always see that leading our equipment growth. Now on the equipment side, we did see some nice pockets of growth relative to orders late in the first quarter. And so this is sequentially encouraging and very closely maps to the pattern of what we would have seen with consumables recovery first, followed by equipment recovery."
},
{
"speaker": "Sameer Ralhan",
"content": "Andy, only other thing I would add from a guide perspective, we're building equipment recovery more in the second half, while the owners, as Jennifer mentioned, in March, were very encouraging, good discussions with the customers that those business teams are having but we're still cautious and we are building into anything on the equipment side in the second half than in the second quarter at this point."
},
{
"speaker": "Andrew Kaplowitz",
"content": "Very helpful. And then maybe a similar question on the Water Quality side, Obviously, you've talked about strengthening industrial business for a while now. Maybe talk about the resilience of that. Are you seeing North American municipalities on the Hach side spend anymore? Is there -- do you see any risk of higher rates, maybe impacting that side of the spend?"
},
{
"speaker": "Jennifer Honeycutt",
"content": "Yes. So the nice thing about our business, Andy, is it's largely an OpEx-focused set of businesses. So interest rates, CapEx approval cycles we are minimally impacted by. And because we operate at the high end of the value continuum in terms of being integral to operating municipal water plants. We see steady spend there."
},
{
"speaker": "",
"content": "And following the pandemic when municipalities were kind of in lock down relative to their levels of investment. They are starting to execute on their project backlog. And that means that as they execute on that activity. There will be more analytics and testing required for refurbishing plants and getting going on those improvements."
},
{
"speaker": "",
"content": "So we continue to see good demand here that's continuing to recover municipalities. And we also have a variety of opportunities here in water reuse and recycling, reclaim activities as well. So we're encouraged by the muni markets that are starting to recover and look forward to continued execution there."
},
{
"speaker": "Operator",
"content": "We'll take our next question from Jeff Sprague with Vertical Research Partners."
},
{
"speaker": "Jeffrey Sprague",
"content": "Hey Jennifer, just first on just kind of the M&A side of the equation. Obviously, a couple of quarters out of the box here probably kind of a solid year. So to think about it given the time line of the spin. Just wonder how the pipeline is coming together. Do you see things that are actionable. And do they lean towards one segment or the other?"
},
{
"speaker": "Jennifer Honeycutt",
"content": "Yes. This is everyone's favorite topic, I think. We are 207 days post spin, I think, today. So it's still early days here. But I have to say, we have a very, very robust process and a strong pipeline of activity, both in the Water Quality side, the PQI side with a number of opportunities that we're considering."
},
{
"speaker": "",
"content": "We are going to stay disciplined here, consistent with our heritage and focus on making sure that we're going after the right markets, strong companies within those markets and making sure that they come at the right valuation. We continue to like businesses that have similar operating model, durability and financial profile to those that we have in the portfolio today. Businesses that can drive VES, or if they can utilize VES for continued improvements in growth in margin."
},
{
"speaker": "",
"content": "And certainly, our bias towards M&A is an important catalyst here going forward. But we will continue to maintain the rigor and the discipline that we have inherited from our history. And as always, M&A is a little bit episodic. We do see more opportunities opening up relative to actionability as the year progresses. And so we are encouraged by that."
},
{
"speaker": "Jeffrey Sprague",
"content": "And then maybe unrelated and for Sameer. Given that maybe kind of the consumables versus equipment mix doesn't really shift a whole lot until we get into the second half of the year. Why is it that margins would be down sequentially Q1 to Q2 on sequentially higher revenues?"
},
{
"speaker": "Sameer Ralhan",
"content": "As we go from Q1 to Q2, Jeff, this is -- really ends up -- the first thing is the second quarter ends up being a seasonally heavier trade show activity quarter for us. So the operating expenses do go up seasonally just for us in Q2 and Q1. And that's kind of -- I would say, applies to both the segments. The other fact that is just some of the corporate spending. As we said at the beginning of the year in February, right, we just want to be very cautious and judicious as you bring in the corporate expenses, from a stand-alone company perspective."
},
{
"speaker": "",
"content": "So some of that is just how we're pacing in and slowly in the second quarter, some of that just going to ramp up. And lastly, I would say, as Jennifer mentioned, we are investing on the SG&A side. And in Q1, we did make investments. We're going to start seeing more run rate impact as you move into the second quarter. So it's really a combination of those 3 things that's driving the sequential decline."
},
{
"speaker": "Jeffrey Sprague",
"content": "Does it bias towards one segment or the other?"
},
{
"speaker": "Sameer Ralhan",
"content": "No, it's pretty universal across the board."
},
{
"speaker": "Operator",
"content": "We'll take our next question from Mike Halloran from Baird."
},
{
"speaker": "Michael Halloran",
"content": "So following up on Jeffrey's question, as you became a stand-alone company, did you have to change processes lean in any way from an organizational perspective with incremental resources, whatever, to essentially build the muscle on the M&A side, obviously, a little bit less prioritized at Danaher?"
},
{
"speaker": "",
"content": "So is there anything that you've had to do to build that up more than what you had done when you came in here and centralization of resources. And then I guess the second part is how integrated is that with your R&D functionalities as we see here today?"
},
{
"speaker": "Jennifer Honeycutt",
"content": "So clearly, standing up -- a stand-alone company does require a corporate organization to support it. Previously, tax and treasury and all of those functions were taken care of for us. But with respect to sort of the M&A trajectory, we were very deliberate in bringing in top talent in our strategy and sustainability function and our corporate development function. Both of those individuals that sit on my staff have long-standing histories within Danaher building strategy and executing on M&A. Insofar as the muscle building within the operating companies themselves."
},
{
"speaker": "",
"content": "We have upskilled the capability for our leadership within the operating companies to be able to performed strong due diligence, look at effective ways of integrating and so on. So we spent actually quite a bit of time here in both the ramp up to the spin and following the spin itself."
},
{
"speaker": "Michael Halloran",
"content": "And the second one is just kind of putting the commentary together on the Water Quality and the PQI side as far as starting to see some green shoots in specific areas or recovery in specific areas. How much of that is embedded from here from a guidance perspective? Are we talking relatively normal sequentials, or is there an assumption for an improved backdrop as we get through the year and just had some context?"
},
{
"speaker": "Sameer Ralhan",
"content": "Hey Mike, yes, I'll take this one. Essentially, it's pretty kind of a gradual sequentially improving quarter-by-quarter that you just built into the guide at this point. As I said earlier, really what we're building is this point for -- in the near term is really more on the consumables side, still that trend slowly kind of building equipment side, it's really more in the second half of the year."
},
{
"speaker": "",
"content": "So there's a little bit of a macro backdrop helping us some of the equipment side coming back, but it's going to be pretty moderate sequentially kind of going up, but on a year-over-year basis, as you can imagine, from the Q3, Q4 will be better. That's how the math works."
},
{
"speaker": "Operator",
"content": "We'll take our next question from Deane Dray with RBC Capital Markets."
},
{
"speaker": "Deane Dray",
"content": "I appreciate all the color and specifics in the slides in your prepared remarks. I'd like to get a very specific question in Water Quality, if I could. So the new EPA regulations on PFAS, the 4 parts per trillion is really -- as that pushes the testing technology limits. And right now, it's still you have to use a prohibitively expensive mass spec, no utility really can afford that."
},
{
"speaker": "",
"content": "So is the industry any closer, are you all any closer to what might be a more economical test because all this is going to be seeing incredible demand over as of now, as of 2 weeks ago."
},
{
"speaker": "Jennifer Honeycutt",
"content": "Yes. Great question, Deane. We knew that the EPA was headed towards a 4 parts per trillion limit of detection here. So that's not fundamentally new news for us. What is new news there is the time line for compliance with [ Salsnes ] in 2027, but you are right that this is a phenomenally difficult and complex problem to solve in a fit-for-purpose way. Right now, the way to solve for this is water sample set to centralized lab, run through GC mass spec, answers come back, a couple of weeks later."
},
{
"speaker": "",
"content": "In the meantime, the municipality has discharged tens, if not hundreds of thousands of gallons of water. We are investing in this area. We do believe we have a right to play here. Hach unit of itself has over a 70-year history of innovating in the analytics space. We've got a broad portfolio there. And certainly, on the water treatment side, particularly in UV applications, we've got great expertise there as well."
},
{
"speaker": "",
"content": "But I would say this is a long game here with solutions that are not imminent, but we're probably still a couple of years out here in terms of identifying and developing fit-for-purpose technology that addresses both detection and destruction. We think that winning is going to require both."
},
{
"speaker": "",
"content": "And right now, the analytical test options, as you say, are not fit for purpose in terms of being at plant. And frankly, destruction technology is not readily available either. There are products out there, granular activated carbon being one of them that can capture PFAS but what happens when you refresh those resin beds, you're just moving the PFAS to some other place like a landfill. So it's going to be a long journey here, but we are investing in a number of organic activities and are open to inorganic options as well."
},
{
"speaker": "Deane Dray",
"content": "That's really helpful. And I fully appreciate that time line that you've suggested that's everything that we've heard as well. There's a question between wanting something and there's a demand -- industry demand versus the practicality given the complexity of the molecules. But I really appreciate the color. And I'm so glad to hear you mention destruction as well because that's an opportunity."
},
{
"speaker": "",
"content": "And then just for a follow-up question, and I'll echo Scott's comments about that 60% threshold on gross margin and how big a deal that is. And I remember when Danaher hit that level as well. And just one of the ways that you might be able to boost that further I know your business model is a direct to customer on the -- overall and especially on the Hach consumables where you just would think there'd be more of a distribution angle to this, which would lower that cost of getting the reagents to the customers."
},
{
"speaker": "",
"content": "Just where does that stand? Is that a nonstarter? Or is that something you've explored? I know in some countries, you will use distributors just because it's not practical to have direct, but just where does that stand?"
},
{
"speaker": "Jennifer Honeycutt",
"content": "Yes. I mean I think you're right, Deane. We do and will use distribution for our analytics businesses in certain countries. They tend to be areas where we don't have critical mass in terms of staffing up the full capability of selling direct. We think it's actually a good thing to sell direct. And it's part of what I would consider to be the secret sauce because we have that long-standing technological applications knowledge."
},
{
"speaker": "",
"content": "And it's that customer intimacy and the insight to their processes, their process control, their analytics needs, they're unmet, that the problems that have yet to be solved that give us great insight and creates the flywheel of feedback loop from our sales and service organization to our new product development organizations that help us continue to innovate and evolve the product portfolio to solve unmet customer needs."
},
{
"speaker": "",
"content": "So we are not inclined to sort of steer away, if you will, from our direct sales model just from a margin benefit standpoint. We think there's lots of opportunity by virtue of applying VES, and working on mix. The teams are doing a great job here in delivering margin as a result of just good operating and execution, right? The factories are running better, procurement teams are pushing back on inflationary pressures, and we're doing far fewer spot buys. So we had a number of other levers that we can pull relative to margin without compromising the secret sauce of customer intimacy."
},
{
"speaker": "Operator",
"content": "We'll take our next question from Andrew Krill with Deutsche Bank."
},
{
"speaker": "Andrew Krill",
"content": "I wanted to ask on -- going back to price and price costs more specifically. Just can you give us an update on what you're assuming there? I think we've heard from several companies like transportation, labor, certain raws all continue to be pretty inflationary."
},
{
"speaker": "",
"content": "So is the guide assuming you can stay price cost positive, like on a margin basis or just dollars? And anything there would be really helpful. And if there's any big difference by the segments?"
},
{
"speaker": "Sameer Ralhan",
"content": "Andrew, I'll take that one. Essentially, from a price, from a guide perspective and the future look perspective, we're modeling in price in line with historical norms. So it's 100 to 200 basis points. This quarter, of course, as things are rolling off, we came in a little bit towards the high end of that range. But I think from an outlook perspective on the guide perspective, 100 to 200 basis points is a good way to model."
},
{
"speaker": "",
"content": "On the raw materials and the material side, look, I think it's a pretty broad mix of kind of things that we buy all the way from semiconductor, some of the circuit boards down to stuff in plastics and think of those nature that's kind of tied to commodities. I would say the operating discipline and the VES really helping us kind of manage that, I think, has been a big differentiator. That's going to really reflected in Q1. And the question that Scott and Deane had us over the gross margin side."
},
{
"speaker": "",
"content": "We saw a big uplift from that side as well. I think really, going forward, having the operating discipline, making sure we are doing less of the smart buy I would say, inflationary pressures are there. We are managing, managing them really well, but it's also about the operating discipline to make sure we are minimizing any smart buys, which can really have a big impact on the market side."
},
{
"speaker": "",
"content": "So I would say pricing. We're doing the value in used pricing, and it's showing up in the market side for the price side, there's a lot of discipline that all starts all the way from operating discipline."
},
{
"speaker": "Andrew Krill",
"content": "And then for a follow-up on free cash flow conversion, it's nice to see the conversion boosted for the year from 100% to 110%. Just any more insight into like what changed to give you cost through 1 quarter? And looking ahead, should we be maybe thinking of like 100% conversion as kind of a lower like legacy Danaher was very consistently over 100%."
},
{
"speaker": "Sameer Ralhan",
"content": "Yes. Andrew, if you look at free cash flow conversion, right, just as a reminder, we do give the conversion on the basis of the GAAP metrics, right, not on any kind of adjusted metrics. So essentially, when you look at that, just add the amortization and the share compensation or the stock-based compensation, I think based on all that stuff, we should be a little bit on the 100%, a little over 100% but really going towards 100% to 110% range this quarter for the full year for us. That guidance is really driven by getting more conviction on the margin side."
},
{
"speaker": "",
"content": "As Jennifer mentioned, our margin will be towards the high end on the 50 to 75 basis points that kind of flows down, that gave us a more conviction. And also, there's a noncash charge in there as well, right, this quarter that's flowing to the GAAP net income, which is tied to the sales divestiture. So that's kind of just from a math perspective, and adds to the cash flow conversion as well. But overall, it was better operating performance."
},
{
"speaker": "Operator",
"content": "And we'll take our next question from Nathan Jones with Stifel."
},
{
"speaker": "Nathan Jones",
"content": "I'm going to follow up on Deane's question on distribution, but I'm going to come at it from the PQI side because I would have thought there might actually be some more opportunities to leverage the distribution model and maybe reduce the cost to serve on the PQI side than on the water side, potentially maybe in lasers where there's not the same kind of consumable revenue or some of the smaller customers that maybe don't need thatkind of super high level of service from you guys. So any commentary you could make on maybe the potential from that side of the business to leverage distribution a bit more?"
},
{
"speaker": "Jennifer Honeycutt",
"content": "Yes. I mean I think it's probably the same answer as for water. I mean we do have distribution and we do consider use of distribution depending upon where we're selling in the world and what types of products are in the portfolio. This is something that we always consider in terms of when we when we decide to make investments and which product lines actually require a more significant level of applications, knowledge and insight."
},
{
"speaker": "",
"content": "But I will tell you that like in water, there are pretty significant insights to be gained from understanding customer problems in a direct way for any kind of customer who's on the packaging and color side or on the marking and coding side. And it actually spurs a great deal of our innovation."
},
{
"speaker": "",
"content": "You will recall from our fourth quarter call that Videojet launched 7 new products last year. They additionally launched another 2 in the first quarter, and these are on the back of innovations for direct to customer feedback. So I continue to be a little bit biased here towards our direct model because I do think it creates a customer intimacy required to have those untapped insights relative to some of the problems that they face. But we do use distribution, and we selectively consider that in the course of every strategic planning cycle."
},
{
"speaker": "Nathan Jones",
"content": "I wanted to ask a follow-up on recycle and reuse in industrial markets, which is a market, I think, has significant growth potential over the next 5, 10, 20 years and would certainly be a market that's right in the bull's eye for a lot of your water quality business. So maybe some commentary on trends in industrial recycle and reuse markets, what you're seeing going on there and what the opportunities are for Veralto to play in those markets?"
},
{
"speaker": "Jennifer Honeycutt",
"content": "This is a great question, and absolutely. We see a great deal of activity, interest and growth potential in both recycle and reuse. And it's one that is pan-operating company, I would say, across our water quality businesses. So the intersection of ChemTreat, Trojan and Hach, can all play in that space. And in fact, do have conversations amongst themselves and amongst the sales folks in the field relative to solving those kinds of applications."
},
{
"speaker": "",
"content": "But increasingly, by virtue of the importance of ESG amongst our customers. We do have them coming to us saying, \"Look, my company has just said, I've got to use 25% less water and of the water that's not used in the process. They've got to recycle 50% of it, right? So can you help me with both reduction and recycling."
},
{
"speaker": "",
"content": "And those are great -- those are sweet spots for us. We've got a great product portfolio that can be deployed to these applications. And so we continue to be excited about the space."
},
{
"speaker": "Operator",
"content": "And we'll take our next question from Andrew Buscaglia with BNP Perles."
},
{
"speaker": "Andrew Buscaglia",
"content": "So I just wanted to check on the Water Quality side, you're talking about really strong industrial demand in your guide -- you did much better than your guidance. I'm wondering what changed, I'd say, from December, January to what transpired throughout the quarter? And then just the sustainability around that? What's driving that really?"
},
{
"speaker": "Jennifer Honeycutt",
"content": "Yes. I mean I think we still see pretty strong industrial output here, particularly in North America. I think as we mentioned in our prepared remarks, we do see food and beverage coming back, which across the portfolio is the largest continuous industrial segment that we play in. But likewise, chemical processing, mining and power generation all continue to be strong."
},
{
"speaker": "",
"content": "We do see opportunities around the reshoring activity as well as the world becomes a little bit more fractured relative to its trade relationships, and so that's providing great opportunity, particularly with respect to microelectronics and the CHIPS Act and so on. So we do see a good macro environment here, particularly in North America for our industrial sector."
},
{
"speaker": "Andrew Buscaglia",
"content": "A lot of little things it sounds like. Yes, yes. And you got a lot of questions on M&A. Obviously, that's where a lot of interest lies. I'm wondering if you can comment on your margins, especially in Water Quality are quite high. How are you thinking about margins as you add M&A to your portfolio? Is there enough out there where you could see some accretion or generally long term, is this not really -- should we not expect those margins to stay where they are if you're adding deals?"
},
{
"speaker": "Sameer Ralhan",
"content": "Yes, Andrew, as we've kind of stated in the past, and when it comes down to M&A, it really -- we follow a very disciplined and rigorous approach around markets, companies and valuation with respect to the financial metrics, it really is a combination of multiple factors, right? We look at ROIC, we look at margin, what's are the things that we can add to the portfolio that can drive overall core growth and create synergies, how do we apply VES into the acquired businesses to really create the differentiated value."
},
{
"speaker": "",
"content": "So it really comes down to the value creation potential and ultimately, that's based on a combination of all these different financial factors that we kind of look at as part of our rigorous process. So I wouldn't really focus on one metric versus the other. It really comes under the combination of all to see how they will create long-term value."
},
{
"speaker": "Operator",
"content": "We'll take our next question from Brian Lee with Goldman Sachs."
},
{
"speaker": "Brian Lee",
"content": "Lots has been covered on the call. So maybe just a few follow-ups, I guess, on PQI. Can you remind us how far out does your visibility extend on the equipment backlog and then the recent strength you're seeing in bookings? And then also maybe remind us what are the mix implications? You kind of alluded to them, but mix implications for margins in PQI as you move through the year. And it does sound like equipment will grow relative to consumables, how should we think about that in the context of margins?"
},
{
"speaker": "Jennifer Honeycutt",
"content": "Yes. I mean, I think what we see here is visibility for equipment in the 60- to 90-day time frame, right? This is the short-cycle business. So a lot of our confidence around equipment here in the second half is a product of history, right, where we see cycles of food and beverage and consumer packaged goods sort of decline in recovery. We see typical patterns, which is pretty intuitive of the inks and solvents, spare parts, consumables recovering first as these lines are brought back online and then equipment following when funds are available to do line expansions, equipment upgrades and so on and so forth."
},
{
"speaker": "",
"content": "So you do see in the guide that we've projected a rebalancing of kind of consumables and equipment here in the back half of the year. And so we've accounted for that."
},
{
"speaker": "Brian Lee",
"content": "And then just one on Water Quality. I think a couple of questions ago, you were talking, Jennifer, about the demand in water reuse, water recycling somewhat from an ESG footprint from a growing subset of your customers. I think there's also a growing subset of customers and industries here levered to power gen growth. We're seeing low growth on the grid in the U.S. especially. First time in a while really seeing some positive inflection."
},
{
"speaker": "",
"content": "So can you kind of give us a sense of from your vantage point, the different technologies, product sets you have the microelectronics sector, how much of the mix it is? And then it seems like there's just incremental volume growth opportunities there. Maybe if you could just speak to that a little bit."
},
{
"speaker": "Jennifer Honeycutt",
"content": "So the business that is -- benefits most from the CHIPS Act and microelectronics is Trojan that sells UV treatment systems in for high-purity -- ultra-high-purity water. That water has to be exceedingly pure given the manufacturing requirements for semiconductor wafer fab. But there are pockets of other equipment and analytics and so on that get sold into that space. But we've really seen some nice growth in our UV treatment business as a result of sort of the onshoring or reshoring of fabs here in North America as well as the ones that continue to be built in China."
},
{
"speaker": "Sameer Ralhan",
"content": "And Brian, the only other thing I would add to that is as you're going to look at the bid activity that our teams are seeing, we're seeing a pretty healthy bid activity that's kind of tied to the reuse point that earlier Nathan had as well on the municipal side and then on the semi side on the -- for the UV treatment system. So the bid activity is actually pretty good on both sides. That kind of tie back into the Trojan business."
},
{
"speaker": "Operator",
"content": "And it appears that we have no further questions at this time. I will now turn the call back over to Ryan Taylor for any additional or closing remarks."
},
{
"speaker": "Ryan Taylor",
"content": "Thanks, Shelby, and thanks, everybody, for joining us today. We really appreciate your time and engagement. As normal, I'll be available for follow-ups today and throughout the next coming days and weeks, should you want to talk, please reach out to me. And at this time, we'll conclude our call. Thank you so much again, and we'll join you next time."
},
{
"speaker": "Operator",
"content": "That concludes today's teleconference. Thank you for your participation. You may now disconnect."
}
] |
vmc | 2,024 | 4 | [
{
"speaker": "Sheyna",
"content": "Good morning. Welcome everyone to the Vulcan Materials Company Fourth Quarter 2024 earnings call. My name is Sheyna, and I will be your conference call coordinator today. Please be reminded that today's call is being recorded and will be available for replay later today at the company's website. All lines have been placed in a listen-only mode. After the company's prepared remarks, there will be a question and answer session. Now I will turn the call over to your host, Mr. Mark Warren, Vice President of Investor Relations for Vulcan Materials. Mr. Warren, you may begin."
},
{
"speaker": "Mark Warren",
"content": "Thank you, operator. Good morning, everyone. With me today are Tom Hill, Chairman and CEO, and Mary Andrews Carlisle, Senior Vice President and Chief Financial Officer. Today's call is accompanied by a press release and a supplemental presentation posted to our website vulcanmaterials.com. Please be reminded that today's discussion may include forward-looking statements, which are subject to risks and uncertainties. These risks, along with other legal disclaimers, are described in detail in the company's earnings release and in other filings with the Securities and Exchange Commission. Reconciliations of non-GAAP financial measures are defined and reconciled in our earnings release, supplemental presentation, and other SEC filings. During the Q&A, we ask that you limit your participation to one question. This will allow us to accommodate as many people as possible during our time we have available. And with that, I'll turn the call over to Tom."
},
{
"speaker": "Tom Hill",
"content": "Thank you, Mark, and thank all of you for your interest in Vulcan Materials today. 2024 was another year of successful execution. Our two-pronged growth strategy of enhancing our core and expanding our reach is working. We improved our industry-leading average cash gross profit per ton by 12% and deployed over $2 billion towards value-creating higher sled acquisitions. These acquisitions expanded our presence into new attractive growth areas and strengthened our existing franchise in three of our top ten revenue states. We finished the year strong. We plan to capitalize on our solid momentum and deliver attractive earnings growth again in 2025. Before discussing our outlook in more detail, I will provide you some key highlights from our fourth-quarter performance. Our teams delivered $550 million of adjusted EBITDA in the fourth quarter, a 16% improvement over the prior year. Importantly, adjusted EBITDA margin improved on a year-over-year basis for an eighth consecutive quarter. In the Aggregated segment, cash gross profit per ton expanded 16% to $11.50 the quarter through a combination of continued pricing momentum and moderating year-over-year unit cash cost of sales. Aggregate freight-adjusted price improved 11% in the quarter, consistent with full-year results. Price improvement remained geographically widespread. Are your shipments more mixed in the quarter across geographies and end uses. Shipments were 3% lower than the prior year. Growing public shipments and strong demand in storm-impacted areas of Western North Carolina and East Tennessee helped to particularly offset headwinds and private construction activity. With less disruption from weather, and our consistent focus on maximizing efficiencies, through our Vulcan Wave operating efforts. Freight-adjusted unit cash cost of sales increased 5% compared to the prior year. This was a meaningful improvement compared to previous quarters, and a testament to the execution of our operating teams. This continued execution will be a focus for us in 2025. The pricing environment remains healthy and we expect freight-adjusted AGUS price to grow between 5% and 7% in 2025. Now this includes an Uber 100 basis point negative mix impact from recent acquisitions. Inflationary cost pressures continue to moderate, and we're making progress our evolving operating process intelligence adoption. We expect freight-adjusted aggregates unit cash cost to increase low to mid-single digits in 2025, leading to another year of double-digit year-over-year expansion in our aggregate unit profitability. We expect 2025 aggregate shipments to increase between 3% and 5% compared to last year. This growth outlook is driven by recent acquisitions, coupled with the expectation of stable demand for our legacy business. I expect that continued growth in public construction activity will offset ongoing or modest contraction in private activity. Over the last year, turning twelve months highway starts have increased by another $7 billion to $122 billion. Blown highway input cost inflation and continued IJA-related spinning support ongoing growth highway shipments in 2025 and beyond. Additionally, $45 billion of funding initiatives were passed at the state and local level in the recent election cycle to spur additional transportation investment in local states. Affordability and elevated interest rates remain headwinds for residential construction activity. Increasing single-family starts over the past twelve months support modest growth in single-family housing in 2025. But multifamily starts, data, and elevated vacancy rates point to another year of declining demand in multifamily housing. Because of demographics in Vulcan market support a consistent need for additional housing, the timing of additional interest rates reductions and overall improvement in affordability will dictate when residential construction activity returns to growth. Likewise, our return to growth in private nonresident construction will also be a matter of timing. While we expect lower private non-residential demand in 2025, we currently anticipate that starts will bottom by mid-2025 and may begin to recover by the second half of the year, boding well for 2026 activity. Recent trends in both warehouse starts and data centers have been encouraging. Currently, twelve-month warehouse starts, the largest category in private nonresidential construction, have continued to flatten out at pre-pandemic levels after a precipitous drop from historic highs throughout 2023. Current planned data centers activity in our markets remains robust. And according to CoStar data, approximately 7% of proposed data center activity is within 20 miles of a Vulcan Soli. As I said earlier, the focus of our teams is execution. Controlling what we control, against the demand backdrop, I just described, we expect to deliver between $2.35 and $2.55 billion of adjusted EBITDA in 2025. Now I'll turn the call over to Mary Andrews to provide some and more details around our 2025 outlook."
},
{
"speaker": "Mary Andrews Carlisle",
"content": "Thanks, Sam, and good morning. I commented a year ago that our balance sheet was a source of strength and provided us considerable financial flexibility to continue to grow. In 2024, we deployed approximately $2.3 billion towards strategic acquisitions. Also reinvested in our existing franchise and furthered our greenfield effort with $638 million of operating and maintenance and internal growth capital. And we returned $313 million to shareholders through dividends and share repurchases. At year-end, our net debt to adjusted EBITDA leverage was 2.3 times. In March, we redeemed our 2026 note at par $550 million. And in the fourth quarter, we issued $2 billion of note across five ten, and thirty-year tenors to fund our 2024 acquisition activity. Recently, we provided notice of our intent to redeem the $400 million of 2025 note with cash on hand. Effective March 28, 2025. Given another year of solid cash generation in 2024, we remain well-positioned to continue our long track record of growth through disciplined capital allocation and consistent execution. In 2024, our teams executed well in a challenging volume environment to expand adjusted EBITDA margin by 190 basis points and deliver $2.1 billion of adjusted EBITDA for the full year. Aggregates cash gross profit per ton grew by 12% to $10.61. Demonstrating the durable compounding nature of the aggregates business, and our continued progress toward our $11 to $12 per ton goal. SAG expenses for the full year were 2% lower than the prior year. We remain focused on continuing to drive value for the business through disciplined investments in SAG expenses to support our organic growth initiatives and innovation through technology. SAG expenses as a percentage of revenue were 7.2% in 2024. Our return on invested capital at year-end was 16.2%. That's largely consistent with the prior year. The increase in invested capital was driven by fourth-quarter acquisitions provided very little earnings contribution given the closing date. Absent that timing impact, return on invested capital improved 40 basis points. Bearing strong momentum into 2025, we anticipate another year of attractive margin expansion and earnings growth. Tom highlighted our views around demand, pricing, and aggregates unit profitability. Let me provide a few additional details around the 2025 guidance. We estimate that recent acquisitions contribute approximately $150 million of adjusted EBITDA in 2025. We expect our downstream businesses to contribute approximately $360 million in cash gross profit with an estimated two-thirds of the contribution from the asphalt segment and one-third from the concrete segment. These expectations reflect expansion and cash unit and the contribution of recent acquisitions. We forecast SG expenses of between $550 and $560 million. We project depreciation, depletion, amortization, and accretion expenses of approximately $800 million, interest expense of approximately $245 million, and an effective tax rate between 22% and 23%. In 2025, we plan to reinvest in our franchise through operating and maintenance and internal growth capital expenditures, between $750 million and $800 million. Included in this plan is approximately $125 million of spending on three sizable plant rebuild projects that are underway. In addition to capital for recently acquired businesses. Overall, we expect 2025 to mark another year of expansion and adjusted EBITDA margin, attractive growth and adjusted EBITDA, and strong cash generation. I'll now turn the call back over to Tom to provide a few closing remarks."
},
{
"speaker": "Tom Hill",
"content": "Thank you, Mary Andrews. I want to take a moment to thank the men and women of Vulcan Materials for your consistent and enduring commitment to excellence. Most importantly, you kept one other safe and look out for your brothers and sisters across the company and communities in which we live, in work. Particularly in the face of persistent inclement and sometimes severe weather. And I am so proud of your consistent execution of the walkway you're operating and the Volker way of selling strategic disciplines. You proved your mettle and increased cash gross profit per ton every quarter for the second year in a row. I'm excited about what we will achieve in 2025. Together, we remain focused on controlling what we can control and generating value for our customers, our communities, and our shareholders. Now, Mary Andrews and I will be happy to take your questions."
},
{
"speaker": "Operator",
"content": "We will take our first question from Trey Grooms with Stephens. Mr. Grimshaw, you might be on mute. Your line is open."
},
{
"speaker": "Trey Grooms",
"content": "Hey. I'm sorry. Sorry about that. Good morning, Tom. Good morning, Tom. Mary Andrews and Mark. Well done on the strong finish to the year. Thank you. I wanted to ask on aggregates pricing. You know, it seems like some markets have seen a shift from January to April as far as just the timing. Can you talk about a little bit about that and maybe it's the success of January increases that you've seen and you know, how we should be thinking about maybe the cadence of pricing this year."
},
{
"speaker": "Tom Hill",
"content": "Sure, Trey. So Q4 in the year in the total year last year, where it was pricing up 11%. So that allows us to carry really good pricing momentum into this year. As you saw, our guide is 5 to 7 but that's also negatively impacted over 100 basis points by the acquisitions. You know, I'm not worried about those. We'll get those back up to our averages quickly. But our January one price increases, you couple that with our booking and back close. I think it supports our guide, as did our I thought our January results. Our 25 results. The timing of price increases, I think, will be very similar to last year. Whether it was in bid work or asphalt or ready mixed pricing. Price increases, the vast majority of our price increases took effect January one. I think we should should we would guide you to I think we'll be in the range quarter to quarter throughout the year. Now remember, mix can impact a single quarter. It can then impact it up or down. But mix adjusted, I think we should be consistently in that 5 to 7 range."
},
{
"speaker": "Mary Andrews Carlisle",
"content": "Yeah. And Trey, you know, I would add that most importantly, we expect that the consistent pricing improvement coupled with, you know, moderating costs that we've talked about in the prepared remarks will yield low double-digit improvement in cash gross profit per ton consistently each quarter as well. Extending what we've now strung together a nine-quarter run on double-digit improvement and really the, you know, the underlying performance of the aggregates business is gonna be the biggest driver of our 2025 EBITDA growth which we expect is gonna improve you know, by about 12% on an organic basis. So really expecting a strong performance from from the ag segment."
},
{
"speaker": "Trey Grooms",
"content": "Yep. Well, thank you for all the color, and that's that's impressive and encouraging. So keep up the good work, and I'll pass it on. Thank you."
},
{
"speaker": "Tom Hill",
"content": "Thanks, Trudy."
},
{
"speaker": "Operator",
"content": "We will take our next question from Steven Fisher with UBS."
},
{
"speaker": "Steven Fisher",
"content": "Thanks. Good morning. I think you mentioned on the aggregates volumes side sort of an organic steady pace. So I'm assuming that means about sort of flat organic volumes expectation. Is that correct? And feel free to correct me on that. But maybe just curious about the the cadence of of how that plays out during the year. And we've been observing this slowdown in overall nonresident. You mentioned the the private side kinda being a little weak to start off. So just curious what you've assumed for the cadence of that organic trend in the the first half of the year versus the second half? Do you have actual declines maybe in in the first half before you know, maybe easier comps and then growth in the second half. Thank you."
},
{
"speaker": "Tom Hill",
"content": "Yeah. I think you I think you completely understand it. It is growing public, offsetting some some challenged private. If you look back at 24, we never really got out of the weather problem. The easiest comp to your point will will is Q3. If you look at January, February, we got a slow start. Some of that is cold and wet weather. But remember, it's just January and February, so not too worried about that. I think regardless of the challenges, our bulk and teams will perform. I think I've I've complete confidence our full year guide but as you said, back half loaded, probably with some either some either comps coupled with probably some help from single family and NREZ construction in the second half. Terrific. Thank you."
},
{
"speaker": "Steven Fisher",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "We will take our next question from Catherine Thompson with Thompson Research Group."
},
{
"speaker": "Catherine Thompson",
"content": "Hi. Thank you for taking that good morning. Thank you for taking my question today. And so your your volume guidance in quarter was very close to ours pricing exactly in line, but what jumps out at me is and and correct me if I'm wrong with this, but your gross margins came in at a record Q4 level. Could you you've articulated in the past the the bulk of way of operations. But if if you could parse out a little bit more for this quarter and how we should think about next year in terms of that margin of kinda the why behind that record. For Q4, the components, and how that plays into the longer-term strategy, including for this year. Thank you."
},
{
"speaker": "Tom Hill",
"content": "Sure. You know, I cost increase in the fourth quarter, which must improve over the prior three quarters, three reasons why. One was weather was not a negative. Two, volumes were not as negative, and three, our involvement with operating technology and tools and disciplines are improving our efficiencies. And as we look to 2025, we believe we'll continue to mature the work we have operating, which will continue to enhance our operating efficiencies. We would guide you to the to the kind of low to mid-single-digit increases in 2025. That is a substantial improvement over over the past couple of years. But really kind of that closer to what we've seen in history. So I think you what you're seeing is the the bulk way of operating at work, and offsetting some of the the the the headwinds we would see."
},
{
"speaker": "Mary Andrews Carlisle",
"content": "And, Catherine, on, you know, on gross margin, we saw improvement on a year-over-year basis each quarter in 2024. That's what I would expect for you to see in 2025. I think in terms of kind of the the cadence of gross margin, I would think about it, you know, it's typically lowest, obviously, in Q1, highest in Q2 or Q3. We did have an outstanding fourth quarter and plan to, you know, carry that momentum into 2025."
},
{
"speaker": "Catherine Thompson",
"content": "Great. Thank you very much."
},
{
"speaker": "Tom Hill",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question is coming from Anthony Pettinari with Citi."
},
{
"speaker": "Ashley Sotto",
"content": "Hi. This is Hey. Hi. This is Ashley Sotto on to Anthony. Thanks for taking my question. I just wanted to ask around, you know, administrative policy. Have you seen any kind of pressure on you know, the pace of ISA rollout or for projects starts from from, you know, any of the policy decisions or executive orders we've seen. And then on tariffs, what kind of impact your business we could we could expect to come soon."
},
{
"speaker": "Tom Hill",
"content": "So I don't think we see any impact from policy on on the public demand. It's IJ, which you're seeing is the growth in public going to work. And remember that money is protected through dedicated long-term funding, so nothing's gonna happen to it? Looking forward, we would think this government will support traditional agrarian sensitive public work legislation. So probably a positive from that perspective on tariffs. On agri tariffs directly, we see very little impact on everything else and we've looked at, you know, steel and rubber. I'm not sure anyone could tell you what's gonna happen, but I don't think it's a it's a it's a big impact to us. And, you know, the flip side of that is I'm confident that both materials teams will navigate whatever's comes at us? You know, look, we've seen a pandemic. We've seen volumes down. We see record inflation. And our teams consistently grow unit margins and earnings, and that's exactly why we develop book we're selling book operating, so that we can consistently grow our unit profitability regardless of any outside challenges. So the government, I think, supports infrastructure, and I don't think we'll handle whatever comes out from the tariffs."
},
{
"speaker": "Ashley Sotto",
"content": "Great. Thanks. I'll I'll send it over. Thank you."
},
{
"speaker": "Operator",
"content": "We will take our next question from Jerry Revich with Goldman Sachs."
},
{
"speaker": "Jerry Revich",
"content": "Hey, Jerry. Yes. Hi. Good morning, everyone. Hi, Tom. Mary Andrews Mark. Hi. Mary and Julie, I just wanted to pull the thread on on the cost performance. If we back out the period cost absorption, your variable cost were risk per ton were essentially flat in the quarter. So I'm wondering if you could just expand on what part of your cost structure is actually inflationary now. And, you know, if we just straight line the performance into the first quarter with normal seasonality, that would imply cost per ton are about flat year over year in the first quarter, which I just wanna make sure that's right considering the pricing outlook relative to that is is pretty I think I'll take that one. I think I would not call cost flat. I would call them up mid to single digit, and I think pretty consistently through the year. Now remember, quarter to quarter cost is gonna be choppy. It's just to make sure it'll be. So really kinda need to look at it on a trailing twelve-month basis. Fourth quarter was encouraging, but we gotta we gotta string that together. If you look at inflation, I don't think there's any deflation or on anything out there that I could think of. You know, as we guide to to twenty five, I would tell you diesel up slightly. Wages, mid-single digit. Electricity, up high single digit. And all of that partially offset by improved operating efficiencies. So but but, you know, I I would not guide you to to to flat. I think you would stay in that longer term that that low to mid-single-digit cost performance."
},
{
"speaker": "Jerry Revich",
"content": "Nice performance. Thank you."
},
{
"speaker": "Tom Hill",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "We will take our next question from Angel Castillo with Morgan Stanley."
},
{
"speaker": "Angel Castillo",
"content": "Hi. Good morning. Thanks for taking my question. Just wanted to go back to the comments on private non-resi. Utah about potential for kind of starts to maybe bottom in the middle of the year and maybe even rebound in the second half. Can you just maybe help us understand, I guess, what what you're seeing or hearing, you know, whether it's from from your customers or terms of quoting activity and maybe just kinda what gives you confidence on on that kind of of a cadence."
},
{
"speaker": "Tom Hill",
"content": "Yeah. So I I think let me be clear. I think we we do see non-residential construction shipments are still down in 2025. I think the good news is we're starting to see some term in that performance. Data centers will be a bright spot, and most of the planned data centers are in our footprint. And while warehouses has been a big drag, and will be addressed still a drag in the near future, I think that's changing. And if you look at a number of our markets, on a trailing three-month basis, we've seen that turn positive. Not everywhere, but it started to turn. So I and then so so I think you're starting to see some green shoots. I think you're starting to see some some some things turn. A lot of money sitting on the sidelines. Light traditional non-res is still is still a drag, but that gonna follow subdivision, so it's gonna take a while. So while nonresidential construction will be negative in 2025, we think it should gradually get better as we progress through the year, which kind of sets us up for a for a more positive outlook at this point, very preliminary for 2026."
},
{
"speaker": "Angel Castillo",
"content": "Cell phone, any anything in the quoting activity that you're saying?"
},
{
"speaker": "Tom Hill",
"content": "Yeah. So we're we're there's that's interesting. I'm glad you asked that. For the last six months, we've quoted a lot of non-res work that has that is still sitting on the sidelines. So we think there's pent-up demand there, but I think people wanna see more. They and they're hoping interest rates go down and but that's good news because the you know, at some point in time, that money will go to work."
},
{
"speaker": "Angel Castillo",
"content": "Very helpful. Thank you."
},
{
"speaker": "Tom Hill",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "We will take our next question from Phil Ng with Jefferies."
},
{
"speaker": "Phil Ng",
"content": "Hey, guys. Tom, congrats on another strong quarter. I had a few questions around the the pricing commentary. You talked about a hundred basis point drag on pricing mix from these recent deals. Can you give us a sense how much lower is ASP for some of these deals versus the corporate average? And how quickly do you think you can narrow that over time?"
},
{
"speaker": "Tom Hill",
"content": "So I I substantially lower. I mean and and I'm not gonna quote numbers on that, but if it had a over a hundred base basis points on the whole company, it's it is lower. We've already started that work. I think we were successful with January price increases in in in those markets, and we'll continue that as we progress the next few quarters and years, I don't think it takes us long to get it back up to where a more reasonable bulk in market would look like."
},
{
"speaker": "Phil Ng",
"content": "Okay. And then separately from a pricing standpoint, if I account for the hundred basis points, you're you're still talking about really good pricing, but perhaps little softer than the high single-digit framework you gave us last quarter? Any puts and takes you wanna give us a little more color because it doesn't sound like you know, timing is a real issue for you, Jen versus April. Like your competitors. So just give us some puts and take on perhaps, what you're seeing in in the marketplace on on price."
},
{
"speaker": "Tom Hill",
"content": "I think we were pretty consistent throughout our geographies on price increases. Same thing within uses. The I think you gotta remember you while you're a little lower than double-digit maybe, oh, same store, high single-digit. You also are not looking at double-digit cost increases. You're looking at mid to low. So we continue that trend of of taking money to the bottom line, which is the most important thing we can do is grow our unit margins by double digits, you've seen us do that over the last couple of years, and I think you'll see us do that. But that's what our guide is for 2025, and I think we feel pretty good about."
},
{
"speaker": "Phil Ng",
"content": "Okay. Appreciate the color. Thank you."
},
{
"speaker": "Tom Hill",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "We will take our next question from Mike Dahl with RBC."
},
{
"speaker": "Mike Dahl",
"content": "Hi. Thanks for taking my question. Susan, you obviously put a lot of capital to work with the acquisitions. They did come with some some mix of downstream businesses. Can you help us understand kinda how you view the down portion, whether those are businesses that are likely to stay within the portfolio, and and what is or is not incorporated into the guide with respect to that?"
},
{
"speaker": "Tom Hill",
"content": "So the acquisitions are pretty new. They were very successfully run. With good management team and good assets. Like anything else, we're gonna look at this set as a set of assets. And if it fits us, we'll run it. If it if it earns appropriate return that suits us, we'll run it. If it is more valuable someone else, then we'll we'll divest of that. And we'll take those proceeds and put them back in the aggregate."
},
{
"speaker": "Mary Andrews Carlisle",
"content": "And in terms of the guide, Mike, the the guide, you know, we own the businesses, like we do, maybe for a little helpful context for you, you know, we commented in the prepared remarks that a hundred and fifty million dollars of EBITDA contribution from the acquisitions. That's about sixty percent. In the aggregate segment, and about forty percent of that would be contributing to the to the downstream businesses."
},
{
"speaker": "Mike Dahl",
"content": "Okay. Great. Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. We'll take our next question from Adam Thalhimer with Thompson Davis."
},
{
"speaker": "Adam Thalhimer",
"content": "Hey, good morning, guys. Congrats on the Q4 beat. Mary Andrews, do you have the well, I was also curious about the downstream portion because that was a pretty big increase year over year. So that looks like it's from acquisitions I was curious if you have the the three sixty is cash gross profit. Do you have that on a reported basis?"
},
{
"speaker": "Mary Andrews Carlisle",
"content": "You know, we're I'm gonna let's stick with the three sixty for now, and we can we can talk offline about some more specifics. But maybe what would be helpful to you is the improvement in the cash gross profit contribution from the downstream business is about seventy-five percent of that overall improvement is is from the acquisitions. We also see you know, improvement in the underlying business in in both segments. And that's about twenty-five percent of the improvement year over year."
},
{
"speaker": "Adam Thalhimer",
"content": "That helps. Okay. Thank you."
},
{
"speaker": "Operator",
"content": "We will take our next question from Timna Stanners."
},
{
"speaker": "Timna Stanners",
"content": "Yeah. Hey. Good morning. I wanted to ask you a little bit about the m and a landscape after the deal you just finished, you know, what how you're looking at 2025 that they could build from what you just accomplished. And then if I could sneak in a question on Mexico, any update on the Calico quarry restitution efforts? With the USMCA panel? Thank you."
},
{
"speaker": "Tom Hill",
"content": "Yeah. So on I think there's still a very healthy pipeline of m and a. There's a number of projects we're working on. It'll take some, you know, it'll take some time, but I think we'll continue to be successful with that as we go through 2025. On Mexico, I think the the short answer there is no real news there. We're still waiting on the the tribunal to make a decision. We feel very good about our case. And think we will win that, and we'll know, we'll they make a decision, we'll let you guys know. We are anticipating that sometime this year."
},
{
"speaker": "Timna Stanners",
"content": "Okay. Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. We'll take our next question from Garik Smois with Loop Capital."
},
{
"speaker": "Garik Smois",
"content": "Great. Thanks for taking my question. We spoke to the pricing cadence being similar this year as opposed the last. So what about the hear your thoughts on midyear increases, what opportunities you see there potentially, and what the what the time frame could be."
},
{
"speaker": "Tom Hill",
"content": "Yeah. So they are not included in our guide. But we will absolutely announce midyear price increases. We will announce those probably towards the end of the first quarter, so we got time to have those conversations. Again, as I always remind you, mid year's will have a bigger impact on 2026 than they will in 2025. But you also do you know, and I it's too early to call how successful those will be, but we'll for sure gonna announce them. We'll have conversation with customers and we'll see where we go from there."
},
{
"speaker": "Garik Smois",
"content": "Great. Do you do you have, by chance, how much 2024 midyears are impacting 2025?"
},
{
"speaker": "Tom Hill",
"content": "Well, that's a really that's a really hard to parse out. They definitely had an impact. I think we're pleased with part of the things that they do is help you give notice to your customers so they have more time to react. Which allows us to be more successful for a January one. So some of it is amplitude, the price, and some of it is timing. But it definitely helps both."
},
{
"speaker": "Garik Smois",
"content": "Understood. Thanks for that, and best of luck."
},
{
"speaker": "Tom Hill",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "We will take our next question from Keith Hughes with Truist."
},
{
"speaker": "Keith Hughes",
"content": "Thank you. Thank you. I I guess I have a short-term weather question that everybody asked me. For the date is whether it's supportive of shipments or if we still had delays year over year. Some of the storm might go to. So short term and January, February has been very cold. We're gonna see that this week with with cold and snow. So not a great start. But, you know, we when we when we put a plan together, we expect weather impact at some point in time of the year. We expect to get to get lucky in some quarters. We're trying to look at more normalized weather as as we make a prediction is and we've in our guidance, think as we pointed out, Q3 was particularly challenged last year. Hopefully, that'll be easy comp in in in the middle of the season. So, hopefully, that'll help us. Ex hurricanes."
},
{
"speaker": "Keith Hughes",
"content": "Exactly. And one other question on the the Southern California acquisition. Is that particularly the downstream, does that mix and well the current operations at Vulcan or is that operate more as a standalone entity?"
},
{
"speaker": "Tom Hill",
"content": "So if you look at the overall, it fits us very well. Particularly on Agri's perspective. We we know we don't have a lot of downstream ready mix in those markets, but it also has some asphalt that fits. So part of it fits in aggregate and asphalt as far as us being there. And then the ReadyBags, they have an excellent position in those markets, but we we were not in the Ready Mix business in those markets."
},
{
"speaker": "Keith Hughes",
"content": "Okay. Thank you."
},
{
"speaker": "Operator",
"content": "We will take our next question from Brent Thalmann with D. A. Davidson."
},
{
"speaker": "Brent Thalmann",
"content": "Hey, bud. Hey. Thanks. Hey. Tom, I had a question more on maybe the direct impacts of tariffs on your business and then Mexico is not really in the conversation, but we're thinking more along the West Coast and and what you know, Vulcan's response is gonna be to the extent that tariffs are implemented on some of your assets shipping down from Canada."
},
{
"speaker": "Tom Hill",
"content": "Well, I think our our our will fall the letter of the law. We've looked at that. It is a pretty negligible impact for us. And, you know, whatever it is, we'll handle handling the business. But I I wouldn't it it it doesn't move the needle."
},
{
"speaker": "Brent Thalmann",
"content": "Okay. Thank you."
},
{
"speaker": "Operator",
"content": "It will take our next question from Michael Dudas with Vertical Research."
},
{
"speaker": "Michael Dudas",
"content": "Morning, Tom Amargary Andrews. Morning. Right. Tom with the very solid pricing, it looks like for 2025, even though it's accelerated from 24, do you do you sense this is you know, even, like, say, your organic volumes are flat and it kinda flattish on the overall market? This look like maybe a more normalized level pricing relative to the history span, or is there still room for upside on that going? Thank you."
},
{
"speaker": "Tom Hill",
"content": "Yeah. I think that, you know, there's always upside on price. You gotta earn that with your customers. Obviously, growing demand always helps that. And we haven't seen growing demand now for for for a few years. Which puts some pressure on price. But I think if you look at the bulk of the way of selling and the way we service our customers, I think we earn price, and I think we're doing that. And I can see that in in our performance in 24 and I got in 25."
},
{
"speaker": "Operator",
"content": "Will take our next question from David MacGregor with Longbow Research."
},
{
"speaker": "David MacGregor",
"content": "Good morning, David. Good morning, everyone. Good morning, Tom. Congratulations on a really strong quarter. Performance. I I wanted to ask you about pricing and the volking the volking way of selling. And and clearly, this process has been very successful, and delivered some very visible results. But your market's evolved, and I'm thinking, for example, if you're ready mix and fixed plant customers who in many instances are now paying more for their limestone than they are for the cement, then, I guess, secondly, your Vulcan way of operating process is giving you better incremental unit cost. Does the profitability algorithm sort of adjust at some point to rely on slightly smaller price increases in favor of larger unit shift gains that are achieved maybe in the way of market share gains from competitors who are continuing to push hard on price increases."
},
{
"speaker": "Tom Hill",
"content": "Yeah. Let me be clear. I wish we had some in pricing. We don't. It's much lower than cement pricing, but also that cost is much lower. I think that as you as you look forward, I think the the what I would go back to the strategic initiatives of both of selling and bulk of offering. In-depth much better in-depth look into what's going on in the market. And gives your salespeople the tools price better, and also gives them logistics. Another tools to better service your customers. I think on the bulk way of operating, it allows for better training and better operators in how we inspect our equipment and reduce downtime and also the the technology allows for better throughput and throughput of critical sizes. Put those two together, and I think both of them have a lot better chance of meeting history both to both the sales piece and the operating piece which leads you to better opportunities on unit margin growth that, again, will be history, and you've seen us do that you know, it's it's over over the last nine quarters, a double-digit improvement. So that's not happening by accident, and it doesn't have by act happen by accident going forward. Again, if you you know, that's over time frames when volumes have actually gone down. This year, we're calling it flat. But when volumes come back, you would have even better opportunity to improve your unit margins both on the price side and on the cost side."
},
{
"speaker": "David MacGregor",
"content": "Yeah. Okay. Alright. Thanks, Tom."
},
{
"speaker": "Tom Hill",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. It appears we have no further questions in the queue. I will turn the program back to our presenters for any additional or closing remarks."
},
{
"speaker": "Tom Hill",
"content": "Yes. Thank you for your time and your interest in Vulcan Materials today. We appreciate the relationship. We hope that you and your family stay safe, particularly with all the weather we're having. And we look forward to talking to you throughout the quarter. Thank you."
},
{
"speaker": "Operator",
"content": "This does conclude today's program. Thank you for your participation. You may disconnect at any time."
}
] |
vmc | 2,024 | 3 | [
{
"speaker": "Operator",
"content": "Good morning. Welcome, everyone, to the Vulcan Materials Company Third Quarter 2024 Earnings Call. My name is Angela, and I will be your conference call coordinator today. Please be reminded that today's call is being recorded and will be available for replay later today at the company's website. All lines have been placed in a listen-only mode. After the company's prepared remarks, there will be a question-and-answer session. Now, I will turn the call over to your host, Mr. Mark Warren, Vice President of Investor Relations for Vulcan Materials. Mr. Warren, you may begin."
},
{
"speaker": "Mark Warren",
"content": "Thank you, operator, and good morning, everyone. With me today are Tom Hill, Chairman and CEO; and Mary Andrews Carlisle, Senior Vice President and Chief Financial Officer. Today's call is accompanied by a press release and a supplemental presentation posted to our website vulcanmaterials.com. Please be reminded that today's discussion may include forward-looking statements, which are subject to risks and uncertainties. These risks, along with other legal disclaimers are described in detail in the company's earnings release and in other filings with the Securities and Exchange Commission. Reconciliations of non-GAAP financial measures are defined and reconciled in our earnings release, our supplemental presentation, and other SEC filings. During the Q&A, we ask that you limit your participation to one question. This will allow us to accommodate as many as possible during our time we have available. And with that, I'll turn the call over to Tom."
},
{
"speaker": "Tom Hill",
"content": "Thank you, Mark, and thank all of you for joining our call this morning. We continue to execute on our two-pronged strategy to deliver attractive long-term value creation for our shareholders. Results and activities in the third quarter demonstrate our success in consistently expanding our aggregate new profitability and successfully expanding our reach through strategic acquisition opportunities. Despite the disruption of four hurricanes impacting our industry-leading Southeast footprint, both gross margin and adjusted EBITDA margin expanded in the quarter. And year-over-year aggregates cash gross profit per ton increased double-digits for the eighth consecutive quarter, a testament to the benefits of our unwavering focus on our Vulcan Way of Selling and Vulcan Way of Operating disciplines. In the quarter, we generated $581 million of adjusted EBITDA, a modest decline versus the prior year given 10% lower aggregate shipments and the prior year earnings contribution from the now divested Texas concrete business. Shipments in the quarter varied widely month-to-month and across geographies reflecting the interruption caused by extreme weather events. So let me walk you through how the quarter played out. In July, seven of our top 10 markets experienced significant year-over-year increases in rainfall and the first of four hurricanes, Hurricane Beryl made landfall in our footprint. Average daily shipments were down mid-teens for the month. Shipments in August rebounded after a slow start due to Hurricane Debby tracking up the East Coast. Daily shipments in August, excluding the two shipping days most impacted by the hurricane, were only down 4%, consistent with our non-weather impacted demand view. As we are all aware, Hurricane Helene, the second of two September hurricanes, devastated many communities across Florida, Western North Carolina, East Tennessee and other parts of the Southeast. I am thankful to report that all of our employees are safe and I'm proud of their immediate efforts to help our communities and neighbors. The catastrophic destruction in Western North Carolina and East Tennessee is both tragic and historic. Vulcan Materials is well-positioned in the affected areas to support the immense rebuilding efforts that will be required. Due to the storm, shipments were down approximately 25% in the final week of September, resulting in quarterly shipments finishing 10% below the prior year. In spite of the challenges from volume, the pricing environment remains positive. Freight adjusted average selling prices improved 10% year-over-year with increases widespread across geographies. We continue to use our Vulcan Way of Selling disciplines and processes to deliver value to our customers and earn their daily business. We also remain focused on our Vulcan Way of Operating disciplines to drive efficiencies and lower unit cost. Although, weather and lower volumes were an even more significant headwind in the third quarter than the prior quarter, the rate of cost increases moderated. At the end of September, we announced the acquisition of Wake Stone Corporation, a leading pure-play aggregate supplier in the Carolinas. This acquisition is consistent with our aggregates led growth strategy and will be a great addition to the Vulcan family. We look forward to welcoming the Wake Stone team upon closing later this year. Now, shifting to demand. The overall demand environment is improving, but with different dynamics impacting each end use. Higher single-family starts over the last 3 months and 12 months provide a solid backdrop for growing single-family demand, particularly with potentially lower mortgage rates on the horizon to help address the ongoing affordability issue. Multifamily starts remain weak but should also benefit from a lower interest rate environment. Fundamentally, there is a consistent need for additional housing in Vulcan markets, which bodes well for future residential construction activity. In private non-residential construction, demand remains varied across categories. Most categories will benefit from improving interest rates since projects in the planning and design pipeline have been accumulating for some time now. Warehouse activity remains a headwind, but comps are easing and start seem to be stabilizing near pre-COVID levels. Data centers are still robust and manufacturing remains a catalyst in some of our markets. Overtime, light commercial activity should follow the positive trends in single-family housing. We are closely monitoring the macro dynamics and likely timing of private non-residential activity making the turn. On the public side, we continue to expect steady growth for multiple years. Our booking activity points to the conversion of growth in contract awards now flowing into aggregate shipments. I am confident we are well-positioned to finish the year strong and deliver approximately $2 billion of adjusted EBITDA in 2024. Now, I'll turn the call over to Mary Andrews to discuss a few more details about the quarter and 2024 before I share some preliminary views of 2025. Mary Andrews?"
},
{
"speaker": "Mary Andrews Carlisle",
"content": "Thanks, Tom, and good morning. Tom covered for you some of our important achievements in the aggregates business during the third quarter. I want to highlight a few other items that underpin our confidence in the durability of our business and the solid execution of our team. Our downstream businesses continue to strategically complement our aggregates franchise and select markets. The asphalt business maintained healthy margins at nearly 16% in the third quarter and cash unit profitability improved 11%. Our concrete business on the East Coast also delivered unit profitability improvement, while the lower volumes related to weak private demand in Northern California compressed margins in our West Coast concrete business. Our SAG expenses in the quarter were $129 million or 6.4% of revenues, 10% lower than the prior year and 20 basis points favorable as a percent of revenues. We remain dedicated to both disciplined cost control and making strategic investments in talent and technology to support our business and drive innovation. Through the first nine months we have generated nearly $1 billion of operating cash flow through our constant focus on maximizing our cash gross profit on every ton of aggregates we sell. After reinvesting over $400 million to sustain and improve our existing operations and grow our business through Greenfield development, we have yielded a 36% increase in free cash flow to deploy for expanding our reach through M&A and returning cash to shareholders. Year-to-date, we have allocated $206 million through strategic bolt-on acquisitions and return $252 million to shareholders through dividends and common stock repurchases. For the full year, we now expect to spend between $625 million and $650 million of capital expenditures. Our balance sheet position provides us the strength and flexibility to grow. At September 30, net debt to trailing 12 months adjusted EBITDA leverage was 1.5x, giving us ample investment capacity within our target leverage range of 2x to 2.5x to fund the Wake Stone acquisition and other growth opportunities that will drive long-term value creation for shareholders. We continue to focus on our return on invested capital, which was 16.1%, a 70 basis points improvement over the last 12 months with higher adjusted EBITDA generated on lower average invested capital. I'll now turn the call back over to Tom to provide some preliminary thoughts on 2025 and a few closing remarks."
},
{
"speaker": "Tom Hill",
"content": "Thank you, Mary Andrews. As I look at 2025 and contemplate the demand backdrop, I expect aggregate shipments to grow next year. Public construction activity remains robust and the environment is improving for the private construction activity. I am confident that Vulcan Materials will continue to execute at a high level and compound our industry-leading cash gross profit per ton at double-digit levels. I expect aggregate price to continue to outpace historical norms and improve by high-single-digit in 2025. I also expect year-over-year cost trends to improve through a combination of execution on our Vulcan Way of Operating disciplines to drive improved efficiencies in our operations and moderating inflation. Vulcan Materials has the right products, aggregates in the right markets, but more importantly, I am confident we have the right focus and the right people to execute our strategy and deliver earnings growth in 2025. And now, Mary Andrews and I will be happy to take your questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions]. We will go first to Garik Shmois with Loop Capital. Please go ahead."
},
{
"speaker": "Garik Shmois",
"content": "Hi, thanks for having me on today. I was hoping to go over --"
},
{
"speaker": "Tom Hill",
"content": "Good morning."
},
{
"speaker": "Garik Shmois",
"content": "Hey, good morning. I was hoping you go over a little more detail on the high-single-digit pricing outlook for next year. How much carryover is there for mid-years from this year? Any help on the pacing for pricing next year and any mix impacts we should be thinking about either from a product mix or a geographic mix standpoint?"
},
{
"speaker": "Tom Hill",
"content": "Yes. First of all, I don't think we have any mix put in there. But let me go back in time a little bit. If you look at our mid-year price increases, they were largely as expected, kind of by market and by customer, very much similar to last year. And so that's a really healthy start for 2025 and I think that if you take mid-year price increases and couple that with what we see in our backlogs, it allows us to carry very good price momentum and visibility into next year. As we said in the press release, I think our preliminary view is high-single-digit increases for 2025. I think I'm confident in that. If you combine that with cost increases, which continue to moderate, I think it makes me feel really good about the continued double-digit unit margin growth throughout 2025. As you heard us say in the prepared remarks, we had eight quarters of double-digit cash gross profit per ton growth and remember, seven of those eight quarters we were dealing with declining volumes. So I think we're confident we continue that streak in 2025. I guess, my -- I want to thank my teams. That's tough to do given the challenges that we've seen with weather and volume throughout this year, particularly in the third quarter. But I think they continue that success into next year. And what that tells me is that the Vulcan team is in control of the destiny to control what they can control."
},
{
"speaker": "Mary Andrews Carlisle",
"content": "Yes. And remember Garik, too, the reason we are so focused on that unit profitability improvement that Tom was talking about is that maximizing cash gross profit on every ton is the key to our free cash flow generation. To me, it's notable that on lower ag volumes and lower revenues year-to-date, EBITDA margin has expanded and free cash flow has increased 36%. So, as Tom said, our teams have executed very well in a really challenging environment. And frankly, I think they've provided a perfect example of just how durable this business is."
},
{
"speaker": "Garik Shmois",
"content": "Yes, makes sense. Thanks for the color, Tom."
},
{
"speaker": "Operator",
"content": "We'll go next to Trey Grooms with Stephens. Please go ahead."
},
{
"speaker": "Tom Hill",
"content": "Good morning, Trey."
},
{
"speaker": "Trey Grooms",
"content": "Hey, good morning, Tom. Good morning, Mary Andrews. Hope everybody's doing well. So I know it's not always perfect science here, easy to do. But as you look at the quarter, can you try to parse out kind of what the weather impacts may have been versus demand and maybe how each played a role in the down 10% volume that we saw here in 3Q?"
},
{
"speaker": "Tom Hill",
"content": "Yes. We tried to parse that out a little bit by month in the quarter, but obviously weather has been a big story this year, and the third quarter underscored that story. If you look at the year we've had, 17 out of our 20 largest markets with more rain than prior year. I would call underlying demand kind of still down mid-single-digit ex-weather. Looking forward to the fourth quarter, we saw Hurricane Milton give us a tough start. But since then we've seen good weather and we've seen our daily shipping rates bounce back, which is encouraging. But to get us back down to earth is still Q4. So how we finished the fourth quarter, I think will just depend on the number of good weather shipping days. So far so good at this point, but we got to see, I think, again in spite of extreme weather and volumes, our folks continue to expand unit margin by double-digits. So we can't control the weather, but we control how we service our customers and price and cost. But again, I would call underlying demand, mid-single-digit and the rest weather and we'll just see how the weather allows us to finish the fourth quarter."
},
{
"speaker": "Trey Grooms",
"content": "Got it. Thanks for that. And I'm sticking to one question, but I did want to congratulate you on the nice improvement there in gross profit per unit -- cash gross profit per unit, especially despite the volume headwinds that you had. So thanks, and --"
},
{
"speaker": "Tom Hill",
"content": "I appreciate that. I give all the credit to the people that sell and crush rock."
},
{
"speaker": "Trey Grooms",
"content": "There you go. Okay, I'll pass it on. Thanks, everybody."
},
{
"speaker": "Tom Hill",
"content": "Thanks, man."
},
{
"speaker": "Operator",
"content": "We will go next to Keith Hughes with Truist. Please go ahead."
},
{
"speaker": "Keith Hughes",
"content": "Thank you. Questions on volume in 2025, I know you said they're going to be up, but we have some pretty easy comps with this weather you discussed. How much could it be up and is to getting the pricing that you just discussed for 2025 or you think you'll have to walk away from some shipments in order to get pricing that high?"
},
{
"speaker": "Tom Hill",
"content": "I don't think that there's any -- if we look at the kind of the volume growth at low-single-digit, I don't think you're looking at any share moving around. I look at volume to 2025. First of all, you're going to have some push from 2024 to 2025, obviously, that volume doesn't go away, it just pushes back, so that that'll be a little bit of a tailwind for us. And we'll continue to, I think experience demand challenges from like non-res and warehouse construction. Hopefully that drop is slowing. I do think we'll see overall growth in residential construction, some challenges on multi, but I think single is and will bounce and then we'll see growth on the public side. So a little bit early to call 2025, flurry thoughts would be kind of low-single-digit with no impact from price."
},
{
"speaker": "Keith Hughes",
"content": "And that's assuming normal weather."
},
{
"speaker": "Tom Hill",
"content": "I don't know what normal is anyway…"
},
{
"speaker": "Keith Hughes",
"content": "Whatever normal is?"
},
{
"speaker": "Tom Hill",
"content": "Yes, yes."
},
{
"speaker": "Keith Hughes",
"content": "All right. Thank you."
},
{
"speaker": "Operator",
"content": "We will go next to Anthony Pettinari with Citigroup. Please go ahead."
},
{
"speaker": "Anthony Pettinari",
"content": "Tom, I was wondering if you could talk a little bit more about Wake Stone, just kind of how long you've been looking at that business and maybe the profile, the assets in terms of kind of the per unit profitability, how it sort of stands up against a larger company. Just any other details you could share?"
},
{
"speaker": "Tom Hill",
"content": "Yes. We've known the brand for years and they run a good company. We looking at closing that business later this year, so not much of an impact, I would say, for this year. They operate in the triangle region of Eastern North Carolina, the Raleigh, Durham, Chapel Hill, and that's one of the 10 fastest growing regions in the country, so a great market. I had the pleasure of meeting with the entire Wake Stone team a few weeks ago. They're a talented bunch and we look forward to them joining the Vulcan family. We are confident that this will have substantial value creation for our shareholders. And I think we're like our strategy, we will say this is expanding our reach into some very attractive aggregate markets."
},
{
"speaker": "Anthony Pettinari",
"content": "Okay. That's helpful. Is there a rough estimate of tonnage or should we wait for that?"
},
{
"speaker": "Tom Hill",
"content": "Historically, they've been in the 8 million to 9 million ton range."
},
{
"speaker": "Anthony Pettinari",
"content": "Got it, got it. That's helpful. I'll turn it over."
},
{
"speaker": "Tom Hill",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "We will go next to Kathryn Thompson with Thompson Research Group. Please go ahead."
},
{
"speaker": "Kathryn Thompson",
"content": "Hi, thank you for taking my question today. You touched on earlier in the Q&A about the volumes down 10%, yet, you were able to get double-digit cash gross profit per ton in the quarter. And you helped us bridge how this is achieved. Following in on that, compare and contrast what happened this quarter and in terms of what your outlook is in 2025 and are there any particular aspects, including cost, that could be different in 2025 versus current quarter? And then maybe also talk about what will be unchanged and what are the things that allow to put up double-digit cash gross profit per ton, even in space of double-digit volume declines. Thank you."
},
{
"speaker": "Tom Hill",
"content": "Yes. I think this kind of goes, that, that is the disciplines of the Vulcan Way of Selling and Vulcan Way of Operating and that's kind of simply put, you saw us continue pricing disciplines throughout this year. And I thought the teams did a good job with that. I think that they did a good job with mid-years, which helps us carry good momentum into 2025 from a pricing perspective. And then the conversations that we've had for the January 1 pricing, they're not complete, but they're pretty far down the road. And so that gives us some confidence of that high-single-digit from a pricing perspective. On the cost side, we've been sitting here facing double-digit cost, unit costs for a number of quarters now, which quite candidly is extremely high. A lot of that is inflation driven. Some of that this year is impacted by weather and by volume. But I think that our operating teams continue to execute on the disciplines from an operating perspective. And that is plant availability, throughput, tons per hour, tons per man hour, and all the metrics that go into what drives cost. So while we continue, I think good pricing momentum going into 2025, I think we are starting to see our cost increases moderate and that's a combination, I think of inflation moderating but also our operating efficiencies improving. And as far as those operating efficiencies, I think we got a long way to go. We were I guess put back a little bit this year because of inclement weather which gives you wet sticky material, it's hard to operate. So I would expect over the next few quarters that to the operating efficiency to continue to improve."
},
{
"speaker": "Kathryn Thompson",
"content": "Great. Thanks so much and best of luck."
},
{
"speaker": "Tom Hill",
"content": "Thank you. Thank you."
},
{
"speaker": "Operator",
"content": "We will go next to Jerry Revich with Goldman Sachs. Please go ahead."
},
{
"speaker": "Tom Hill",
"content": "Good morning, Jerry. Good morning, Jerry."
},
{
"speaker": "Jerry Revich",
"content": "Yes. Hi, good morning, Tom, Mary Andrews, Mark, congratulations on the strong unit profitability given the volumes this quarter, mind as well. I want to ask the pricing sequentially I thought was quite constructive given the disruption in terms of relative to an attractive part of your footprint here. Can you just talk about how the weaker volumes this year are impacting the pricing cadence, if at all? I'm assuming new spot market business would have come online were it not for the demand decline. And how does that impact the planned pricing cadence in terms of the price increases that you've announced to customers for January 1 for 2025 compared to the cadence of pricing actions that you took in the beginning of 2024 just to calibrate us?"
},
{
"speaker": "Tom Hill",
"content": "Look, demand, I mean volumes going down never helps price. But I think that the visibility to coming demand both on the public side, particularly on the public side, but now also we think some growth on the private side and residential are helpful for price. I think as far as you know, we talked about mid-year price increases that's a good up for 2025. It helped a little bit in 2024. I think if you look at the cadence in 2024, we were probably up a little bit higher from Q1 and Q2 than last year, probably not quite as high from Q2 into Q3, but that's just timing. And so I think that you put all that together where demand has been a drag I think is us and our customers look to 2025. I think the future looks much better from a public side and from a residential side and probably not as bad from a non-residential side. You pull that together. I think we're encouraged by opportunities for price and unit margin as we look out to 2025."
},
{
"speaker": "Jerry Revich",
"content": "And sorry, Tom, can you comment on the timing part of that question, January 1 versus April 1? How does that look in terms of your plans for all compared to the --"
},
{
"speaker": "Tom Hill",
"content": "Yes. The vast majority of our prices will be January 1. I'm trying to think if there's any, there will be April. I'm sure there's a minority out there, but none that I can think of right off top of my head. So we -- that's changed -- been changed now for two or three years, and I don't -- I expect to continue January 1."
},
{
"speaker": "Mary Andrews Carlisle",
"content": "And just Jerry, talking about the sequential price, you're right. We thought that third quarter sequentially played out in line with what we expected, given the execution on the mid-year increases. So good momentum moving into the fourth quarter, which obviously we don't usually see sequential growth that too much mix really to call that, but tremendous momentum moving into 2025 and those January 1 increases."
},
{
"speaker": "Jerry Revich",
"content": "Thank you."
},
{
"speaker": "Tom Hill",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "We'll go next to Brent Thielman with D.A. Davidson. Please go ahead."
},
{
"speaker": "Tom Hill",
"content": "Good morning."
},
{
"speaker": "Brent Thielman",
"content": "Hey, thanks. Hey, good morning. Thanks. Tom, I know a lot of attention on the private sector for 2025 and what may come, but on infrastructure, I mean, I know some of the leading indicators out there showed some flattening at relatively high level. Guess my question is, do you think your business can still see an acceleration in those volumes next year? I know you've got the weather stuff this year, but also just thinking about a lot of projects that are just still getting going that have been released over the last couple of years. So wanted to get your sense around that."
},
{
"speaker": "Tom Hill",
"content": "Yes. I think we feel good about the public side. I think we're seeing the IIJA and state and local funds flow into highways now. Overall, we see public demand growth. It's -- this year similar to our expectations, steady growth as we look forward. And then if you look over beyond IIJA, you've got substantial state funding. Texas and California are two of our largest states and they're at record letting levels. And then you got Georgia, Tennessee, Florida, South Carolina, that all approved large additional funding, state funding. You put all that together, it'll impact some lettings in 2025, which will help us, but it'll go past that. So you got six of our largest states at record funding levels and that should support public demand this year, next year, and obviously the next three or four years. And then you've got the other infrastructure over beyond highways to support by IIJA that is a little better than we would have expected at this point. So feel pretty good about the public side."
},
{
"speaker": "Brent Thielman",
"content": "Very good. Thank you."
},
{
"speaker": "Tom Hill",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "We'll go next to Phil Ng with Jefferies. Please go ahead."
},
{
"speaker": "Phil Ng",
"content": "Hey, guys, how are you doing? I guess, from a cost per ton standpoint, how should we think about the fourth quarter? Does that start to normalize? And we look out to 2025; your gross profit per ton has been pretty stellar, despite weaker volumes, does that accelerate a little more, as we get a little more volume growth as we think about next year in terms of cost per ton coming down as well?"
},
{
"speaker": "Tom Hill",
"content": "I would expect, simply cost -- the cost increases to start moderating. But I think if you -- despite the volumes and the weather challenges that we had in the quarter, we continue to moderate that cost looking backwards and that we stick on material hurts that efficiency. So volume growth in a more normal weather pattern, coupled with the continued implementation of the Vulcan Way of Operating, I think will help our cost issues as we move forward and support that double-digit margin growth. So simply put it, I would expect our cost pressures to start easing over the next few quarters."
},
{
"speaker": "Phil Ng",
"content": "Can we get it back normal, like in that low to mid-single-digit range in the fourth quarter or it's going to take a little longer? And is that a good basis for 2025?"
},
{
"speaker": "Tom Hill",
"content": "That's a great target. But that's the target. I'm not paying in victory on that one yet, but yes, that's our goal is to get it back down to normal."
},
{
"speaker": "Phil Ng",
"content": "Okay. All right. Super. Thank you."
},
{
"speaker": "Tom Hill",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "We'll go next to Timna Tanners with Wolfe Research. Please go ahead."
},
{
"speaker": "Tom Hill",
"content": "Hi, Timna."
},
{
"speaker": "Timna Tanners",
"content": "Hey, good morning. Hello. I wanted to ask, if I could, about capital allocation, just shifting gears. So you paused the buyback, wondering why given such a strong free cash flow the quarter. You talked about more M&A. Is there still some left? I know you accentuated that on the last call. And just wondering in general if you can talk about other uses, including debt paydown potentially into next year with a maturity in the second quarter? Thanks."
},
{
"speaker": "Tom Hill",
"content": "So I'll let Mary Andrews go first with capital, and then I'll talk about acquisitions."
},
{
"speaker": "Mary Andrews Carlisle",
"content": "Yes. Timna, I think through the first nine months, our capital allocation decisions have been consistent with what we always communicate, which is the biggest gating item for us is always growth opportunities. We've obviously announced the Wake Stone opportunity and the pipeline remains active. So I think there's other opportunities ahead of us. We obviously have the balance sheet well-positioned to fund those growth opportunities. And also, as you mentioned, are taking into account the notes that are coming due in April of next year."
},
{
"speaker": "Tom Hill",
"content": "On M&A, I think we saw us close a couple of small bolt-ons in Alabama and Texas earlier in the year where obviously, we're excited about Wake Stone, and looking forward to closing that one. That aside, I think the M&A pipeline remains active. We're working on some other opportunities that we hope to get to the finish line and talk about in the next few quarters."
},
{
"speaker": "Timna Tanners",
"content": "Thank you."
},
{
"speaker": "Tom Hill",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "We'll go next to Michael Dudas with Vertical Research. Please go ahead."
},
{
"speaker": "Tom Hill",
"content": "Hey, Mike."
},
{
"speaker": "Michael Dudas",
"content": "Good morning, Mary Andrews. Good morning, Mary Andrews, Mark, and Tom. Tom, back to looking maybe at the private sector, can you maybe share how your manufacturing, industrial energy customers, how their plans, their back -- how your backlog looks relative to that market? And have you sensed any maybe generally, maybe definitely on the private side, across the board, any hesitancy because of the election and once that gets through? And with maybe rates certainly hopefully normalizing though the market is not cooperating in the last couple of weeks of that giving you a little more better tailwinds to some of the volume numbers that you're sharing with us today?"
},
{
"speaker": "Tom Hill",
"content": "Yes. I think, obviously, the warehouses and distribution centers and the like that have been challenges. That being said, I think the drop on that is easing. And as you said, it's offset with heavy and heavy manufacturing and data centers that's been a good tailwind for us. That continues to be a good tailwind for us going into 2025. But I think it's insightful about what you said about what's in the pipeline. I think there's a lot of projects on hold. If you talk to a number of our customers and the large general contractors, they're bidding a lot of work, but nobody is pushing the button. I think that with election being over, interest rates easing, hopefully in the second half of next year, we'll some -- see some of these come off the sideline. But there is a lot of pent-up out there that's kind of a wait and see. So we hope that a number of factors helps ease that, and we see some of that come off. Second half of -- that will impact second half of 2025, but probably a bigger impact on 2026."
},
{
"speaker": "Michael Dudas",
"content": "Thank you, Tom."
},
{
"speaker": "Tom Hill",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "We'll go next to Tyler Brown with Raymond James. Please go ahead."
},
{
"speaker": "Tom Hill",
"content": "Hey, good morning."
},
{
"speaker": "Tyler Brown",
"content": "Hey, Tom, I want to kind of come back to some prior comments. But where are you all on the plant technology journey that you talked about at the Analyst Day? And what do you think that those efficiencies mean increasing cost call it, disinflation perspective over the next couple of years? I mean, does it shave a point or two off of those unit costs? Just any way to frame it? I'm just trying to understand just how idiosyncratic it is bolt-on."
},
{
"speaker": "Tom Hill",
"content": "It's insight -- your insight -- your -- what your question is a cycle because it's a big deal for us. We're still pretty early stages. I think we probably have that fully implemented in 25%, 30% of our operations. The capital cost is spent on the remaining operations. Remember, it's about the top 110, 120 plants which is about 70%, 75% of our production. What we're seeing out of that is double-digit throughput improvements on the plants where it's fully implemented. Long ways to go on that one. I think we make that journey throughout 2025. The weather probably didn't help us with some of that stuff and some of the distractions we have with storms, but I think that Pruitt and team are making good progress there, and I think they'll get that done sometime early 2026. And it's hard -- really hard to call. And we spent some time trying to do it. What is the dollar impact for us? And I think we quit doing that and we'll concentrate on what's the throughput impact because we know its degrees of goods. So -- we'll hopefully finish that journey by first or second quarter of 2026. But you are correct; it will have an impact on our cost."
},
{
"speaker": "Tyler Brown",
"content": "Excellent. Yes, that’s extremely helpful. Thanks."
},
{
"speaker": "Tom Hill",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "We'll go next to Adam Thalhimer with Thompson Davis. Please go ahead."
},
{
"speaker": "Adam Thalhimer",
"content": "Hey, good morning, guys."
},
{
"speaker": "Tom Hill",
"content": "Good morning."
},
{
"speaker": "Mary Andrews Carlisle",
"content": "Good morning."
},
{
"speaker": "Adam Thalhimer",
"content": "I'm still a little fuzzy. What do you want us to plug in for volumes in Q4? And then Tom, how much demand variability are you seeing by state?"
},
{
"speaker": "Tom Hill",
"content": "So on Q4, if you give me the weather report for November, December, I'll give you the volume for Q4. It's just -- it's a hard one to call because it's so dicey. Like I said, October started off slow, but bounced really good. And it's been dry in October, and we shipped appropriately well. But November, December, we all know what can happen in those. So kind of a hard one to call. I would call you to underlying demand for the year is at that probably mid -- down mid-single-digits. We've seen some balance of that in October. But again, it's how many shipping days that we have."
},
{
"speaker": "Mary Andrews Carlisle",
"content": "Yes. And Adam, I think overall, our volume guidance from the second quarter was minus 4% to minus 7%, and that's still what we expect for the full year on a demand environment, like Tom described, is down mid-single-digits and the rest of that weather impacted. So where we fall within that will depend on how fourth quarter plays out."
},
{
"speaker": "Tom Hill",
"content": "I'm sorry. What was your second question?"
},
{
"speaker": "Adam Thalhimer",
"content": "Demand variability by state."
},
{
"speaker": "Tom Hill",
"content": "That was hard to call because who get washed out -- who got washed out what month this year. But I think all of them are okay. I don't see the -- Illinois has been a challenge with the public side, more of a challenge than most of our states. I think Virginia has had its share of challenges. Northern California has been challenged. And the rest of them, I think, kind of in that low to mid-single-digit rate down of what we've seen, so. And the Southeast is probably healthiest. In Texas, when if you look at Texas, when it quit rain, we should actually shipped quite well, but they got boiling out in the first half of the year, but the second half has been better. But I think most of them are consistently kind of down in that mid-single-digit except for the challenged ones I would call out would be Northern California, Illinois, may kind of Virginia area."
},
{
"speaker": "Adam Thalhimer",
"content": "Got it. Thank you."
},
{
"speaker": "Tom Hill",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "We'll go next to Mike Dahl with RBC Capital Markets. Please go ahead."
},
{
"speaker": "Tom Hill",
"content": "Good morning, Mike."
},
{
"speaker": "Mike Dahl",
"content": "Good morning. Thanks for taking my question. Follow-up on Wake Stone, so I appreciate the volume comment. Can you help us understand just how pricing looks both in terms of kind of where you stand -- where that business stands relative to your core portfolio? And also just how their pricing strategy has looked over the past couple of years relative to the strategy you employ and what you can do with that? And then if I could sneak one more on Wake and just any sense of kind of the cash outlay to close the acquisition?"
},
{
"speaker": "Tom Hill",
"content": "So you probably don't love my answer, but that's -- as you know, that's a new market for us. We've not been in that in the Raleigh, Durham, Chapel Hill market before. So kind of new ground from a commercial perspective. So -- and we've got to get it closed. So a little bit early for me to make any calls how we operate -- how they operate today or what we would do differently, if anything, in those markets. So that was -- let me get it closed. Let me get a little digested, understand the markets, and we could be -- give a much better answer on that. As a practice, we don't typically disclose purchase price of acquisitions that aren't material to the company. So again, give us a little time on these things, and let's get it closed, and we can be a lot clear on Wake Stone. We are like I said, very excited about this. We're excited about the team, the Wake team, who we think is very talented. We're excited about the assets and we think the markets are a good addition to that Southeastern footprint and in markets where we can be a leader in the market. So excited about it, and we'll have to get back with you a little more information when we can after we close it."
},
{
"speaker": "Mike Dahl",
"content": "Got it. Okay. Thanks."
},
{
"speaker": "Tom Hill",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "We'll go next to Angel Castillo with Morgan Stanley. Please go ahead."
},
{
"speaker": "Angel Castillo",
"content": "Hey, good morning. Thanks for taking my question. Just maybe I wanted to expand on that conversation a little bit more. As you think about more high-level kind of competitive pricing dynamics across your markets, just what are you seeing from maybe kind of the private side of competition in terms of being disciplined on price? And what does that kind of tell you about the price disparity of potential acquisition opportunities versus your corporate level?"
},
{
"speaker": "Tom Hill",
"content": "It's hard for me to really comment on competitors pricing. Obviously, we get information about markets. But I think that as people look at the aggregates business, they understand the value of the rock in the ground and that's a depleting asset and you shouldn't give it away because you can't replace those tons and people understand that they got to make a return on investment, whether that's the private side or the public side. So I think that the pricing in the aggregates business is -- has always been good and will continue to be good. And I think the onset of growing public demand and potentially growing private demand only helps that situation."
},
{
"speaker": "Angel Castillo",
"content": "Very helpful. Thank you."
},
{
"speaker": "Tom Hill",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "We'll go next to Michael Feniger with Bank of America. Please go ahead."
},
{
"speaker": "Tom Hill",
"content": "Good morning."
},
{
"speaker": "Michael Feniger",
"content": "Yes. Good morning. Thank you for squeezing me in guys. Just Tom, if you could just talk about, I mean, a few years ago, you guys had a target of $11 to $12 cash gross profit per ton on a much higher number of tonnage you're kind of doing today. So just -- how should we kind thing about that as we're starting to close in on that figure? How are you guys kind of thinking about that? And now that we're moving into next year, it looks like we're going to be starting to see some volume increase or at least to end these volume declines."
},
{
"speaker": "Tom Hill",
"content": "Well, the short answer to that we got to give you new goals. We reached a lot faster than what we thought we would have. My hats off to my division presidents and all those division employees who accelerated that, that target a lot lower volumes than I would have expected, particularly in the face of, as I said, seven or eight quarters of falling demand. They just have done a good job, and they've executed on the Vulcan Way of Selling and Vulcan Way of Operating. But the short answer is, we owe ourselves and you do goals because we're basing down that $11 right now, and we plan on getting some of those new goals in the not-too-distant future."
},
{
"speaker": "Michael Feniger",
"content": "Great. And if I could just maybe squeeze one more in. I'd love to get a sense, Andrews, just on -- for next year, maybe just moving pieces for free cash flow. Obviously, CapEx has done some acquisitions. Just kind of how to think about that as we're moving into 2025, some of the buckets there in terms of working capital or CapEx in next year. Thank you, everyone."
},
{
"speaker": "Mary Andrews Carlisle",
"content": "Yes. Mike, obviously, in February, we'll give full 2025 guidance and include a lot of the things that you just mentioned. But specific to CapEx, we believe we've been reinvesting at appropriate levels for the current business needs. If you look over the last five years, that's ranged 8% to 9% of revenues. As Tom said, we don't even have the acquisitions closed yet. So I don't have a specific view on what CapEx will look like for the acquired operations next year. But as you model, I think that our historical level is a reasonable place to be."
},
{
"speaker": "Operator",
"content": "It appears we have no further questions at this time. I will now turn the program back over to our presenters for any additional remarks."
},
{
"speaker": "Tom Hill",
"content": "Thank you for your time. Thank you for your interest in Vulcan Materials. We look forward to talking to you throughout the quarter. We hope that you and your families are safe and healthy during the holiday season and look forward to talking to you soon. Thank you."
},
{
"speaker": "Operator",
"content": "This does conclude today's program. Thank you for your participation. You may disconnect at any time."
}
] |
vmc | 2,024 | 2 | [
{
"speaker": "Operator",
"content": "Good morning. Welcome, everyone, to the Vulcan Materials Company Second Quarter 2024 Earnings Call. My name is Todd, and I will be your conference call coordinator today. Please be reminded that today's call is being recorded and will be available for replay later today at the company's website. [Operator Instructions] Now I will turn the call over to your host, Mr. Mark Warren, Vice President of Investor Relations for Vulcan Materials. Mr. Warren, you may begin."
},
{
"speaker": "Mark Warren",
"content": "Thank you, operator, and good morning, everyone. With me today are Tom Hill, Chairman and CEO; and Mary Andrews Carlisle, Senior Vice President and Chief Financial Officer. Today's call is accompanied by a press release and a supplemental presentation posted to our website vulcanmaterials.com. Please be reminded that today's discussion may include forward-looking statements, which are subject to risks and uncertainties. These risks, along with other legal disclaimers, are described in detail in the company's earnings release and in other filings with the Securities and Exchange Commission. Reconciliations of non-GAAP financial measures are defined and reconciled in our earnings release, our supplemental presentation and other SEC filings. [Operator Instructions]. And with that, I'll turn the call over to Tom."
},
{
"speaker": "Thomas Hill",
"content": "Thank you, Mark, and thank all of you for your interest in Vulcan Materials. Our results demonstrate how our teams have successfully navigated a challenging first half of the year. Unfavorable weather conditions in many key markets impacted our shipments and operating efficiencies. Our second quarter performance reinforces our consistent execution the durable characteristics of our aggregates-led business and the benefits of our continued focus on both enhancing our core and expanding our reach. Even in the face of lower aggregate shipments, and weather-driven inefficiencies, our teams delivered a seventh consecutive quarter of double-digit year-over-year improvement in aggregates unit profitability. In our trailing 12 months, average cash gross profit per ton has reached $9.96 per ton, marking consistent progress towards our $11 to $12 target. These achievements exhibit the benefits of our commitment to enhancing our core through our Vulcan selling and Vulcan way of operating disciplines. But our strategy is two-pronged, and we are also focused on expanding our reach. During the second quarter, we closed two strategic bolt-on acquisitions. These acquisitions enhance both our aggregate production and distribution capabilities and our downstream asphalt business in Alabama, Texas, two of our top 10 states. In the quarter, we generated $603 million of adjusted EBITDA and expanded our adjusted EBITDA margin by 170 basis points despite 5% lower area shipments. Shipments in the quarter were negatively impacted by a significant number of rain days in many markets, particularly in May across 70% of our geographies and in select key markets in April and June. The pricing environment remained positive and freight-adjusted average selling prices improved 12% on or $2.29 per ton versus the prior year. Freight adjusted unit cash cost of sales increased 13% or $1.13 per ton. Most importantly, cash gross profit per ton improved over $1 per ton or 12%. We remain consistently focused on improving unit profitability on every ton we sell to maximize earnings and aeration in any man environment. Let me share with you my thoughts on the current demand backdrop by discussing each end use. Single family starts again recovering in the second half of last year and continue to point growth in 2024, albeit at a slightly lower level than we had initially anticipated. The timing of starts converting to shipments continued affordability issues and persistent elevated interest rates are impacting both the pace of recovery and the likelihood of single-family growth fully offsetting weaker multifamily activity. Looking ahead, the underlying fundamentals of population growth and low inventories in Vulcan markets continue to support long-term growth in residential construction. In private nonresidential construction, the landscape continues to vary across categories, but is unfolding largely as we anticipated for 2024. Warehouse activity is the biggest headwind with some positive momentum in manufacturing activity in data centers. Light commercial activity is still relatively weak, but over time, we expect it to follow the positive trends in single-family housing and benefit from lower interest rates. On the public side, we continue to expect growth in 2024 as two consecutive years of record growth in contract awards flow into projects and aggregate shipments. The IIJ funding is benefiting both highways and other public infrastructure activity. Given the demand backdrop just discussed and the weather impacted first half shipments being down 6%, we now expect aggregate shipments to decline between 4% and 7% for the full year. Combined with solid pricing environment and double-digit profitability improvement, we still anticipate same-store adjusted EBITDA growth, margin expansion and attractive free cash flow generation in 2024. Now I'll turn the call over to Mary Andrews for some additional commentary on our results and revised outlook. Andrew?"
},
{
"speaker": "Mary Andrews Carlisle",
"content": "Thanks, Tom, and good morning. The strong fundamentals of our aggregates-led business and our consistent execution continued to deliver attractive cash generation, which, coupled with disciplined capital allocation, is driving our returns on invested capital higher over time. During the second quarter, we deployed capital to reinvest in and expand our existing franchise to grow our business through acquisitions and to return cash to shareholders. Capital expenditures for maintenance and growth projects were $195 million in the quarter and $298 million on a year-to-date basis. We continue to expect to spend between $625 million and $675 million for the full year. During the quarter, we also allocated $181 million to the strategic bolt-on acquisition Tom mentioned earlier and returned $111 million to shareholders through our quarterly dividend and common stock repurchases. At June 30, our return on invested capital has improved 160 basis points over the last 12 months, with a 10% improvement in adjusted EBITDA generated on flat average invested capital. And with net debt-to-adjusted EBITDA leverage of 1.7 times at quarter end, we have considerable investment capacity within our target leverage range of 2 to 2.5 times to capitalize on attractive acquisition opportunities that will drive long-term value creation for shareholders. SAG expenses in the quarter were 6.7% of revenue and year-to-date have increased less than 3% over the prior year. We are focused on both disciplined cost control and [technical difficulty] in the first six months and lower shipments, we now expect unit freight adjusted cash cost of sales to increase high single digits compared to the prior year. We continue to expect aggregates prices to increase 10% to 12% for the year, driving another year of double-digit improvement in cash gross profit per ton. We anticipate that the strong unit profitability improvement, coupled with the lower volume expectations, will generate adjusted EBITDA between $2 billion and $2.15 billion for the full year. I'll now turn the call back over to Tom to provide a few closing remarks."
},
{
"speaker": "Thomas Hill",
"content": "Thank you, Mary Andrews. I want to conclude by thanking our talented Vulcan team for their commitments to each other and to excellence. As they work each day, Rainer Schein, to operate safely and deliver value for our customers and our shareholders. I am confident that we have the right, two-pronged strategy of enhancing our core and expanding our reach. And I'm excited about the runway ahead of us on both fronts to drive attractive growth for Vulcan Materials. And now Marry Andrew and I will be happy to take your questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Our first question comes from Stanley Elliott with Stifel. Please go ahead."
},
{
"speaker": "Stanley Elliott",
"content": "Good morning, everyone. Thank you all for taking the question. Tom, could you talk a little bit more about just the overall demand environment? I understand there's been pretty tough operating conditions kind of on a year-to-date basis, and probably even into July a little bit. Any sort of help in how we should think about the balance of the year, kind of where you see momentum and things like that?"
},
{
"speaker": "Thomas Hill",
"content": "Yes, good morning Stanley. I think, Stanley, all of the data and the leading indicators would support demand as we originally expected back in February, with the exception of single-family demand growth the growth in single family is a little slower than we would have expected maybe four or five months ago, and we'll talk about that a little bit later. But as we look at the current volume guidance, as you said, we had a very wet July that influenced those numbers and will definitely have a negative impact on Q3. Where we ultimately fall in that volume range of a negative 4% negative 7% will really come down to the number of dry shipping days, we have left in the last five months of the year. So I'd frame it underlying demand as expected, except a little bit slower growth in single family, weather has not been our friend. We'll see how the second half goes. I think the good news is we continue to expand unit margins by double-digit. And I think our folks have taken a difficult hand in the first half and turn it to a winner, and I'm proud of their performance."
},
{
"speaker": "Stanley Elliott",
"content": "Great, guys, thanks so much. And Beth, welcome to backyard."
},
{
"speaker": "Thomas Hill",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question will come from Garik Shmois with Loop Capital. Please go ahead."
},
{
"speaker": "Garik Shmois",
"content": "Hi thanks. Just wanted to follow-up on that point with respect to the second half volume outlook. I was wondering if you could go into maybe a little bit more detail on how to think about the pent-up demand opportunity. I think you did speak to weather influencing you can get all the projects done. But is this the case of projects being delayed and not canceled, and just maybe a little bit more color on how you expect the second half of the year to play out from demand? Thanks."
},
{
"speaker": "Thomas Hill",
"content": "Sure. I think that if you kind of look at what's happened and take that into the second half, your point of demand doesn't go away. It's absolutely spot on. And you probably got some pent up there and it comes down to what the weather does to us. I think it's - looking back, if you'll explain the future that we were really impacted by rain in the first half, and I'll give you a couple of examples. In Q2, Nashville had 30 rain days, and it dramatically impacted shipments. Look, we lost half of our shipping days in that Middle Tennessee market, DFW had doubled the amount of rainfall. So we just have dried out and couldn't ship. The flip side of that is, you saw Atlanta weather pretty much normal and shipments were as expected. L.A. had weather normal and shipments were right on where we had planned. So weather has played a role it will impact Q3 as July was very wet. And now we're experiencing a tropical storm on the East Coast. So kind of a tough start to the third quarter. But as you said, the demand is still there. It's as we thought it was going to be. So these are temporary events and it doesn't go away. So, we get dry days we're shipping just fine."
},
{
"speaker": "Garik Shmois",
"content": "Great, thank you."
},
{
"speaker": "Thomas Hill",
"content": "Operator, is there another question."
},
{
"speaker": "Operator",
"content": "Yes, I apologize. So we will take our next question from Anthony Pettinari with Citi. Please go ahead."
},
{
"speaker": "Anthony Pettinari",
"content": "Good morning."
},
{
"speaker": "Thomas Hill",
"content": "Good morning."
},
{
"speaker": "Anthony Pettinari",
"content": "You raised the guide for cost inflation from mid-single digit to high single-digit should we think about that incremental cost inflation as just essentially all volume deleverage? And are there any other kind of puts or takes, either good or bad, that we should think about for the second half on costs, whether it's diesel or other items?"
},
{
"speaker": "Thomas Hill",
"content": "Yes. I think you're insightful about the volume impact. It definitely has an impact on us. you saw our first half of 11%. I'd also tell you that it has been - inflation was as we expected. Weather was a big difference in that and don't underestimate the efficiency impact of trying to run wet sticky material versus dry rock, which just flows a lot better. We think we can cost some of that cost back in the second half, so we can get back to the high single-digit for the full year versus the 11% where we are. And I think all of that allows us to continue that double-digit unit margin growth."
},
{
"speaker": "Anthony Pettinari",
"content": "Okay. That's helpful. I'll turn it over."
},
{
"speaker": "Thomas Hill",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "We'll take our next question from Jerry Revich with Goldman Sachs. Please go ahead. Your line is open."
},
{
"speaker": "Thomas Hill",
"content": "Hi Jerry."
},
{
"speaker": "Mary Andrews Carlisle",
"content": "Good morning."
},
{
"speaker": "Jerry Revich",
"content": "Hi, Tom, Mary Andrews, Mark. Good morning. Pricing for agri was really strong in the quarter, up nicely sequentially. Can you just talk about the confidence around midyear that you focus in place guidance did not assume major pricing and it feels like you've got momentum just from contracts rolling. So I'm wondering if you could just give us an update on how you expect the tailwind just from natural contracts rolling to play out in the third quarter, compared to last year and then the incremental opportunity from midyears?"
},
{
"speaker": "Thomas Hill",
"content": "Yes, I'll give you some color on price let Mary just talk about sequential. The pricing momentum continues in all markets and all product lines. We had a successful midyear pricing campaign. I think both by customer and by market, I'd call it as we thought it was going to be as anticipated. But remember, as we explained, those midyear prices will have a small impact on '24, but a much bigger impact on '25. So we've already begun to set the solid foundation for pricing for '25. As always, we would ultimately guide you the unit margin growth which was 12% despite weather and volumes down 5%. So I'm proud of operators hard work. Look, that kind of margin growth is tough to begin with. It's particularly difficult to earn when it's raining, you got bud in the mug. So really thanks to our team."
},
{
"speaker": "Mary Andrews Carlisle",
"content": "And Jerry, in terms of sequential growth, candidly, I would have expected a bit less sequential improvement in Q2 than what we realized really due to mix and timing. We still expect some modest additional sequential improvement in the back half given the impact of the midyear that Tom just discussed, paired with a higher jumping off point from a Q2 where we already captured some of the expected sequential improvement. I guess, as Tom said to me, what's really important is the solid underlying price environment, our continued expectation of realizing price increases in that 10% to 12% range the full year. And of course, ultimately, what you can take to the bottom line, like Tom just highlighted."
},
{
"speaker": "Anthony Pettinari",
"content": "Thank you"
},
{
"speaker": "Thomas Hill",
"content": "Thank you"
},
{
"speaker": "Operator",
"content": "Our next question from Kathryn Thompson with the Thompson Research Group. Please go ahead."
},
{
"speaker": "Thomas Hill",
"content": "Good morning, Kathryn"
},
{
"speaker": "Kathryn Thompson",
"content": "Hi, good morning and thank you for taking my question today. Please provide some good detail on project on your work. It's not necessarily lost, but it's delayed. And you've also given some good color just on pricing and continuing that double-digit pace, perhaps pointing to shrink a little bit more on the pricing question because it's a particular focus given lighter volumes even though those volumes are delayed. . What type of impact are you seeing from product mix and geographic mix and really not as much looking backwards, but looking forward, in part because our channel checks are showing that you're starting to see a ramp-up of some larger infrastructure projects that were taking a while to build up. So any color that you can talk about in terms of product mix, geographic mix and how that may impact pricing on a go-forward basis? Thank you."
},
{
"speaker": "Thomas Hill",
"content": "Yes. So I think you're correct with the ramp-up of infrastructure and public work, you'll see more base in fines, which is a little bit less lower prices. That being said, it's also lower cost and you need that mix to balance your plants, otherwise you get out of whack. I think that being said, while we'll have some impact on price, I don't expect it to have an impact on your margins. So why it's maybe not as material may not be as high as price as a concrete outer asphalt rock, he also comes with a cost benefit. So I would expect us to continue our present pace of elevated unit margins regardless of mix."
},
{
"speaker": "Kathryn Thompson",
"content": "Okay, great. Thank you very much."
},
{
"speaker": "Thomas Hill",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "We'll take our next question from Angel Castillo with Morgan Stanley. Please go ahead. Your line is open."
},
{
"speaker": "Thomas Hill",
"content": "Good morning."
},
{
"speaker": "Angel Castillo",
"content": "Hi, thanks. Good morning. Thanks for taking my question. Just to deliberate point, but I just wanted to maybe touch base on the price discussion a little bit more. To the extent that these meters that you've done, give you any kind of insight into preliminary views in 2025. Can you just talk about what kind of the shape of that is in terms of kind of the magnitude? Are we still talking about price increases next year in the kind of high single digits, low double digits range? And kind of along with that, just any sense of kind of customer sensitivity and kind of competitive discipline around price increases would be helpful?"
},
{
"speaker": "Thomas Hill",
"content": "I think we feel like the price run continues. We feel good about what we're bidding today. As I said, those mid-years, while they have a little bit of impact on second half of this year, they're going to have a much bigger impact in the first half of next year. So that leads us to also helps you when you saw having your price increase conversations in October for beginning of the year. I think it's too early to make a call on the level of pricing for 2025. But as I said, I think the conversations that happened for mid-year price increases are encouraging for 2025."
},
{
"speaker": "Angel Castillo",
"content": "That's helpful. And if I may just kind of clarify on the pricing, just a quick one. But 10% to 12%, I thought that was kind of the guidance that you had laid out before midyear. So what kind of change so that it now includes midyear [indiscernible]. Can you just help us understand that?"
},
{
"speaker": "Thomas Hill",
"content": "Well, I think, as I said, the mid-year help a little bit, but it doesn't get you out of that 10% to 12%. What it does is it sets you up for 2025."
},
{
"speaker": "Angel Castillo",
"content": "Got it. Thank you."
},
{
"speaker": "Thomas Hill",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question will come from Mike Dahl with RBC Capital Markets. Please go ahead."
},
{
"speaker": "Thomas Hill",
"content": "Hi Mike."
},
{
"speaker": "Michael Dahl",
"content": "Hi, Tom, Mary Andrews. Thanks for taking my question. It just as maybe just to help clarify kind of the cadence because it sounds like even with July, understandably some things are moved around with whether it's not like August. It's probably been fantastic either. But when you're thinking about those puts and takes from the volume and also some of the price cost dynamics, can you put a finer point on within your guide, how you'd expect 3Q versus 4Q to play out?"
},
{
"speaker": "Thomas Hill",
"content": "Yes. I think that, first of all, the third quarter has already been impacted. July was extremely wet and particularly in our southeastern markets. And now you've got troubling storm blowing up the East Coast. So it's going to - you're starting off to a little bit of a rough start in Q3. I think as we said, the fundamentals of the underlying demand are still there. You've got some pent-up demand. They're all doing, sun comes out, we'll ship well. You have asphalt producers, they're telling us get ready, because when it's dry out, we got to go. And so we'll be ready for them. I would call it - and the fourth quarter is always tough to call because it's also weather dependent, and the season, hopefully, will stretch. I do think that when you have a year where you have so much moisture it may push the season a little bit, so you may get a little extra bump out of Q4 that you wouldn't have in a normal weather year, which is because people want to get those projects done. And it comes down between the negative four to negative seven, what's - how many shipping days do you have and when you have those shipping days. So a little bit of a rocky start with July and kind of this week with that trouble storm, but again, the demand is there. And when some comes out, we're shipping fine, as I talked about with L.A. and Atlanta."
},
{
"speaker": "Mary Andrews Carlisle",
"content": "Yes. And Mike, one other thing to keep in mind as you think about third quarter versus fourth quarter and the challenging start, Tom just mentioned from a weather perspective is that strictly from a seasonal basis, we have easier, relatively easier comps in the fourth quarter than we do in the third quarter. So if you think about where those volumes fall, that's something else to keep in mind as to how the back half might play out."
},
{
"speaker": "Michael Dahl",
"content": "Got it, thank you."
},
{
"speaker": "Thomas Hill",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question will come from Trey Grooms with Stephens. Please go ahead."
},
{
"speaker": "Thomas Hill",
"content": "Hi Trey."
},
{
"speaker": "Trey Grooms",
"content": "Hi Tom. Good morning. So you guys have closed a few bolt-on acquisitions this year. But if you could maybe talk about the pain there. Are you seeing any more or less opportunities? And any potential for larger transactions out there?"
},
{
"speaker": "Thomas Hill",
"content": "Yes. As you said, you saw us close on two smaller, I call it very strategic bolt-on acquisitions, kind of 1 in North Alabama and 1 in Texas. I would tell you that we'll close on some more meaningful acquisitions in the near future and which we'll share with you when the time is right. But it's a busy season for acquisitions. ."
},
{
"speaker": "Trey Grooms",
"content": "Good to hear, thank you. Thank you."
},
{
"speaker": "Thomas Hill",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question will come from David MacGregor with Longbow Research. Please go ahead."
},
{
"speaker": "Unidentified Analyst",
"content": "This is Jon Allen on for David. I was just hoping you could provide some detail on what you're seeing for 2025 DOT budgets in key states for Vulcan and maybe [indiscernible] that's playing into your pricing outlook for 2025 and the ability to sustain double-digit pricing growth?"
},
{
"speaker": "Thomas Hill",
"content": "Yes. So I think that as we look at public demand out there, and just in general, the highway market. We're seeing the IJAA and state and local funds flow through to highway lettings right now. Overall, demand growth is similar to expectations. Steady growth in public demand. We've got a lot more funding in critical states. You saw Tennessee, Georgia, Florida, all raise funds. George is up $1.5 billion. Tennessee had a 3, Florida had a 4. All of which -- we'll see that fund flow in the lettings in '25, '26 and '27. So 6 of our larger states are at record level funding. Texas, California are also at record levels. And all of this supports I'd say, growth and public demand for the next three or four years. So we should slow and steady wins the race here."
},
{
"speaker": "Unidentified Analyst",
"content": "Great, thanks."
},
{
"speaker": "Thomas Hill",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Our next question comes from Adam Thalhimer with Thompson Davis. Please go ahead."
},
{
"speaker": "Thomas Hill",
"content": "Hi Adam."
},
{
"speaker": "Adam Thalhimer",
"content": "Hi, good morning, guys. I thought it was a nice quarter. Are you -- like Trey, I was also curious on M&A. And gosh, it feels like every international materials companies trying to grow U.S. materials exposure. Are you seeing increased competition for deals?"
},
{
"speaker": "Thomas Hill",
"content": "I don't think much changed. Same bidders are out there. There's a lot going on. You also got to remember, you got pent-up demand from nothing going on last year as everybody was worried about a recession. So we'll get a look at all those opportunities. We pass a lot on a lot of them. I think it comes down to M&A, it's about discipline, what markets do you want to be in what synergies are you, what are you willing to pay for it and make sure you can get a return on what you're paying and then once you buy it, integrate it accurately and rapidly."
},
{
"speaker": "Adam Thalhimer",
"content": "Sounds good. Thank you, Tom."
},
{
"speaker": "Thomas Hill",
"content": "Thank you."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question comes from Phil Ng with Jefferies. Please go ahead."
},
{
"speaker": "Phil Ng",
"content": "Hi guys. I guess, Tom, just a little more perspective on this midyear increase. How did it kind of shake out relative to perhaps last year, appreciating A lot of this is really [ 425]. So help us kind of conceptualize perhaps how much of a carrier or price lift you could see next year? And the demand...?"
},
{
"speaker": "Thomas Hill",
"content": "Go ahead -- from a macro perspective, I'd say similar that's always going to be different when I say different, you get different customers, different product lines, different geographies where you got it last year, maybe you didn't get it this year or vice versa. So I would call it out very similar."
},
{
"speaker": "Phil Ng",
"content": "Okay. Any way to kind of help us think about what that could transpire to from a carrier pricing next year? And from a demand standpoint, I heard you lower underlying demand still quite good when you don't have weather -- so some of this demand seems to be pushed out to 2025, right? So if that does kind of materialize in terms of how you're thinking about end markets, are you in a position to see volumes grow next year just because it's been pretty new in the last few years."
},
{
"speaker": "Thomas Hill",
"content": "I think it's early to call. I think you continue to see growth in the public side. I think that we do know just because the funds are there and they're starting to flow into lettings. On the private side, I feel good that single-family will continue to grow. It's a little slower than what we anticipated. And it has some catch-up to do with lead indicators. And obviously, interest rates will help that. But we just don't have the inventory of houses in these markets to keep up with population growth. So I would expect the res to kind of slow and steady growth also I think the big question will be nonres. We've taken the hit on warehouses and distribution centers. The manufacturing is good, but interest rates will help that sector also. It's a matter of timing, I believe."
},
{
"speaker": "Phil Ng",
"content": "Thank you. Appreciate the call."
},
{
"speaker": "Thomas Hill",
"content": "Sure."
},
{
"speaker": "Operator",
"content": "Thank you. Our next question will come from Michael Dudas with Vertical Research. Please go ahead."
},
{
"speaker": "Michael Dudas",
"content": "Good morning, gentlemen. Mary Andrews."
},
{
"speaker": "Thomas Hill",
"content": "Good morning."
},
{
"speaker": "Michael Dudas",
"content": "Tom, let me follow-up your final remark there to Phil. On the large private heavy non-res opportunities, can you talk about what your backlog looks like, how it looks on bidding relative to what it's been in the last six to 12 months? Are we seeing an acceleration of some of the larger type projects that are in your areas that you can certainly serve into over the next couple of years? Is that potentially a tailwind as we look through the second half of this year weather permitting in 2025?"
},
{
"speaker": "Thomas Hill",
"content": "Yes. It is definitely a tailwind. It is helping us with backlog a number of those big projects and big manufacturing projects. We're shipping on them now when the rain fits. And I think that will help us in '25. And I think there's more behind that. You've got with 12 projects in our footprint, you've got a number of data centers and then you continue to see growth in the reshoring of manufacturing facilities. So it is a tailwind for us. I don't think it's a big enough tailwind yet to take on what happened with warehouses and distribution centers, but definitely helpful."
},
{
"speaker": "Michael Dudas",
"content": "Thank you."
},
{
"speaker": "Thomas Hill",
"content": "Operator, do you have another question?"
},
{
"speaker": "Operator",
"content": "We'll take our last question from Michael Feniger with Bank of America. Please go ahead. Your line is open."
},
{
"speaker": "Thomas Hill",
"content": "Good morning."
},
{
"speaker": "Michael Feniger",
"content": "Hi, guys. Thanks for taking my question. Just, Tom, on the manufacturing side, it's been a tail on the private non-res based on your backlog pipeline, is that -- did you feel that, that means stable in '25? Because is there a risk that some of these manufacturing projects had been a tailwind kind of roll off and there's not enough to be backfilled. Just curious if you kind of address that how we head into '25? And just secondly, I know there was talks on the public infrastructure side, you highlighted the record growth in highway contract awards has really helped infrastructure this year. There's been some mixed data points in the last few months around that. Just curious if you feel like that's just more of a pause, and we see more of the funding sort of flow through to continue that trend into '25, '26?"
},
{
"speaker": "Thomas Hill",
"content": "Yes. I'll take the highway on first. I think that's just a matter of timing. The fund is sort of too big there. You got a lot more coming, as I talked about, the additional state funding and 6 of our top 10 states plus IIJA. On the public side, I think that I wouldn't get too worked up about a moment in time. As I said, I think slow and steady wins the race there, and I think it will be slow and steady for the next three or four years. So I think that's solid. There will be some hotter moments and cooler moments, but overall, I think it will continue steady growth. On the manufacturing, we've got a healthy backlog, I think, and we're shipping on some of that backlog, but I don't see a big dip in the pipeline there. I think we continue to have other projects come up. And I think that's probably a strong point, particularly for Vulcan with the footprint we have. In closing, I'd like to thank you for your time and interest in Vulcan Materials Company. Our thoughts go out to our employees, our neighbors who have been or will be in the path to top storm. We hope they stay safe. We look forward to speaking with you through the quarter, and thank you again for your time this morning."
},
{
"speaker": "Operator",
"content": "This does conclude today's program. Thank you for your participation, and you may now disconnect."
}
] |
vmc | 2,024 | 1 | [
{
"speaker": "Operator",
"content": "Good morning, and welcome, everyone, to the Vulcan Materials Company First Quarter 2024 Earnings Call. My name is Jamie, and I will be your conference call coordinator today. Please be reminded that today's call is being recorded and will be available for replay later today at the company's website. [Operator Instructions]"
},
{
"speaker": "",
"content": "Now I will turn the call over to your host, Mark Warren, Vice President of Investor Relations for Vulcan Materials. Mr. Warren, you may begin."
},
{
"speaker": "Mark Warren",
"content": "Thank you, operator, and good morning, everyone. With me today are Tom Hill, Chairman and CEO; and Mary Andrews Carlisle, Senior Vice President and Chief Financial Officer. Today's call is accompanied by a press release and a supplemental presentation posted to our website, vulcanmaterials.com."
},
{
"speaker": "",
"content": "Please be reminded that today's discussion may include forward-looking statements, which are subject to risks and uncertainties. These risks, along with other legal disclaimers, are described in detail in the company's earnings release and in other filings with the Securities and Exchange Commission. Reconciliations of non-GAAP financial measures are defined and reconciled in our earnings release, our supplemental presentation and other SEC filings. During the Q&A, we ask that you limit your participation to one question. This will allow us to accommodate as many as possible during our time we have available."
},
{
"speaker": "",
"content": "And with that, I'll turn the call over to Tom."
},
{
"speaker": "James Hill",
"content": "Thank you, Mark, and thank all of you for joining our Vulcan Materials earnings call this morning. Our first quarter results moved us towards delivering on a fourth consecutive year of double-digit adjusted EBITDA growth. Although the weather was unusually cold and wet across many geographies for much of the quarter, our teams executed well and improved our Aggregates cash gross profit per ton by 10%. Their commitment to our Vulcan Way of Selling and Vulcan Way of Operating disciplines is driving solid results."
},
{
"speaker": "In the quarter, we generated $323 million of adjusted EBITDA and expanded our adjusted EBITDA margin. Importantly, several key trends continue",
"content": "Pricing momentum, cost deceleration, unit profitability expansion, robust cash generation, disciplined capital allocation and return on invested capital improvement."
},
{
"speaker": "",
"content": "In the Aggregates segment, year-over-year shipments declined by 7%, but the durability of our Aggregates business and the consistency of our execution stood out in a weather impacted quarter. We again improved our trailing 12 months Aggregate's cash gross profit per ton, pushing it to $9.66 per ton and making further progress toward our current $11 to $12 target. The pricing environment remains positive and year-over-year Aggregates cash cost of sales continues to moderate. Aggregates freight adjusted price improved 10% in the quarter and increased $1.25 per ton sequentially from the fourth quarter, a clear illustration of the success of January increases and the continuous execution of our Vulcan Way of Selling disciplines."
},
{
"speaker": "",
"content": "Our first quarter cash cost of sales performance resulted in a fourth consecutive quarter of trailing 12 months cost deceleration and improving sequentially by another 230 basis points. Our relentless focus on improving efficiencies in our plants through our Vulcan Way of Operating disciplines remains a key driver of managing costs, expanding unit profitability and ultimately generating attractive free cash flow."
},
{
"speaker": "",
"content": "There is a healthy pipeline of opportunities to deploy this free cash flow for both attractive acquisitions and complementary strategic greenfield development. These targeted opportunities are at varying stages. But as an example, earlier this week, we closed on a bolt-on Aggregates and Asphalt acquisition in Alabama, [indiscernible] state. I'm proud of how our teams continue to execute our 2-pronged growth strategy. They are focused on expanding our reach in addition to enhancing our core with consistent expansion of unit profitability by controlling what we can control, even in a dynamic macro environment and demand environment."
},
{
"speaker": "",
"content": "On the demand side, I want to provide a few comments about each end use, starting with private demand and then moving to public. Momentum in single-family continues to accelerate across our footprint and points to growth in 2024. However, we continue to expect weaker multifamily residential construction to largely offset the single-family approval this year. Overall, affordability and elevated interest rates remains a challenge, but the underlying fundamentals of population growth and low inventories in Vulcan markets support recovery in residential construction."
},
{
"speaker": "",
"content": "An improving residential backdrop is also a positive sign for future activity in certain categories of nonresidential construction. And recent data has shown some signs of stabilization in overall [ stash ]. However, the landscape continues to vary across categories. As expected, continued moderation in warehouse [ stash ] will be the biggest headwind to private and nonresidential demand this year."
},
{
"speaker": "",
"content": "Currently, light commercial activity remains weak, but over time, we expect it to follow the positive trends in single-family housing."
},
{
"speaker": "",
"content": "We continue to see and capitalize on opportunities in the manufacturing category. Our unmatched Southeastern footprint and unique logistics capabilities positions us well to service these large Aggregates intensive projects. Our footprint is also an advantage on the public side with over 2/3 of federal highway spending allocated to Vulcan states. Additionally, other public infrastructure activity, which benefits from IIJA funding is growing faster in Vulcan states than the country as a whole. It sustained elevated level of highway [ stash ] of over $100 billion, coupled with record 2024 state budgets, supports healthy growth in highway and infrastructure demand both in 2024 and for the next several years."
},
{
"speaker": "",
"content": "Now I'll turn the call over to Mary Andrews for some additional commentary on our first quarter. Mary Andrews?"
},
{
"speaker": "Mary Carlisle",
"content": "Thanks, Tom, and good morning. Tom discussed our solid Aggregates results in the quarter and shared some important ongoing trends. In addition to providing a few more details about our first quarter results, I'd like to first expound upon 4 of the trends Tom highlighted earlier in his remarks: Unit profitability expansion, robust cash generation, disciplined capital allocation and return on invested capital improvement."
},
{
"speaker": "",
"content": "For the last 4 quarters, we have consistently expanded our trailing 12-month unit profitability in all 3 of our operating segments. Increasing cash unit profitability by nearly $1.50 per ton in Aggregates, almost $6 per ton in Asphalt and nearly $5 per cubic yard in Concrete. Our trailing 12 months gross margin has also steadily improved in each product line. This organic growth is underpinned by our daily focus on execution and driving results through our Vulcan Way of Selling and Vulcan Way of Operating disciplines. Better unit profitability yields better free cash flow."
},
{
"speaker": "",
"content": "Our free cash flow conversion over the last 5 years has averaged over 90%, enabling us to strategically allocate capital to reinvest in our franchise, grow our business and return cash to shareholders."
},
{
"speaker": "",
"content": "During the quarter, we invested $103 million in capital expenditures and returned $81 million to shareholders through dividends and share repurchases. We continue to expect to spend between $625 million and $675 million on capital expenditures for the full year. Our current balance sheet positions us well to continue to deploy capital to each of our priorities. At the end of the first quarter, our net debt to adjusted EBITDA leverage was 1.5x, with $300 million of cash on hand, following the March 1 redemption of our 2026 senior notes at par for $550 million. Our liquidity position and financial flexibility are competitive strengths as we look to continue to grow and create value for our shareholders."
},
{
"speaker": "",
"content": "Over the last 12 months, we've achieved a 260 basis points improvement in return on invested capital. Invested capital has increased less than 1%, while adjusted EBITDA has improved 20%. Adjusted EBITDA margin has also improved by 350 basis points through consistent operational execution and disciplined SAG cost management. SAG expenses in the quarter were in line with our expectations, and we continue to expect to spend between $550 million and $560 million for the full year. Most importantly, we reaffirm our expectations of delivering adjusted EBITDA between $2.15 billion and $2.3 billion for the full year. At the midpoint, a double-digit year-over-year improvement for a fourth consecutive year."
},
{
"speaker": "",
"content": "I'll now turn the call back over to Tom to provide a few closing remarks."
},
{
"speaker": "James Hill",
"content": "Thank you, Mary Andrews. At Vulcan, our #1 priority will always be our people, keeping them safe and fostering our Vulcan culture. They are the foundation of our great company. As a team, we are focused on the daily execution of our Vulcan Way of Selling and Vulcan Way of Operating disciplines to ensure attractive cash generation in any macro backdrop. We will be strategic and disciplined in allocating capital to continue to grow our business and deliver value for our shareholders."
},
{
"speaker": "",
"content": "And now, Mary Andrews and I, will be happy to take your questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] We'll take our first question from Stanley Elliott with Stifel."
},
{
"speaker": "Stanley Elliott",
"content": "Tom, nice start to the year, very clean quarter despite kind of some of the weather issues, I think a lot of people had and some of the comp issues. Can you talk about how the rest of the year plays out, thinking about this more like maybe from a demand standpoint? And then to any extent commentary you could share on April would be great."
},
{
"speaker": "James Hill",
"content": "Sure. Looking at the quarter itself, I'd call the quarter -- volumes in the quarter as expected within the margin of error. We had less shipping days in March, but about the same amount of shipping days in the quarter overall. January was a slow start, really due to wet weather and cold weather. February and March, I call it a bit better, better on a daily shipping basis. So Q1, all things considered as expected. As we look forward to the rest of the year, I don't see any real change in our thinking on demand. We would still guide to the flat to down [ 4 ], and the dynamics are very similar to what we said last quarter, headwinds in nonresidential, some challenges in multifamily. We've got recovering single-family construction and growing public demand. I think that our position -- our superior position in the Southeast really helps, the footprint makes a difference. And that Southeastern market is probably the healthiest market in the country. I think our Vulcan Way of Selling disciplines and tools are very helpful with this."
},
{
"speaker": "",
"content": "So at this point, I'd call it confident for volume outlook. As far as going into the second quarter, I'd call it this way, when the sun comes out, we're shipping very well."
},
{
"speaker": "Operator",
"content": "We'll go next to Jonathan Bettenhausen with Truist Securities."
},
{
"speaker": "Jonathan Bettenhausen",
"content": "I'm curious about your outlook on midyear pricing. You had conversations with your customers about midyear. And I'm also wondering how much of that is baked into your guide?"
},
{
"speaker": "James Hill",
"content": "Yes. I'd start off with saying that I think the fundamentals in pricing remained very good and very healthy. As you saw, we had a solid start in Q1 with prices a little north of 10%, that was really across every market. And so it's a really good start and supports our full year guidance. Midyear price increases are not in our guidance at this point. We're having those midyear price discussions right now, so it's a little too early to call. Remember, the midyears will be good for 2024, but they're going to be even better for '25. So our teams are working really hard on this, and I think I'm sure they'll deliver. The most important thing, though, I think, is that the fundamentals for pricing remain very healthy. And so I think when it comes to midyears, we'll revisit pricing guidance in August and give you an update."
},
{
"speaker": "Mary Carlisle",
"content": "And one more thought on price. We always like to point out how important it is to remember that regardless of what the level of pricing is, the key is really how much price we're able to take to the bottom line. In the first quarter, we achieved 10% improvement in cash gross profit per ton and some Aggregates margin expansion even given the lower volume quarter due to the weather. Overall, gross margin also improved by 140 basis points and adjusted EBITDA margin expanded as well. So importantly, we expect this margin expansion to continue and to improve further through the balance of the year."
},
{
"speaker": "Operator",
"content": "We'll go now to Anthony Pettinari with Citi."
},
{
"speaker": "Anthony Pettinari",
"content": "I'm wondering if you could talk a little bit more about how costs have kind of been trending among your major cost categories. If you can touch on maybe some of the nonenergy categories. And then also just with higher diesel, how that's impacted conversations around price increases or just how you think about the full year from that context?"
},
{
"speaker": "James Hill",
"content": "Yes. I think the first quarter for cost is always tricky as volumes and weather definitely had an impact on costs in the first quarter. That said, I think we're still comfortable with the cost guidance of up mid-single digit for the full year. As always, we would get you to look at costs on a trailing 12-month basis because it's just going to be choppy on quarter-to-quarter. And if you look back on a trailing 12-month basis over the last year, cost increases have fallen from, I'd say, mid-teens to single digit. So as we said in the prepared remarks, we've seen 4 quarters of decelerating cost and as we march through this year, we should see that those increases decline as we march through the year, next quarter better, next quarter better, next quarter better as we saw over the last 4 quarters. So I think we're on a good path to that mid-single-digit cost for the full year."
},
{
"speaker": "",
"content": "As far as different pieces of this, a diesel was probably a slight tailwind in the quarter. What stays up is parts and services remain elevated, but our comps are getting easier. And I think that we also through the Vulcan Way of Operating, we're improving our operating efficiencies and will continue over the next 2 years with that to offset those inflated parts and services. So I think we're in a good place, and I think the teams are working through this, and I'm pleased with what I see."
},
{
"speaker": "Mary Carlisle",
"content": "Yes. And in terms of diesel, Anthony, we do assume in our plan that it will move somewhat higher through the rest of the year. And you're right, while diesel prices for us -- well, they're always hard to predict and -- but they can really be a good thing in this business since we have the ability to catch it with pricing as it goes up and also take advantage of it when it goes down."
},
{
"speaker": "Operator",
"content": "We'll go now to Kathryn Thompson with Thompson Research Group."
},
{
"speaker": "Kathryn Thompson",
"content": "Stepping back, just looking at the bigger picture. In last year, you divested mainly downstream ops just in terms of optimizing portfolio. As you look into 2024 and beyond what are your priorities in terms of overall Vulcan Materials and product mix? And how does this mix strategy -- how do you think about that against the backdrop of a broad reindustrialization of the U.S. and putting Vulcan in the best position possible?"
},
{
"speaker": "James Hill",
"content": "Well, as always, we would tell you that it's Aggregates and we are an Aggregates company. We have the highest percentage of EBITDA in Aggregates of probably anybody in the sector, and that's what we do. Now we have strategic downstream. And as we always say, it's a portfolio, we look at it as a portfolio, and if one of those sectors or geographies doesn't earn appropriate return or somebody else would divest of it and plow that money back into our Aggregates business. So I think that nothing has changed as far as how we look at the world. And as we look at the growth part of M&A in greenfields, it will be Aggregates focused."
},
{
"speaker": "Operator",
"content": "We'll now turn to Trey Grooms with Stephens."
},
{
"speaker": "Trey Grooms",
"content": "I kind of want to follow up on the comment, Mary Andrews, you had earlier about cash gross profit per ton. Clearly, it was up 10% in the quarter. I think you were maybe initially looking for mid- to high single-digit improvement. So maybe a little better there. And then full year is mid -- I think looking for mid-teens type of improvement. So I guess the first one is kind of how we see that progress. I think it's going to accelerate somewhat as we go through the year, but any way to help us kind of think about that as we progress through the year to get to that mid-teens for the full year? And then maybe stepping back a little bit longer term. These are clearly better numbers of better performance than the historical kind of average of profitability improvement. How are you thinking about that longer term? Do you think it has the opportunity to kind of see a long-term better kind of consistent improvement versus kind of historicals?"
},
{
"speaker": "James Hill",
"content": "Yes. Let me take your last question first about long term. This is why we have developed the Vulcan Way of Selling and Vulcan Way of Operating disciplines. I think they secure our ability to improve cash gross profit per ton, which we've done 12-month basis every quarter [indiscernible] going flat for 5 years. That's pretty good consistency even with some of the dynamics that are out there. So I think that overall in history, we -- versus history, we're in a better place for higher improvements in cash gross profit per ton, and that's not by actions, that's by design, and we've been working on that now for years, and it is working and those tools are only getting better or we're getting better implementing them."
},
{
"speaker": "",
"content": "I think as far as this year is concerned, as we talked about, as we progress through the year, you've got cost increases decelerating and as inflation comps get easier and our operating efficiencies get better. So that's one piece of that. And then I think as we march through the year, we have the ability to continue to raise prices, both in what we do on project work, but also a fixed plant. So you put all that together, I think as we progress through the year, we have the opportunity to continue to march our unit margins improvement through the year."
},
{
"speaker": "Operator",
"content": "We'll go next to Jerry Revich with Goldman Sachs."
},
{
"speaker": "Jerry Revich",
"content": "I'm wondering if you could just talk about how you expect the pricing cadence to play out this year over the past couple of years, third quarter versus second quarter, we saw a big $0.60 type step up in pricing. Is that feels like that's what you're assuming this year to get to the guidance. But maybe Mary Andrews, you could expand on how you expect the cadence to play out? And how much higher could that be if we do implement midyear price increases?"
},
{
"speaker": "Mary Carlisle",
"content": "Yes, sure. I would expect a cadence of, Jerry, likely some sequential growth in the second quarter, more in the third quarter, as you referenced, and then we would typically see less in the fourth quarter due mostly to seasonality. And the magnitude of the midyears, which as Tom referenced earlier, it's just too early to call at this point, but that's what would influence that third quarter sequential improvement and to what level that gets and where we fall out overall."
},
{
"speaker": "Jerry Revich",
"content": "Okay. And then in terms of just the exit rate with double-digit pricing growth exiting the year and potential midyears on top of it, I guess that suggests the starting point for '25 should be in the high single-digit pricing range just from a carryover effect. And I just want to make sure that that's consistent with how you folks are thinking about it."
},
{
"speaker": "James Hill",
"content": "Yes. I think when it comes to midyears, we're going to call that when we earn it. And I think we feel good about midyears, and I think those conversations are going fine. As I said, they mean a lot for '25. I do think it's a bit early to call what '25 is going to start out at. We got to get midyears under our belt and take a look at what we're going to do in the first part of '25. But I do think it's -- I feel good about the midyears and I think it is a good omen for 2025 pricing."
},
{
"speaker": "Operator",
"content": "Next, we'll hear from Mike Dahl with RBC Capital Markets."
},
{
"speaker": "Michael Dahl",
"content": "I'm going to follow up again on kind of midyears. I think last quarter, you talked about how those conversations would be April conversations, so maybe it's just semantics, and you want to have those really finalized before you communicate to us. But I'm wondering if just given some of the wet weather to start the year, if some of those conversations perhaps got pushed out a little bit relative to your expectations or how you characterize that? And any other regional differences in pricing that you may be experiencing relative to what you thought coming into the year?"
},
{
"speaker": "James Hill",
"content": "I don't think weather had anything to do with it. I think you may have read a little bit too much into the April month comment. You send the letters out in April, you spend May having those conversations and you finalize end of May, kind of beginning of June. So I don't see anything different in timing or sequencing versus what we did last year. Like I said, I think I'm encouraged by the conversations that we're having, and I think that we will implement a solid midyear price increases. But I wouldn't read anything into the comment on weather versus -- excuse me, comment on April versus how this goes. It's really kind of a process. We introduced it in April, have conversations in May and again, finalize it in June."
},
{
"speaker": "Mary Carlisle",
"content": "And one other thought on pricing for the rest of the year is that we've had positive momentum over the last 12 months in our bid work, and that should also be a good catalyst for us from where we ended Q1 to where we expect to be for the full year in addition to whatever is realized on midyear increases."
},
{
"speaker": "Operator",
"content": "We'll go now to Garik Shmois with Loop Capital."
},
{
"speaker": "Garik Shmois",
"content": "I wanted to ask on the M&A environment. If you could provide a little bit more color on the bolt-on that you just completed? And is it possible at all to maybe size how much are you going to anticipate spending on acquisitions this year and the types of deals you're looking at?"
},
{
"speaker": "James Hill",
"content": "Yes. As you saw, we had a small but strategic bolt-on kind of northeast of Birmingham up sort of Guntersville. It's about 2 million tons of Aggregates and just under 0.5 million tons of Asphalt. It fits us well. I think as you look at the full year, the next 12 months, M&A outlook is quite good. So more to come. And I'm having a lot of those conversations and very encouraged by it. I think it's always M&A will be Aggregates-led and conducted with discipline. But I think we feel very confident that this will be a busy M&A year for us."
},
{
"speaker": "Operator",
"content": "And now we'll go to David MacGregor with Longbow Research."
},
{
"speaker": "David S. MacGregor",
"content": "I guess I wanted to kind of tap your many years of experience in this business with respect to the second half of this year in election years. And in an election year, do you find that projects kind of accelerate as people kind of focus on [indiscernible]? Or do you think things maybe slow down a little bit as people get a little more [indiscernible] and wait to see how the election plays out? I'm just trying to get a sense of how you're thinking about the risk around second half volumes in public sector spending."
},
{
"speaker": "James Hill",
"content": "I don't see -- I will take it in pieces. Overall, I don't see any impact with the election year on our demand. I think that our guidance is -- has taken the factors into account. I don't think election year moves the needle on that. I think on the public side, it is really the DOTs trying to get highway dollars into lettings and into projects. And I think that's happening. And I think we call that, as you know, mid-single digit on the private side, I think, as we said, we've got some challenges on nonres and multi. And I think that single-family is recovering with health. So that's how I look at it with not much impact from the election year."
},
{
"speaker": "Operator",
"content": "And next, we have Timna Tanners with Wolfe Research."
},
{
"speaker": "Timna Tanners",
"content": "I wanted to ask about a little bit more on the demand side as well. How is the government infrastructure dollars? How are they flowing through? How are you seeing the pace of that activity? Any evidence of some of those larger IRA projects? And any sign that data centers could make much of a dent against the decline in warehouse demand?"
},
{
"speaker": "James Hill",
"content": "Yes. I will start with highways. We're seeing the IIJA money and the local funds flow into lettings. At this point, we'd stick with that mid-single-digit growth on the public side this year, which is both non-highway infrastructure and highways. And we see that kind of steady growth for years to come. We also are seeing additional state funding come into play. We've got 3 states with some big dollars. Tennessee added $3 billion, Florida I think added $4 billion and Georgia just added $1.5 billion to their funding. I think when it comes to public demand, slow and steady wins the race on this, and particularly when you're compounding your margins like we are, so I think a good healthy sector with steady growth for years to come. And I think the DOTs will continue to work hard to get those dollars into lettings."
},
{
"speaker": "Mary Carlisle",
"content": "And Timna, you also mentioned data centers, which have never really provided some good opportunities for us in some markets. I can think of some projects we booked recently in Virginia, Alabama, Georgia. And it's obviously a subject that's getting a lot of press. But I do think it's important to remember that the square footage according to Dodge for data centers is only a low single-digit percentage of total non-res [indiscernible]. So as you know, there are a lot of different categories and dynamics and private non-res, so data centers may not move the needle overall. But overall, for us, in non-res, right -- so far, it's playing out as we expected with kind of all those different dynamics."
},
{
"speaker": "Operator",
"content": "We'll go now to Tyler Brown with Raymond James."
},
{
"speaker": "Patrick Brown",
"content": "So [indiscernible] doing a great job on unit margins. But I am curious what you're seeing on the plant productivity side. Because If I go back, Tom, to the Vulcan Way of Operating, some of the technology rollouts in the plants that you talked about at the Analyst Day, I'm just kind of curious how those are tracking if you're seeing improved plant utilization? And is that kind of a continued good guidance to '25?"
},
{
"speaker": "James Hill",
"content": "Yes. I think that where we are on that, and you're talking about the process intelligence on those plants. As we said, we did that in our top 100 plants, which is about 7% of our -- roughly 7% of our production. The tools are all there. About 25%, 30% are actually -- of those plants are actually fully utilizing those tools. And there's a lot of work that has to go into that to get the screens right and everybody trained in those, we're seeing marked progress as we march through kind of this year, maybe the first part of next year, we'll get up to 100% of those. But -- and as we do, we'll see improvement. So where it's working. I think it's working well, maybe a little slower than I would have wanted it to go through as far as full implementation, but we're getting there. And I think we'll see that. As you said, we'll see progress to that show up in our numbers in '24 and in '25 and into '26, to be honest with you. So, so far, so good, and we'll keep plugging at it."
},
{
"speaker": "Operator",
"content": "And now we'll hear from Adam Thalhimer with Thompson Davis."
},
{
"speaker": "Adam Thalhimer",
"content": "Great quarter. On the demand side, I guess I wanted to hit that as well. There's a lot of angst out there about just private construction demand in general. Are you guys seeing any incremental weakness or strength there?"
},
{
"speaker": "James Hill",
"content": "Well, I think it depends on which part of it you're talking about, and I'll take them a piece at a time. We're seeing -- on the non-res side, you've got weakness in warehouses and kind of traditional light non-res. That being said, the warehouses, we -- if you look at starts, they are -- the fall is decelerating. It's getting better as you look at starts on a short-term basis. So hopefully, that will get better. You've got strength in large manufacturing projects, which we've got 11 of those big projects, and we're shipping on them now and I think more to come. So it's too early to call whether it's getting better or getting worse, but that's kind of how we call it for -- on the non-res side."
},
{
"speaker": "",
"content": "On highways -- excuse me, on housing, I would tell you the weakness is in multifamily and continues that. I think it doesn't last too long, we'll be past that, I think, '25. And then single-family res is recovering, and I think recovering with some momentum."
},
{
"speaker": "Operator",
"content": "We'll go now to Phil Ng with Jefferies."
},
{
"speaker": "Philip Ng",
"content": "Congrats on a really strong quarter. I had a question. I mean, a competitor of yours has just closed on a deal in the Southeast, and they've already announced price increases for midyears in those markets and called out how pricing there is for us below their corporate average. I've always thought that the Southeast is actually a pretty good pricing market. Do you see that dynamic improving the backdrop on pricing, anything on the structure side of things? And then similarly, California, I think pricing still kind of below what that market probably should warrant just given the cost and demand profile. Any thoughts on the momentum modern pricing around California as well?"
},
{
"speaker": "James Hill",
"content": "Yes, I think we've got to be thoughtful when we call out pricing on individual markets. But that being said, the Southeast is very good pricing, some of the best we have. And I think that if you look at the western part of the United States, I think we're seeing marked improvement in pricing, and we'll continue -- that momentum will continue."
},
{
"speaker": "Operator",
"content": "And now we'll go to Angel Castillo with Morgan Stanley."
},
{
"speaker": "Angel Castillo Malpica",
"content": "Just wanted to maybe expand a little bit on some of the dynamics. First, just a quick clarifier. For pricing, is the assumption still 10% to 12%, given the kind of unchanged top line? And then You mentioned kind of no impact from election year. Could you maybe talk about some of the other dynamics that are at play here in terms of the weakness you're seeing in non-resi and just interest rate environment and kind of some of those challenges. Is that having any kind of impact on your midyears? It sounds like the discussions there have been quite constructive. So just any kind of color there would be helpful."
},
{
"speaker": "James Hill",
"content": "Yes. I think you're seeing improvement. We're seeing improvement in single-family, which is always helpful. And the most important thing is that you see growth in public demand, which is still visible and it is a very good foundation for pricing. I don't know that interest rates have had a big impact on pricing. Obviously, they'll have -- they've had impacts on demand and volumes. But I think -- so I think that -- and I don't think that the election year has had any impact on pricing dynamics. So I think that the fact that we've got strong, very visible public demand for a long time is good. I think you've got some improvement in res. All of that is helping the pricing dynamics. And I think we feel pretty good about a midyear at this point."
},
{
"speaker": "Operator",
"content": "We'll go now to Michael Dudas with Vertical Research."
},
{
"speaker": "Michael Dudas",
"content": "So it's an interesting highlight on 67% of your of the IIJA dollars are going to the Vulcan states. So you can talk a little bit about what states does that matching up with some of the DOT budgets in some of your important states? And what it may be throughout the business, what regions or states maybe are lagging a bit that may have some opportunity to catch up as we move into the next several quarters?"
},
{
"speaker": "James Hill",
"content": "Well, I think a big part of that is you've got the big DOTs, Caltrans and TxDOT and Georgia DOT and Virginia. Obviously, Tennessee, obviously, have excellent funding, both state and local. I think that probably the most -- the best -- DOT is best at getting money through at this point because they started earlier with their own funding with Texas. Georgia had some struggles, but I think is catching up with that. So I think Caltrans is doing a good job getting their money in. Illinois, I think, has struggled getting some of their funding out. So that's how I call it. But I think they're all plugging at it, and I think they're all getting better at it. It is coming through with improvement in lettings. I think that all of them are going through the '25 budgeting right now, a little too early to call, but I don't see them going down. I would expect most of them to go up. So as we said, I think that it's a long road. I think it's steady growth in public, and it's not just highways, it's also the infrastructure, which is ports and airports and water and sewage and that will be substantial growth, I think, this year and for years to come."
},
{
"speaker": "Operator",
"content": "And at this time, that will conclude our question-and-answer session. I'd like to turn the call back over to Tom Hill, Chief Executive Officer, for any additional or closing comments."
},
{
"speaker": "James Hill",
"content": "I thank all of you for your time this morning and your interest and support of Vulcan Materials Company. We hope you and your families are healthy and safe and stay that way through the quarter, and we look forward to talking to you over the next few months. Thanks."
},
{
"speaker": "Operator",
"content": "Once again, ladies and gentlemen, that will conclude today's call. Thank you for your participation. You may disconnect at this time."
}
] |
vrsk | 2,024 | 3 | [
{
"speaker": "Operator",
"content": "Good day, everyone, and welcome to the Verisk Third Quarter 2024 Earnings Results Conference Call. This call is being recorded. Currently, all participants are in a listen-only mode. After today's prepared remarks, we will conduct a question-and-answer session where we will limit participants to one question so that we can allow everyone to ask a question. We will have further instructions for you at that time. For opening remarks and introductions, I would now turn the call over to Valmet Head of Investor Relations, Ms. Stacey Brodbar. Ms. Brodbar, please go ahead."
},
{
"speaker": "Stacey Brodbar",
"content": "Thank you, operator. And good day, everyone. We appreciate you joining us today for a discussion of our third quarter 2024 financial results. On the call today are Lee Shavel, Verisk's President and Chief Executive Officer, and Elizabeth Mann, Chief Financial Officer. The earnings release referenced on this call as well as our traditional quarterly earnings presentation and the associated 10-Q can be found in the Investors section of our website, verisk.com. The earnings release has also been attached to an 8-K that we have furnished to the SEC. A replay of this call will be available for 30 days on our website and by dial-in. As set forth in more detail in today's earnings release, I will remind everyone today's call may include forward-looking statements about Verisk's future performance, including those related to our financial guidance. Actual performance could differ materially from what is suggested by our comments today. Information about the factors that could affect future performance is contained in our recent SEC filings. A reconciliation of reported and historic non-GAAP financial measures discussed on this call is provided in our 8-K and today's earnings presentation posted on the Investors section of our website, verisk.com. However, we are not able to provide a reconciliation of projected adjusted EBITDA and adjusted EBITDA margin to the most directly comparable expected GAAP results because of the unreasonable effort and high unpredictability of estimating certain items that are excluded from projected non-GAAP adjusted EBITDA and adjusted EBITDA margin, including, for example, tax consequences, acquisition-related costs, gains and losses from dispositions and other non-recurring expenses, the effect of which may be significant. And now, I'd like to turn the call over to Lee Shavel."
},
{
"speaker": "Lee Shavel",
"content": "Thank you, Stacey. Good morning and thank you for participating in today's call. I'm pleased to share that our operating momentum continued as Verisk delivered another quarter of strong financial results, led by our subscription revenue growth of 9.1% with contributions from both underwriting and claims. Transactional revenues were down slightly due to the strong double-digit growth from weather and shopping activity in the prior year as well as the ongoing conversion of transactional revenues into committed subscription contracts. Returning to overall revenue growth, unaffected by contract transitions from last year, organic constant currency revenue growth was 8% on a two-year compound annual growth basis at the high end of our longer-term targets established at Investor Day. Elizabeth will provide much more detail in her financial review, but these results demonstrate the compounding power of our subscription-based business model, driven by the value we create for our clients. I'm confident that 2024 is on track to be another year delivering on the strategy and financial targets we established at Investor Day. There are two fundamental drivers to the strong subscription growth we've been achieving. First is our enhanced go-to-market approach, which elevates and intensifies our strategic dialogue with clients. The second is the strength of our products and solutions built on proprietary data sets and continuously enhanced as we scale innovation and invest on behalf of the industry. On the first lever, with our client engagement, as I engage across the property and casualty insurance industry, we are seeing improving industry-wide financial metrics, helped by continued strong premium growth. Swiss Re now forecasts that 2024 direct written premiums will grow 9.5%. So there will be variability by line. Profitability across the sector is also improving as net industry-wide combined ratios have improved by over 2 points to 99.4, indicating underwriting profits. While catastrophe losses are expected to be elevated for the remainder of the year due to recent hurricanes, the expectation is that insurance and reinsurance industry participants are in a stronger financial position than in prior years and better able to absorb these cat-related losses. Since our last call, I've had the opportunity to participate in several industry events, including the Rendez-Vous de Septembre in Monte Carlo, the CIAB Insurance Leadership Conference, and our own Valmet Insurance Conference in London. At each of these, the opportunities to engage with the highest levels of leadership has enhanced our understanding of our clients enterprise needs, broadened and strengthened our relationships, and opened new doors to opportunities to work with them. What I have heard consistently and we are acting on is a strong desire to see us connect more of our data sets and analytics for enterprise solutions directly and with our partners. We are pursuing several product initiatives between underwriting claims, extreme events, and specialty business solutions to deliver on that very objective. Another reflection of our broader engagement to find, develop, and leverage solutions for the industry is the opportunity I'll have to engage with insurance constituencies as a member of the Federal Advisory Committee on Insurance. With heightened focus on the importance of the insurance industry in the midst of severe weather events, being at the table with industry partners to find ways to improve is an important responsibility for Verisk. I have already participated in discussions on improving community resilience and managing the impact of severe weather events. In addition, we believe the opportunity to serve a broader range of agencies beyond our role in supporting the National Flood Insurance Program and Community Rating System for FEMA and the Terrorism Risk Insurance Act program for the Department of Treasury is an important opportunity to support communities and industry. With all client engagements, the follow-up on these opportunities is focused, supported by the enhancements we've made in our client engagement structure and investments in our sales coverage. I believe the strength in our subscription growth reflects in part the progress we are making in elevating our dialogue and relationships, and then capitalizing on the opportunities we create. The second factor driving our subscription revenue growth is the strength of our data and solutions and our ability to innovate through data enhancement and responsibly combining data sets. Let me give you some examples of our progress this quarter. Our most significant initiative to drive more value for our clients is Core Lines Reimagine, which we have discussed with you at length. We continue to advance our progress in delivering proprietary content to clients more digitally, integrating more seamlessly into their workflows, and providing more analytics and insights. To that end, in the third quarter, we had the first release of an initiative we call the Future of Forms. Future of Forms addresses our clients' challenge of understanding and managing through the complexity of major policy updates. The Future of Forms introduces a data visualization for our forms filing with this first release focused on general liability. This new digital experience allows insurers to save time analyzing our content by interacting with our forms filings in an entirely new way. And the early response from our clients has been very positive with specific feedback saying that this new solution is easy to navigate and a significant time saver for their teams. Additionally, as we have previously discussed, we continue to receive interest and inbound inquiries from our clients through the release of our executive insights reports, which leverage our statistical data to provide key trends. In the third quarter, we added to our library of reports by introducing executive insights for personal auto and general liability. We now have executive insights covering five of the six major lines of business, with plans to introduce reports for commercial auto in the first half of 2025. Executive insights not only provides our clients with benchmarking analyses for their book of business, but also provides a deeper look into the broader market. These reports reinforce Verisk's thought leadership position in the industry by providing this granular and unique view of the data in a timely manner. And the new product creates additional fuel for our client engagement teams, serving as a touch point for new C-level conversations and delivers on a consistent request for more insights. As I mentioned earlier, we are also driving value by continuing to enhance our solutions by combining data sets across the Verisk family. To that end, we recently combined Verisk's claims data into Okta's enhanced peril score for the Canadian market. The peril score is powered by predictive analytics and location-specific data to predict severity and the likelihood of claims at a property. The addition of the Verisk claims data has enhanced the model, driving more insightful signals for our clients and leading to reinvigorated sales growth of this solution. Our commitment to driving value and improving efficiency and automation is also a focus within the four walls of Verisk as we innovate around our internal data collection and management processes. We recently launched a new fully mobile application that allows our field representatives to complete engineering assessments and loss cost surveys directly from the field. We expect this initiative to speed up cycle times for surveys, while also including more data validations and further automation of our quality control process. As you might imagine, our continued engagement focuses on issues that are top of mind for our clients and often top of mind for our shareholders as well. Most recently, Hurricanes Beryl, Helene, and Milton have brought renewed attention to climate risks, catastrophe losses, and resilience. Our conversations are focused on the comprehensive suite of solutions we currently offer that help our clients plan for, react, and respond to climate risks. In our extreme events business, we help our clients evaluate and price catastrophe risks by modeling the view of probable outcomes and impacts on their book of business before the events make landfall. Our catastrophe models calculate a view of loss outcomes, incorporating not only the most advanced weather signs, but also detailed understanding of local building codes and construction standards. Investing in mitigation efforts to manage and reduce losses is one of the keys to containing the industry losses from climate change. To that end, Verisk's work in conjunction with FEMA's National Flood Insurance Program helps assess community level efforts to reduce and avoid flood damage to insurable properties. Known as the Community Rating System, this program is based on technical data on flood plain mitigation that is collected and analyzed by Verisk. Through this program, communities can achieve discounts on flood insurance premiums for their property owners, making flood insurance more affordable for the end consumer. And finally, our property estimating solutions and anti-fraud solutions help insurance ecosystem participants respond after the impact of storms. Our solutions power a network that allows carriers, independent adjusters, and restoration contractors to estimate the cost to repair and rebuild storm impacted property in an automated and efficient way while also identifying fraud to make sure that only the valid claims get paid. I'm energized by the opportunity that lies ahead. In my conversations with the leaders of our clients, there is strong appetite to invest in technologies that can drive value in the form of better risk selection, more automation efficiency, and they are turning to Verisk as the trusted partner to help them. Now let me turn the call over to Elizabeth to review our financial results for the third quarter and year-to-date basis."
},
{
"speaker": "Elizabeth Mann",
"content": "Thanks, Lee. And good day to everyone on the call. On a consolidated and GAAP basis, third quarter revenue was $725 million, up 7% versus the prior year, reflecting consistent levels of growth across both underwriting and claims. Income from continuing operations was $220 million, up 17.4% versus the prior year, while diluted GAAP earnings per share from continuing operations were $1.54, up 19.4% versus the prior year. The increase in diluted GAAP EPS was driven by strong operating performance, a litigation reserve expense in the prior year period, and a lower effective tax rate. Moving to our organic constant currency results for the third quarter, adjusted for non-operating items as defined in the non-GAAP financial measures section of our press release. Our operating results demonstrated consistent growth across both underwriting and claims. OCC revenues grew 6.8%, with growth of 6.5% in underwriting and 7.4% in claims. The solid revenue growth is compounding from the 9.4% OCC revenue growth from the prior year and reflects improvement from the second quarter in both the underwriting and claims businesses, as well as in our total subscription and transactional revenues. Our subscription revenues, which comprised 82% of our total revenue in the quarter, grew 9.1% on an OCC basis during the third quarter, building upon the 9.3% OCC growth we delivered last year. This quarter's growth was broad-based across most of our subscription-based solutions, especially in our largest businesses. In particular, our forms rules and loss costs business led the contribution to subscription growth where our engagement efforts and the enthusiasm around Core Line Reimagine continues to deliver strong outcomes during contract renewal as we are focusing on the value we are creating for our clients, supported by the tailwind of premium growth. In anti-fraud, we experienced strong growth in our claim search and claims essential solutions, primarily driven by the continued success of our pricing and bundling strategy, with a focus on third-party administrators. Growth was also augmented by a strong uptake of some of our newer solutions, including claims coverage identifier and claims scoring. In extreme event solutions, we delivered another quarter of very strong growth. We are hearing from our insurers, reinsurers, and brokers' clients that they value our continuous updates to our models incorporating the most recent data and science, including in our next generation models. This momentum has led to an additional 10 new clients signed in this quarter alone, as our sales teams are capitalizing on the growth of certain client segments, including excess and surplus lines of insurance and managing general agents or MGAs. Finally, this quarter's subscription growth does also reflect the benefit of ongoing conversions to subscription from previously transactional contracts, including the one discrete government contract that we mentioned last quarter, which contributed approximately 60 basis points to the third quarter's subscription revenue growth. Our transactional revenues, representing 18% of total revenue in the quarter, declined 2.5% on an OCC basis. This decline was a function of the strong results reported last year, which benefited from elevated levels of weather auto shopping activity and the non-rate action deal. This decline also reflects the impact of the conversions to subscription from previously transactional revenue. If you normalized for the one discrete contract conversion previously mentioned, transactional revenue growth would have been essentially flat. Partially offsetting the decline, we did experience double-digit growth in international underwriting, including life, health, and travel business. A modest transactional benefit from the storms in our property estimating solutions business and strong transactional growth in our personal lines property solutions as our carrier clients are turning to Verisk data to help them navigate rising premiums in that line of insurance. Moving now to our adjusted EBITDA results, OCC adjusted EBITDA growth was 7.2% in the quarter, while total adjusted EBITDA margin, which includes both organic and inorganic results, was 55.2%, up 120 basis points from the reported results in the prior year. As we have mentioned previously, the margin rate in any given quarter can be influenced by revenue mix and timing of expenditures. Therefore, we find it useful to examine our margin on a trailing 12 month basis, which stood at 54.6% at the end of the third quarter, up 130 basis points year-over-year. This level of margin expansion highlights the effects of strong revenue growth, ongoing cost discipline, and our global talent optimization initiative, offset in part by continued investment in our finance transformation and higher medical benefit expenses. Additionally, our margins benefited from a foreign exchange translation impact, which helped margins by approximately 60 basis points in the quarter. This FX benefit was not contemplated in our guidance, as we do not forecast or hedge foreign currency. For the full year 2024, we continue to expect our margins to remain in the 54% to 55% range. We remain confident in our ability to achieve our margin expansion targets, while strategically investing in future growth opportunities. Continuing down the income statement, net interest expense was $32 million compared to $29 million in the same period last year. This increase is primarily due to higher interest expenses from the issuance of senior notes in the second quarter at a higher interest rate, leading to an increased run rate expense going forward. Our current leverage remains at 2 times, which is at the lower end of our targeted range of 2 to 3 times adjusted EBITDA. Our reported effective tax rate was 22.9% compared to 25% in the prior year quarter. The prior year quarter's rate was elevated due to one-time items that did not repeat. For the fourth quarter, we believe that our tax rate will be in the previously provided range of 23% to 25%. There could always be some quarterly variability related to employee stock option exercise activity. Adjusted net income increased 7.8% to $239 million, and diluted adjusted EPS increased 9.9% to $1.67 for the quarter. The increase is primarily driven by solid revenue growth, strong margin expansion, a lower effective tax rate, and a lower average share count. This was partially offset by higher depreciation and amortization expense. From a cash flow perspective, on a reported basis, net cash from operating activities increased 18% to $296 million, while free cash flow increased 23% to $241 million, demonstrating the strong cash flow generation characteristics of our subscription-based business model. We are committed to returning capital to shareholders, and during the quarter, we returned $455 million through repurchases and dividends. This includes our new $400 million accelerated share repurchase program, which was completed in October, and our cash dividend of $0.39 per share, an increase of 15% from 2023. We are pleased with the third quarter and year-to-date performance. Our outlook for 2024 remains unchanged. More specifically, we continue to expect consolidated revenue for 2024 to be in the range of $2.84 billion to $2.9 billion. We expect adjusted EBITDA to be in the range of $1.54 billion to $1.6 billion, and adjusted EBITDA margin in the 54% to 55% range. Below the line, we expect fixed asset depreciation to be at the high end of the range as we continue to put new projects into service. Combined with the slightly higher net interest expense due to our refinancing, the net result is that we still expect adjusted earnings in the range of $6.30 to $6.60 per share. A complete listing of all guidance measures can be found in the earnings slide deck, which has been posted to the Investors section of our website, verisk.com. And now I will turn the call back over to Lee for some closing comments."
},
{
"speaker": "Lee Shavel",
"content": "Thanks, Elizabeth. In summary, our strategic priorities are unchanged as we remain focused on delivering consistent and predictable growth while allocating capital to our highest return on investment opportunities and returning excess capital to shareholders. Our focus on heightened strategic engagement with clients has strengthened relationships and fostered new product and business opportunities for the industry where we can invest at scale to drive value for our clients, employees, and shareholders. We continue to appreciate the support and interest in Verisk. Given the large number of analysts we have covering us, we ask that you limit yourself to one question. With that, I'll ask the operator to open the line for questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions]. And your first question comes from the line of Toni Kaplan with Morgan Stanley."
},
{
"speaker": "Toni Kaplan",
"content": "Just given where we are in the year, I'm trying to think of through the dynamics for 2025. So I think there was 10% net premium growth in the industry in 2023. So the part that's tied to your premiums should be pretty strong. And transactional has pretty easy comps over the next four quarters. And then it seems like extreme events and life and international are going really well. So I guess my question is, is 2025 setting up for an outsized year of growth? Or are there any headwinds that we should be thinking about?"
},
{
"speaker": "Elizabeth Mann",
"content": "As we think about 2025, I think you've articulated well the tailwinds that we see in the business, the subscription momentum that we feel and the continued strong premium environment. As we think about potential headwinds that could offset it, we are going into the third year of elevated premium growth. And so, that is a longer cycle that the pricing momentum can feel those challenges. I think another element we are in an environment where the carriers are very focused on their profitability. They're evaluating lines of business and which ones that they are in, as well as kind of evaluating their overall spend. So that is one element of headwind. And then finally, you could start to see a normalization of attrition, which has been a boost for us over the last couple of years. So those are some of the headwinds. Then as an unknown, there is the weather factor. But in general, as we think about it, we do see strong momentum in the business."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Ashish Sabadra with RBC Capital Markets."
},
{
"speaker": "Ashish Sabadra",
"content": "Is there a way for us to estimate the tailwinds from the hurricanes Helene and Milton in 4Q, but also the tailwinds for the property estimating solutions going forward."
},
{
"speaker": "Elizabeth Mann",
"content": "As we think about the fourth quarter – and both Helene and Milton hit in the fourth quarter, Helene was the very end of September, Milton obviously in early October – it is early to tell and quantify the impact to us. You can look at the estimates of insured losses that have been published. Verisk's estimates, which our extreme events business has published, had insured losses estimated at $6 billion to $11 billion for Helene and $30 billion to $50 billion for Hurricane Milton. As you look at those combined, you could say on average they're similar to Hurricane Ian. But the flow through to us can vary based on the number of assignments, the type of peril, whether it's wind or flood, the overall area covered by the storm. And from what we're seeing, it does take time for the claim to actually be filed as everyone there is focused on getting those communities back on their feet. The other thing I do want to put in context as you think about those – the impact of those storms in the fourth quarter. You've heard us talk in general across the business about converting contracts from transactional to subscriptions and from customers increasing their usage and committing to higher tiers. And that's happening in this property estimating solutions business as well. We've seen customers increasing their usages and then adapting their subscription contracts to reflect that higher usage. So how that could play out over time could mean less transactional swings on the impact of one single storm proportionally because the customers may be less likely to be in overage. So that transition to subscription has in general been a win-win for our business and you've seen it play out in our subscription growth."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Kelsey Zhu with Autonomous."
},
{
"speaker": "Kelsey Zhu",
"content": "It's just on subscription revenues in Q3. I was wondering if you can share a bit more colors on what drove the acceleration of growth. I know you've highlighted a number of segments where you've seen really strong growth and one of them is property estimating solutions. Now I was wondering if that is also impacted by kind of demand around Hurricane Helene and Milton as well."
},
{
"speaker": "Elizabeth Mann",
"content": "As we looked at, you're right, we've seen accelerating subscription growth even sequentially from last quarter. When you really look at it, it isn't any one thing or one area of our business. Obviously, we've now called out and quantified the impact of the contract conversion, but the underlying subscription growth really hits across all of our businesses and the drivers are the ones that we really highlighted in the prepared remarks. It's the two factors, our focus go-to-market and customer client engagement and then the strengths being driven by our product development and innovation. And those two things are supported by the tailwind of premium growth. But in general, what you're seeing is the momentum from new sales from conversions to subscription and from upsizing usage and adding products from Verisk."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Surinder Thind with Jefferies."
},
{
"speaker": "Surinder Thind",
"content": "As we think about just the current health of the insurance companies and all of the change that's kind of pending, how do we think about this idea that insurance companies are trying to enter this period of much more focused profitability and you hear about – you see what's going on in Florida, California, some of the topics that we've talked about in the past. How are you guys assessing that? I don't want to call it a headwind, but just that transition that the industry seems to be going under in this part of the cycle."
},
{
"speaker": "Lee Shavel",
"content": "Surinder, thank you very much for the question, particularly value the context and looking at the industry as a whole, which as you know, we spend a lot of time thinking about. From our perspective, I think when you look at the premium growth, you look at the improvements in the combined ratios and overall profitability of the business, and particularly in light of the significant storms and some of the hits that the industry has taken, I think it's a reflection of continued interest in the data and the analytics that we provide to them to make better risk decisions, which will continue to be a driver of opportunity for us because we can gather that information, we can apply analytical methods across – that can be utilized across the industry. But also to your point in terms of moving into this more focused profitability dimension, our work to identify where we can improve their internal processes by automating more of their functions, integrating data into the workflow has been a very active component of those higher level enterprise discussions that we're having. And it's a conversation that is happening at the chief information officer level and the CEO level or the heads of business that are interested in improving their process. And then a second element of that is how do we integrate external parties that are part of the insurance ecosystem in what they're doing to improve overall efficiency. A great example of that is what we have been doing in London with our white space platform where we are integrating brokers and underwriters to both improve the efficiency of that interaction, but also improving the data quality that the underwriters are utilizing to make to make placement decisions. So I think everything that you're that you are describing encourages continued engagement with us on finding and developing those solutions."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Faiza Alwy with Deutsche Bank."
},
{
"speaker": "Faiza Alwy",
"content": "I wanted to ask about the benefits that you've been highlighting from Core Lines Reimagine. I'm curious of where we are in that journey and maybe if you could share with us sort of what percentage of your clients or any metrics you want to share are sort of on that Core Lines Reimagine program. And I think you talked about the new initiative called the Future of Forms. Should we expect that to be sort of a continuing or a similar level of value driver as we look ahead to 2025 and beyond?"
},
{
"speaker": "Lee Shavel",
"content": "I'm delighted to talk about that. I'm actually going to ask Saurabh Khemka who leads that business and has been an architect and a driver of that Core Lines Reimagined. And I'll just say that if both qualitatively the feedback and the engagement that we're getting from clients, we referred a little bit of that in terms of the executive insights that we're providing to them, but also the very specific dynamic of our ability to capture the value of that through the repricing of our longer term contracts and what we're hearing. But allow me to have Saurabh give more color in terms of what he's hearing directly from clients there."
},
{
"speaker": "Saurabh Khemka",
"content": "I think you had asked three things. First, in terms of where we are with the program, we are slightly more than halfway through the program as we think about the investment and where we are in terms of bringing new innovations to the customers. Second, you talked about how do we think about KPIs and how do we think about KPIs internally about the program. One of the things we look at is the number of new insights that we're bringing to market and the number of new insights that customers are benefiting from. So we've talked about the experience index where we've now launched that for five out of the six major lines of business. We'll launch the sixth one next year. The Future of Forms that we talked about, we started with our major general liability update. We expect that to become part of our major updates going forward. So you will see that next year as we bring in new updates to our BOP program. You're going to see that. So that is a continuous innovation that we're going to bring to market. And one thing that I just want to highlight that brings it all together for us as we think about customers and their engagement, we have a new engagement platform at core.verisk.com and we're highlighting that to our customers. And what we're seeing is as we're putting these new content and our existing content on this new platform, the engagement level is multiple times what we had previously. So we're excited that these new innovations are driving usage at our customers, which, as you know, drives the value for us from a core lines perspective."
},
{
"speaker": "Lee Shavel",
"content": "And if I could add in a broader sense, I think that this is a reflection of several things. One, it's improving our ability to utilize the data sets because we've effectively had to pull those data sets out, manipulate them in ways in order to deliver them to our clients more effectively, which facilitates more fluidity analytically in what we can do and coupled with both the strong response that we're getting from clients to the product and our higher level of engagement. It is, I think, a change in the culture in which we're approaching developing our business. And while there are specific targets and product enhancements that we're pursuing, I think that it actually opens up a broader opportunity for us to think about how we utilize those data sets in new ways, serving other constituencies within our clients."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Andrew Steinerman with J.P. Morgan."
},
{
"speaker": "Andrew Steinerman",
"content": "When you were talking about 2025 headwinds, and I appreciate the business has a lot of momentum, it's just prudent to mention the headwinds as well. One of the things you didn't list there is kind of the continued conversion from non-subs to subs. And we had that dynamic. You were kind enough to help us quantify it this quarter. But do you feel like that's going to be a notable headwind going forward?"
},
{
"speaker": "Elizabeth Mann",
"content": "The impact of that one conversion will be felt for approximately a year from the second quarter. So you'll see that. But we were talking about the business in aggregate. That's just a geographic shift from transaction to subscription, which is why I didn't call it out as a headwind overall."
},
{
"speaker": "Lee Shavel",
"content": "I think that is an important distinction. And that's the reason why I pulled back to the overall growth. That adjustment was a specific geographic just shift from transactional to subscription. But that doesn't impact, I think, the longer term, the longer term opportunity for growth that we see in both the transactional and the subscription businesses."
},
{
"speaker": "Andrew Steinerman",
"content": "Lee, when you said 8% in your prepared remarks, you just meant all in total organic review growth a year ago. It was nine 9.4%. And this quarter was 6.8%. And you just did the two year stack for that. Right?"
},
{
"speaker": "Lee Shavel",
"content": "That's exactly right, Andrew."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Jeff Meuler with Baird."
},
{
"speaker": "Jeff Meuler",
"content": "Can you just give us any sense of, I guess, bookings, trends or quota attainment? The reasons you're citing as the primary drivers of the subs acceleration and momentum sound like better solution sales, not just the industry written premium tailwinds and transaction to subs conversion. But just if you can give us any sense on how bookings are trending."
},
{
"speaker": "Elizabeth Mann",
"content": "Yes, they are trending well. That subscription growth is a function of strength overall, strength in acquiring new customers, strength in selling – all of the factors we talked about, cross sell and upsell and adding some of our new products and data sets."
},
{
"speaker": "Lee Shavel",
"content": "I would broaden it to say, I think we are – the sales results have been strong relative to our expectations, given this performance and I think reflective of some of the changes that we made in our go-to-market strategy, focusing some of our territories, changing incentives, making some adjustments there, coupled with the higher level engagement, which is opening up opportunities for us to make a more value driven sale at a senior level. And so, it's a complementary impact of that higher senior level engagement and then more effective follow up and engagement on the sales front."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Manav Patnaik with Barclays."
},
{
"speaker": "Manav Patnaik",
"content": "Just a somewhat similar question. But, Elizabeth, I think in your remarks, you mentioned how Core Lines Reimagined, the progress there, was leading to better renewals. You mentioned pricing, but also it sounded like there was a volume component. So I was just hoping for some examples of how and what with that Core Lines Reimagined upgrade like are you – is the customer buying more of? I understand there's probably a pricing element because it's upgraded, but just some help there just to visualize that would be helpful."
},
{
"speaker": "Elizabeth Mann",
"content": "For Core Lines Reimagined, there isn't exactly a volume component per se. So we're referring more to addition of new data sets, particularly in the underwriting data and analytics solutions business, as well as there's some growth products affiliated with Core Lines Reimagined, things like electronic ratings content and other ratings of the service. So, those are some of the types of additions that clients could be adding."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Andrew Nicholas with William Blair. Please go ahead."
},
{
"speaker": "Andrew Nicholas",
"content": "I wanted to ask on extreme event solutions. Elizabeth, you talked about or cited 10 new customer wins in the quarter in a few of the different customer segments where you're having success. Could you flesh that out a little bit more? Where are those wins coming from? What specifically is driving that increased interest from clients? And then also, like within that, are those competitive takeaways or are those taking advantage of white space on the extreme event front?"
},
{
"speaker": "Elizabeth Mann",
"content": "Of those 10 new customers, 9 of them are new to the modeling space entirely. So, I think this this shows and reflects the broader interest of adding more specific modeling information around the climate change and climate impacts that we're seeing. And I called out specifically some of the segments including excess and surplus lines of insurance and the managing general agents, which has been a significant growth area in the insurance industry, and focusing on those areas is something that has driven strength across our business, but the extreme events business has seen that as well. Let me also add my colleague Rob Newbold who runs that business to see if there's anything he'd add to that."
},
{
"speaker": "Rob Newbold",
"content": "I'll just add to the point that, obviously, there have been heightened catastrophe loss activity for the past several years as we've referenced in past calls. Helene and Milton have already been mentioned. And you see an increasing number of market participants looking to better understand and quantify the risk from these events and that's driving interest in extreme event modeling solutions."
},
{
"speaker": "Operator",
"content": "Your next question comes from line of Alex Kramm with UBS."
},
{
"speaker": "Alex Kramm",
"content": "Just maybe quickly on the auto shopping trends, I think this was the first quarter where it finally turned from a tailwind to a headwind. So, maybe you can help us a little bit in terms of the potential outlook here, maybe if we stay flat at these current levels how much that would weigh on the growth in the next 12 months or maybe if it's down whatever 10%, 15%, what that would mean for overall growth if you can be that specific."
},
{
"speaker": "Elizabeth Mann",
"content": "You've heard us call out over the past five, six quarters now the strength in the auto shopping activity and more generally the transactional revenue growth in our auto insurance data business. And so, those headwinds are now playing out in the quarter as expected. I'm not sure we can quantify them in the future other than to say that the comps continue to be challenging on the transactional side for the auto business."
},
{
"speaker": "Operator",
"content": "Your next question comes from line of Jeffrey Silber with BMO Capital Markets."
},
{
"speaker": "Jeffrey Silber",
"content": "You reaffirmed your 2024 revenue and adjusted EBITDA guidance, but it applies a pretty wide range for the fourth quarter. Are you being overly conservative or can you at least give us some indication what would be at the top end of the range or the low end of the range in terms of what's driving those assumptions."
},
{
"speaker": "Elizabeth Mann",
"content": "As you know, for our guidance, our intention has always been to provide a full year estimate and not to give kind of quarterly mark-to-market. Obviously, here where we are, there's one quarter left. So, you're inferring that. But I think from everything we see, we are very much in line with that full year range."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Peter Knudsen with Evercore."
},
{
"speaker": "Peter Knudsen",
"content": "Thank you for the helpful color and the prepared remarks on some of the new initiatives and products Verisk has rolled out and been working on. I'm wondering if you could share some more color specifically on the Discovery Navigator tool, if there are any adoption or utilization metrics you could share, that would be great. And maybe just more generally on any of your Gen AI capabilities. How are those going and what kind of conversations are our clients having with you around those products?"
},
{
"speaker": "Lee Shavel",
"content": "On your question, I'm going to ask Maroun Mourad, who has responsibility for our claims business and the Discovery Navigator feature to talk a little bit about how our clients are interacting with that. And then I'll circle back and provide some more color on a number of the Gen AI initiatives that we've been pursuing."
},
{
"speaker": "Maroun Mourad",
"content": "Within claims, we have been thoughtfully and responsibly deploying Gen AI solutions, both internally to drive productivity and externally to help our clients on their talent augmentation, modernization, as well as productivity journeys. To your specific question around Discovery Navigator and our casualty and bodily injury space, Discovery Navigator is effectively an AI driven automation innovation in the medical data extraction space that helps us extract specific data elements, organize and catalog them, and in addition, provide an executive summary to case files. And the technology has been developed with the help and supervision over a 12 to 14-month period of our highly experienced medical, as well as legal staff within the casualty business. We've also embarked just to add a couple of other notes on an innovation journey in the property estimating space for Gen AI. And a couple of examples there is an adjuster Copilot transcription summary that helps drive efficiency for adjusters, whether they're independent or working for companies as well as a last note summary as well within a claims file."
},
{
"speaker": "Lee Shavel",
"content": "Peter, just to kind of broaden that out, in fact, your timing is great. Last week, we had, within Verisk, a Gen AI day where we pulled together all of our Gen AI practitioners and our data analytics executives to talk about how they are developing in their specific areas, generative AI for their for their tools, so that we can learn from each other, understand what's working and what's not. Some of the some of the products that we talked about was within our fast business, utilizing a feature called Ask Max, which is a an intelligent virtual assistant that helps clients understand how to utilize the fast installations for configuring and for end user processes, which facilitates their effectiveness and deploying that solution. We've talked previously about our underwriting copilot that we are working with a number of clients to develop to pull together data sets and automate functions in the underwriting, particularly in commercial property where we have a lot of data sets. We also have an application for our premium auditing as a service element. There's a lot of complex premium actuarial information. And this AI application helps cut the research time and empowers our customers to make informed decisions by accelerating their ability to retrieve and summarize premium audit documents. We also have an AI knowledge tool for our ISO electronic rating content that provides organized and detailed information about ISO circulars. And then we're also applying this to our Mozart Forms Composer. And you heard SK talk earlier about our Future of Forms. We are also applying an AI solution that will call out and summarize any changes made to ISO forms across versions. So this is just a sample of probably half dozen to a dozen specific applications as we're integrating this technology across our products to again improve the efficiency and productivity of our clients underwriting and claims professionals."
},
{
"speaker": "Operator",
"content": "Your next question comes from line of George Tong with Goldman Sachs."
},
{
"speaker": "George Tong",
"content": "Transactional revenue, tough comps begin to lap in 4Q. Can you discuss what transactional revenue trends in 4Q are incorporated into your guidance? And how much benefit from hurricanes Helene and Milton is actually embedded into the reiterated outlook versus your upside?"
},
{
"speaker": "Elizabeth Mann",
"content": "I think we forecast in each year for sort of an average year of storms. I think you heard me talk about some of the puts and takes on Helene and Milton in the fourth quarter. The transactional revenue comps do lap, but of course, if you just look at the growth rate in the prior year, that itself was lapping the Hurricane Ian in the fourth quarter of 2022. The final thing I'll point out on the transactional variability is the contract conversion that we called out this quarter will continue to play out in the fourth quarter and first quarter next year."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Jason Haas with Wells Fargo."
},
{
"speaker": "Jason Haas",
"content": "I'm curious if you could walk through again the moving pieces on guidance. It sounds like there's now at least some level of hurricane benefit baked into 4Q. I think I also caught that there was a 60 basis point benefit to margins from FX in 3Q. I'm not sure if you now expect to see something similar in 4Q. And then it sounds like there was an offset from higher interest expenses. I'm sorry if I missed it, but if you could say what interest expense you're expecting for 4Q and then if there's just any other puts and takes that I missed, it would be appreciated if you could walk through this again."
},
{
"speaker": "Elizabeth Mann",
"content": "Our guidance ranges are really for the full year, and so the puts and takes that we're talking about in the quarter are all kind of small relative to that, but happy to walk you through those in order. On the margin, we called out for this quarter the 60 basis point FX benefit, which was not contemplated in the guidance range, nor do we forecast that for the fourth quarter. We feed that to the currency traders, I guess. The interest expense I called out was $32 million this quarter, up from $29 million the year previous. You could think of that as a reasonable run rate. Possibly over time, I suppose the net interest expense would go up as interest rates earned on cash balances could come down. I think those were the various puts and takes that I called out for the full year guidance and that hit the third quarter."
},
{
"speaker": "Jason Haas",
"content": "It sounds like, otherwise to the underlying business, there's no change relative to your prior guidance?"
},
{
"speaker": "Elizabeth Mann",
"content": "That's right."
},
{
"speaker": "Operator",
"content": "[Operator Instructions]. And your next question comes from the line of Russell Quelch with Redburn Atlantic."
},
{
"speaker": "Russell Quelch",
"content": "I wanted to ask about the international business. I think you called out, if I heard it right, in the pre-scripted remarks, you've seen an increased contribution to growth from the international business in the quarter. Maybe you could be a bit more specific about that, exactly what parts of the international business that's coming from, and if this is an area where you might look for further inorganic opportunities to grow in 2025, now you're at the bottom end of your leverage range and obviously funding rates are coming down."
},
{
"speaker": "Lee Shavel",
"content": "We've seen strength actually in a number of our international businesses. I think we called out the life health and travel business, which continues to expand into new regions and being pulled there by their customers. So that's seen strong growth. Our Okta business in Canada contributed as well to that growth. I think Lee talked about some of the integration of some of the Verisk data sets there. So that's a good example of synergies and strength from the Verisk overall business contributing to one of our international acquisitions. So all of those are factors for good growth and our claims businesses in Germany have been doing well as well. So, yes, that is an area where we will continue to look for potential acquisitions."
},
{
"speaker": "Lee Shavel",
"content": "I would just add also, as we've talked about with our specialty business solutions business, that we continue to see strength and a strong contribution to our overall growth rate from the services that they're providing."
},
{
"speaker": "Operator",
"content": "There are no further questions at this time. Therefore, this concludes today's call. Thank you for joining. You may now disconnect."
}
] |
vrsk | 2,024 | 2 | [
{
"speaker": "Operator",
"content": "Good day, everyone, and welcome to the Verisk Second Quarter 2024 Earnings Results Conference Call. This call is being recorded. [Operator Instructions] For opening remarks and introductions, I would like to turn the call over to Verisk's Head of Investor Relations, Ms. Stacey Brodbar. Ms. Brodbar, please go ahead."
},
{
"speaker": "Stacey Brodbar",
"content": "Thank you, operator, and good day, everyone. We appreciate you joining us today for a discussion of our second quarter 2024 financial results. On the call today are Lee Shavel, Verisk's President and Chief Executive Officer; and Elizabeth Mann, Chief Financial Officer. The earnings release referenced on this call as well as our traditional quarterly earnings presentation and the associated 10-Q can be found in the Investors section of our website, verisk.com. The earnings release has also been attached to an 8-K that we have furnished to the SEC. A replay of this call will be available for 30 days on our website and by dial-in. As set forth in more detail in today's earnings release, I will remind everyone today's call may include forward-looking statements about Verisk's future performance, including those related to our financial guidance. Actual performance could differ materially from what is suggested by our comments today. Information about the factors that could affect future performance is contained in our recent SEC filings. A reconciliation of reported and historic non-GAAP financial measures discussed on this call is provided in our 8-K and today's earnings presentation posted on the Investors section of our website, verisk.com. However, we are not able to provide a reconciliation of projected adjusted EBITDA and adjusted EBITDA margin to the most directly comparable expected GAAP results because of the unreasonable effort and high unpredictability of estimating certain items that are excluded from projected non-GAAP adjusted EBITDA and adjusted EBITDA margin, including, for example, tax consequences, acquisition-related costs, gains and losses from dispositions and other non-recurring expenses, the effect of which may be significant. And now I'd like to turn the call over to Lee Shavel."
},
{
"speaker": "Lee Shavel",
"content": "Thanks, Stacey. Good morning, and thank you for participating in this morning's call. As we mark the halfway point in 2024, I can confidently say that we are on track to deliver against the strategic, operational and financial goals that we articulated at Investor Day and in our 2024 full year guidance. Elizabeth will provide the detailed financials, but at a high level, Verisk delivered solid organic constant currency revenue growth led most importantly by strong subscription growth of 8.3% that was broad-based across most of our businesses. This was partly offset in the quarter by modest declines in our transactional business, related to historically high volumes in auto shopping and elevated weather-related activity in the prior year quarter, which made for tough comparisons to normalized activity this quarter. We also experienced a drag on our transactional growth from the conversion of transaction-based contracts to subscriptions, which enhances the consistency of our growth going forward. To put this quarter in perspective and minimize the transaction to subscription conversion impact on a two-year compound annual growth rate basis, our total organic constant currency revenue growth has been 8%, at the high-end of our Investor Day revenue growth targets. We are driving subscription growth through strong renewals and improved price realization as our customers recognize the innovation and value-added upgrades we have incorporated into existing solutions. This is something that we've heard repeatedly in our renewal discussions with our largest clients. Our focus on cost discipline and operating efficiency resulted in healthy organic constant currency adjusted EBITDA growth and strong margin expansion, translating into 15% adjusted EPS growth. We delivered these results while continuing to invest in innovation and technologies that can help our clients improve speed, efficiency and accuracy through deeper insights, improved data and increased automation. Our strategy is unchanged as we focus on building long-term value for the insurance ecosystem while delivering consistent and predictable growth with high returns on capital for shareholders. The industry backdrop in which we are currently operating is one marked by continued strong premium growth as rate increases continue to earn in. In fact, in the first quarter of 2024, industry-wide direct premium growth increased 10%, and Swiss Re's forecast is for 8% growth for the full year. Profitability across the sector has improved, and industry-wide combined ratios have come down, though there is variability by line and geography. Carriers continue to be cautious in an uncertain environment and focused on driving profitability. Specific to the homeowners line of insurance, 2023 was the worst year on record for catastrophic losses with $15.2 billion in losses, and direct combined ratios in 17 states were above the breakeven threshold of 100. This has driven carriers to restrict underwriting in certain markets and in some cases, exit challenging states and lines of business. We are working with our clients and innovating new solutions that target these problem areas, including introducing new roof analytics that leverage aerial imagery and engaging with the respective departments of insurance in Western states to share the updates we have made to our wildfire solutions. In the near term, these market conditions may present some headwinds for our predominantly subscription property business, but in the longer term, we continue to believe it highlights the need for the most accurate information to best price the risk. Technological and regulatory change also continue to challenge the industry structurally. And we continue to partner with clients to help them address the rapid pace of technological change as well as increased regulatory scrutiny on data privacy, fairness, generative AI and climate risk. As another example of our work to support understanding of broad industry challenges, we recently co-authored a paper along with research organization RAND Corporation analyzing the impact of social inflation in insurance casualty claims payments with a focus on better understanding the trends, impact and potential structural factors in growing jury verdicts and trial awards. At the center of our growth strategy is our effort to engage with our clients on a more strategic level. As an example of what I've been hearing recently from clients, I've had conversations with both client CEOs and CIOs about the importance to them of integrating data sets across their enterprise for efficiency and consistency. We are the natural trusted technology partner to help with this data asset convergence as we are best positioned, given our deep data and domain expertise, our position in the industry and our proven track record of aggregating and integrating industry data at scale. These C-suite level and strategic conversations are opening up broader and enterprise-wide opportunities and applications of our data and analytics with the industry and new avenues for growth for Verisk. For example, in casualty, an area of focus for carriers due to the rising claim severity, our Liability Navigator is an analytic solution that objectively assesses bodily injury claims to help carriers improve settlement consistency across claim teams. By integrating our proprietary medical provider fraud data and our Discovery Navigator medical record review technology, we transformed previously unstructured and disparate medical data into actionable insights at the point of decision, thus improving efficiency and accuracy in bodily injury claims outcomes. Also key to our growth strategy is building upon our 50-plus year history in insurance and our competitive advantages and positioning to serve as a network for the insurance industry. To that end, in our specialty business solutions, we are delivering solid double-digit growth as we build out an interconnected ecosystem built upon the white space platform for participants in the London market, including brokers, underwriters and managing general agents. We are continuing to win new clients, adding 15 new clients in the quarter, and placement volumes are growing rapidly as the scale of the platform builds. This network effect is also active across our claims platforms as we continue to add new partners to our claims solutions ecosystem. The ClaimSearch partnership enables insurance technology providers to integrate with the ClaimSearch platform, allowing insurers to select the technology that best fits their individual business needs. Earlier this year, we announced two new collaborations with FRISS and Globlue Technologies, who are integrating with our ClaimSearch platform. This integration will facilitate advanced fraud analysis and detection, including more complex scoring and triaging to improve decision-making. Additionally, it should minimize the manual fraud detection process, saving valuable time and reducing operational costs for our clients. Finally, we continue to focus on innovation as a key pillar of our growth strategy. To that end, earlier this month, we officially launched ISO Experience Index, a new benchmarking tool which is part of our Core Lines Reimagine initiative. The ISO Experience Index is designed to modernize how actuaries in the insurance industry analyze risk patterns by addressing the increasing volatility and scale of loss patterns in the industry and offering a responsive and up-to-date indicator of observed underwriting experience. Experience Index empowers our clients to be more responsive to changing conditions across various geographic markets by offering quarterly releases with more frequent updates compared to traditional loss cost reviews. This enables our customers to make more informed decisions in real time. Experience Index is available for the homeowners line and will be expanded over time to other lines of insurance. Our customers are realizing the value we are delivering through Core Lines Reimagine, and we are benefiting from this investment through better price realization and improved client dialogues. In a recent conversation with the CEO of a national carrier, he expressed appreciation for our quarterly Emerging Issues updates. These reports are just one example of listening to our customers' requests to not only provide data but also deliver more valuable and actionable insights. And with that, let me turn it over to Elizabeth for the detailed financial review."
},
{
"speaker": "Elizabeth Mann",
"content": "Thanks, Lee, and good day to everyone on the call. On a consolidated and GAAP basis, second quarter revenue was $717 million, up 6.2% versus the prior year, reflecting consistent levels of growth across both underwriting and claims. Income from continuing operations was $308 million, up 51% versus the prior year, while diluted GAAP earnings per share from continuing operations were $2.15, up 53% versus the prior year. The GAAP figures include a cumulative $102 million net gain associated with retained interest in previously disposed businesses as well as a gain associated with the bond tender transaction we entered in June. The underlying EPS growth reflects strong revenue and profit growth combined with a lower effective tax rate and a lower average share count. Moving to our organic constant currency results for the second quarter. Adjusted for non-operating items as defined in the non-GAAP financial measures section of our press release, our operating results demonstrated consistent growth across both underwriting and claims. OCC revenues grew 6% with growth of 6% in underwriting and 5.8% in claims. This was a slowdown in growth as expected from the first quarter as we overlap the tough comparison to our largest ever transactional revenue dollar quarter in the second quarter of 2023. Our subscription revenues, which comprised 81% of our total revenue in the quarter, grew 8.3% on an OCC basis during the second quarter. We experienced broad-based growth across most of our subscription-based solutions with strong renewals and expanded relationships with existing customers and solid sales of new solutions. Our subscription growth also reflects the benefit of conversion to subscription from previously transactional contracts. In some cases, temporary assignments or pilots are converting into longer-term contracts. In other cases, customers are looking to move away from pricing mechanisms tied to volume and instead opting for fixed pricing to give more visibility in their own cost structures. We are experiencing this trend across underwriting data solutions, anti-fraud solutions, specialty and property estimating solutions. And we expect the impact of these conversions to continue for the remainder of the year. The largest contributor to subscription growth continues to be forms rules and loss costs, where we are benefiting from improved price realization in our renewals as we continue to modernize our platform and deliver more value and insights to our clients through features like Experience Index that Lee spoke about earlier. In anti-fraud, we experienced underlying strong price realization in the business with growth augmented by strong sales of new solutions, including Claims Coverage Identifier and Claims Scoring, our new real-time monitoring tool that uses both rules-based and predictive models to identify and triage suspected fraudulent claims. And within Extreme Event Solutions, we delivered another quarter of high single-digit subscription growth driven by strong multiyear renewals with existing clients as well as the addition of new logos to Verisk. Our transactional revenues, representing 19% of total revenue in the second quarter, declined 3% on an OCC basis, reflecting a tough comparison versus the prior year, a drag on growth from conversion to subscription and the impact of more year-over-year weather-related claims activity. This was offset in part by strong growth contribution from our life insurance business and securitization within our Extreme Events business. Specific to the tough comparisons, last year, transactional revenues increased 12.4% and included benefits from elevated levels of auto shopping activity as well as the large non-rate action deal we had called out. Our revenue associated with auto shopping did continue to grow in this year's second quarter, but not at the level of the trailing 12 months. We expect those tough comparisons in auto to continue for the balance of the year. And with regard to the weather-related claims activity, while frequency of events was up in the second quarter, the severity events and associated claims volume from those events was down year-over-year from record levels in 2023. It is this volume metric that impacts our transactional revenues within property estimating solutions. All that said, we continue to experience a longer-term secular trend of growing weather-related claims across the property sector. And in fact, while 2024 claims volumes are down in the second quarter year-over-year, they are still continuing an upward trend as they are running approximately 20% above the trailing 5-year average. Moving now to our adjusted EBITDA results. OCC adjusted EBITDA growth was 8.5% in the quarter. While total adjusted EBITDA margin, which includes both organic and inorganic results, was 55.4%, up 130 basis points from the reported results in the in the prior year. As we've said the past, margin rate in any given quarter can be influenced by revenue mix and timing of spending. So we think it's useful to look at our margin on a trailing 12-month basis, which, as of June 30, 2024, was 54.3%, up 120 basis points over last year's level. This level of margin expansion reflects the positive impact of sales leverage, cost discipline and our global talent optimization efforts. Our margins also reflect a lower level of headcount growth in the quarter we expect to accelerate hiring in the back half of year to support our growth investments. For the full year 2024, we continue to expect our margins to be in the 54% to 55% range. We remain confident in our ability to meet our margin expansion targets while strategically investing in future growth opportunities. Continuing down the income statement, net interest expense was $29 million for second quarter compared to $32 million in the prior year, reflecting higher interest income on cash balances. During the second quarter, we issued $600 million of senior notes due 2034 and successfully tendered for $400 million of our notes due in 2025. The net effect of these two financing transactions is that the ongoing run rate for net interest expense will be higher in the second half of the year than it was in the first half. That said, we are comfortable with our current leverage, which at 2x is at the low end of our targeted range of 2x to 3x EBITDA. On taxes, our reported effective tax rate was 21.7% compared to 23.8% in the prior year quarter. The year-over-year decrease in the tax rate is primarily due to the timing of certain discrete items that we do not expect to repeat. We believe that our tax rate for the full year 2024 will be at the low end of the 23% to 25% range. There could some quarterly variability related to employee stock option exercise equity. Adjusted net income increased 13% to $249 million, and diluted adjusted EPS increased 15% to $1.74 for the quarter. The increase is primarily driven by solid revenue growth, strong margin expansion, a lower effective tax rate and a lower average share count. This was partially offset by higher depreciation and amortization expense. From a cash flow perspective, on a reported basis, net cash from operating activities increased 10% to $212 million while free cash flow increased 14% to $154 million. This is the first quarter that our cash flow metrics demonstrate the results of our insurance-only business and are reflective of the operating cash flow of the new Verisk. From an M&A perspective, we did not acquire or dispose of any businesses in the quarter. But we did receive $112 million in cash proceeds related to the prior sales of our health care business in 2016 and our specialized markets business in 2022. In both of those cases, we maintained a small structured equity position, which was monetized in this quarter. As of June 30, we had $632 million in cash on our balance sheet, which gives us the financial flexibility to continue self-fund the investment back into the business. We are also committed to returning capital shareholders. During the second quarter, we initiated a $150 million accelerated share repurchase program, which was completed in July. As of June 30, we had $1.3 billion in capacity remaining under our share repurchase authorization. We are pleased with our results for the second quarter and the first half of the year. Our outlook for 2024 remains unchanged. More specifically, we continue to expect consolidated revenue for 2024 to be in the range of $2.84 billion to $2.9 billion. We expect adjusted EBITDA to be in the range of $1.54 billion to $1.6 billion and adjusted EBITDA margin in the 54% to 55% range. Below the line, we expect fixed asset depreciation to be at the high end of the range as we continue to put new projects into service and the tax rate to be at the low end of the range, given certain onetime discrete items for the first half of the year. Combined with the slightly higher net interest expense due to our refinancing, the net result is that we still expect adjusted earnings per share in the range of $6.30 to $6.60. A complete listing all guidance measures can be found in the earnings slide deck, which has been posted to the Investors section of our website, verisk.com. And now I will turn the call back over to Lee for some closing comments."
},
{
"speaker": "Lee Shavel",
"content": "Thanks, Elizabeth. In summary, our execution priorities are unchanged as we remain focused on delivering consistent and predictable growth while allocating capital to our highest return on investment opportunities. Our focus on heightened strategic engagement with clients, both large and small, has strengthened relationships and has fostered new product and business opportunities for the industry where we can invest at scale to drive value for our clients, employees and shareholders. We continue to appreciate the support and interest in Verisk. [Operator Instructions] With that, I'll ask the operator to open the line for questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] The first question comes from the line of Manav Patnaik from Barclays. Please go ahead."
},
{
"speaker": "Manav Patnaik",
"content": "Thank you. Good morning. Lee, I just wanted to follow up. You talked about the 8% growth on a two-year stack that's above kind of what it used to be. I was just wondering the components of that outperformance. I know you talked about pricing before. I was wondering this transition from transaction to subscription if there was a way to quantify how much that might have helped and just the sustainability of this for the next several years."
},
{
"speaker": "Lee Shavel",
"content": "Good morning. Thank you, Manav, for the question. Yes. I appreciate the focus on the 8% two-year stack growth rate because I think it does give broader context beyond what we experienced in this quarter. And to answer your question, the drivers of that have been, generally speaking, more demand for our products from the industry as they are facing a variety of challenges in - on the underwriting side, on the claims side, the value of what we have been providing to them. But also, and I think this is the element that is the sustainable aspect of it is the success that we've had in increasing our value capture from the investments that we have made across the business. And this is something I referenced in the earlier comments. We are hearing it repeatedly from clients that they recognize the innovations, the investments that we have made, and that's enabling us in this environment to capture more of that value. And we believe that, that is a longer-term trend that will enable us to continue to meet that growth, supplemented by new products and new innovations that we are adding. We continued to see strong growth in our specialty business solutions area, where we've been innovating with our white space platform, which has those very strong network effects. We have continued to see growth in our international businesses, which is a penetration opportunity for us and growth in our life insurance business. So as we said at Investor Day, we have core strength where we are adding value and capturing that value in pricing. And that's supplemented by new penetration opportunities that we believe will sustain that growth over time. And then I'd finally add that the elevated strategic dialogue that we have accomplished with our clients is opening up new opportunities to provide our products on a broader enterprise and global basis to our clients. Recent - last week, I had two CEO-level calls, visits, where we spoke about how we can help improve the consistency of the data and the analytics that they are using across their organizations for some portions that aren't utilizing our data or our analytics. And I think that is a structural and relationship benefit that we've been able to achieve, and we'll see continued support on the growth - in our growth from those aspects. On the trends sub transition, it's happening in a variety of ways. Some of it is structural. Some of it is episodic. I think that it will be a diminishing impact over time. We had some stronger elements that that contributed to dynamic in this quarter and made for some of the more pronounced differentiation between subscription growth and transaction growth."
},
{
"speaker": "Operator",
"content": "The next question comes from the line of Surinder Thind from Jefferies. Please go ahead."
},
{
"speaker": "Surinder Thind",
"content": "Thank you. Lee, is there any way to characterize the level of transaction activity related to things like weather? I think you guys mentioned auto remains elevated, but just get a better sense of how should we think about that on a go-forward basis or maybe a historical context?"
},
{
"speaker": "Lee Shavel",
"content": "Thank you, Surinder. So I think the thing that I would emphasize is that when you look at the second quarter of 2023 and you see the 12.4% growth, this is in the investor presentation on - in - that we had provided on the website. What we're experiencing was a very high level of shopping activity in auto as a function of rising rates within that business. You can look at the commentary of that. It was kind of truly exceptional - an exceptional level of shopping activity that was driving that transaction element. In addition, as you will see in the description around claims business, we were experiencing still a high level of weather-related claims activity that was also driving that business. And so that's really what is contributing to what we're - we are experiencing a relatively tough comparison enhanced by some of the transaction to subscription migrations that are more pronounced in this quarter. As we think about that element on an ongoing basis, I think we generally expect that our transactional growth rates are ones that are generally at our broader growth rates to slightly higher because in many cases, they represent some of our higher-growth businesses that tend to have more of a transactional aspect at the early stage. So with that, I'll ask Elizabeth to add some perspective."
},
{
"speaker": "Elizabeth Mann",
"content": "Yes. Thanks, Lee, for characterizing the factors that impact our transaction growth, and you can see the historical trends of it in that earnings presentation that he referenced. I think for mechanical reasons - well, first of all, it is variable over time. It's inherently harder to predict. We don't try predict the weather. But that inherent variability for some of the mechanical factors, for example, the conversion of transactional to subscription, that can have a one year - that effect can persist for a full year after a subscription locks in. So I just want to - we do expect tough comparisons for the balance of the year on that transactional revenue side."
},
{
"speaker": "Operator",
"content": "The next question comes from the line of Toni Kaplan, Morgan Stanley. Please go ahead."
},
{
"speaker": "Toni Kaplan",
"content": "Thanks so much. And I sort of wanted to continue on this conversion topic. So I guess over the years, there have been some times that I can remember moving some revenue streams to subscription from transaction. And over time, I think that, that makes a lot of sense. In the near term, it creates a little bit of noise. And so I know you said you expect this to continue. But are there other products that you can think of within the portfolio that you will also pursue this conversion for as well? Like should we expect this to every so often come up as a theme that maybe the growth is a little bit lower in quarter, but for the long term, we're thinking of moving stuff to subscription? Are there other products that could fall into that as well? Thanks."
},
{
"speaker": "Elizabeth Mann",
"content": "Yes. Thanks for the question, Toni. You're right that we have previously talked about this in the context of our Claims Essential bundle, where there was a targeted effort for a certain customer segment. I would say as you hear us talk now more broadly across the business, we are seeing it in a number of different businesses where customers are on a pilot and choose to lock that in for a longer-term subscription or they have a subscription with overage tiers. And as their business grows, they lock into a higher subscription so that they have more visibility into their own price point. So those are trends that we will continue to see across the business. Over time, you've still seen that subscription-transactional mix of our revenues be fairly steady at 80-20-ish. And probably as some of our transactional customers convert into subscription, at the same time, we will have new and introductory products or new markets that we're entering where it's more common to enter it in a transactional basis. So we will continue to top up, I think, that transactional revenue base as well."
},
{
"speaker": "Operator",
"content": "The next question comes from the line of Ashish Sabadra from RBC Capital Markets. Please go ahead."
},
{
"speaker": "Ashish Sabadra",
"content": "Thanks for taking my question. Last quarter, there was also a reference to a double-digit growth within life insurance solutions and benefited the transactional revenue growth. I was wondering if you could highlight what is going on with the life insurance solution, both on the subscription but also transactional side? Thanks."
},
{
"speaker": "Lee Shavel",
"content": "Yes. Thank you for the question, Ashish. We do not break out for individual businesses that the transactional versus subscription. There are transactional elements for the development opportunities that we have within life. As I indicated earlier in response to Manav's question, that's a business that continues to contribute and add to our growth rate, generally falling into that higher - the double-digit rate that we have for many of our higher-growth businesses."
},
{
"speaker": "Operator",
"content": "The next question comes from the line of Andrew Steinerman from JPMorgan. Please go ahead."
},
{
"speaker": "Andrew Steinerman",
"content": "Sure. Hi. It's Andrew. Could you quantify if you're willing to how Verisk's auto insurance revenue growth did in the second quarter? And specifically, when thinking about data providers into that end market, does Verisk believe that's gaining, losing or maintaining share currently for auto insurance?"
},
{
"speaker": "Elizabeth Mann",
"content": "Yes. Thanks, Andrew. Our auto insurance related - the shopping-related revenue did continue to grow in this quarter. But the year-over-year comp, it means that it's growing off a much higher level. So there's deceleration there. From a market share standpoint, we believe we're generally steady in the market."
},
{
"speaker": "Andrew Steinerman",
"content": "Okay. Thank you."
},
{
"speaker": "Operator",
"content": "The next question comes from the line of Gregory Peters from Raymond James. Please go ahead."
},
{
"speaker": "Gregory Peters",
"content": "Good morning, everyone. I'm going to pivot back to your comments, Lee, about strengthening relationships among your customer set. I have no doubt that your focus has really helped with your larger accounts. Maybe you could spend a minute and provide us an update on how you're progressing with your smaller accounts and also speak to potential disintermediation risk that might exist inside the smaller customer set?"
},
{
"speaker": "Lee Shavel",
"content": "Great. Thank you very much for the question. And I appreciate we have a broad range of clients. Naturally, our largest clients receive a lot of focus because their sophistication, their specific needs. But to your point, we want to make certain that we are delivering value for the entire insurance ecosystem. One thing that I would say kind of specific to the small and the midsized clients is that proportionately, they receive a greater value from the scale that we are able to deliver to them, both from an operational standpoint and from the value of data that we provide to them because often they have a lower share of access to overall loss costs or general information. I think they benefit more from the scale competitiveness that we provide them in a variety of claim solutions. And we have not seen any evidence of higher levels of attrition or disintermediation of that range of clients within our business. And that is something that we've watched and we've asked the question around. I think one - or two points that I would make supplementally is that a lot of our clients, while they are interested in new ideas, the risk of taking on a new, small, private technology vendor is something that they think about very carefully because they have to know that some - a firm that they can rely on over the long term. This is clearly an advantage for us because of our stability, our reliability. And to that end, we have also been working, as we've talked about, kind of most significantly in the claims area of finding ways to deliver some of those new technology providers by integrating them into our systems and platforms so that our clients can receive the benefit of that, but also in - with greater confidence that we have vetted and are supporting and integrating those products into our overall systems. So I really appreciate the perspective. It's not something that we have observed in terms of the behavior of our clients. Obviously, I think a much bigger impact is occasionally, our clients decide to leave a line of business or leave a state. That will have more influence, and we haven't seen any pattern of clients in the smaller, the midsized that have been leaving to another technology provider."
},
{
"speaker": "Operator",
"content": "The next question comes from the line of Alex Kramm from UBS Financial. Please go ahead."
},
{
"speaker": "Alex Kramm",
"content": "Yes. Hello, everyone. Apologies in advance to harp on the whole subs versus transaction one more time, but clearly, it matters to people and also for the quarter in particular. So maybe you can just help us talk about the impact of the transition in this specific quarter. I know, Lee, you gave the two-year stack. And if you're not willing to be so specific for this year, I look at what you said 8% over two years, I think the average of the reported numbers were 8.7. So is it fair that maybe that added 70 bps this quarter and maybe the core growth was more in mid-7s? Any help would be helpful since people are clearly asking."
},
{
"speaker": "Lee Shavel",
"content": "Yes. And Alex, I am - we're trying to relate the 8.7 that you have and the 8% was looking at our total revenue, not a subscription versus transaction. So just kind of taking into account the - or trying to eliminate the impact of that that migration between subs and trans, I wanted to point out our overall revenue growth over that two-year period at 8% was still at the high end of that range. The thing that I would say further is that there was a specific significant contract that has a function of the renewal of that contract. And some of the regulatory aspects of how that needed to be approved had to be characterized as transactional in the prior year and was a subscription is now on the subscription side. So that is an element. We're not going to quantify that within it. But I would characterize that as a kind of a specific situation that added to the weakness in the subscription growth. And beyond that, we have other - I'm sorry, the weakness in the transactional growth there. So this was last year revenue from a contractual standpoint was transactional. And now that, that contract has been confirmed and executed is now subscription. So that is an element. In addition to what I think, you can look at those historical transactional growth rates in the second quarter of 2023 and see a normalization more to that longer-term growth rate. So those are the elements. We don't think it makes sense to break all of those pieces apart. But hopefully, it's clear enough that that you had some seasonal highs or cyclical highs in prior year quarter plus some structural elements that were contributing to an exceptional tough comparison on the transactional revenue growth."
},
{
"speaker": "Operator",
"content": "The next question comes from the line of Jeff Meuler from Baird. Please go ahead."
},
{
"speaker": "Jeff Meuler",
"content": "Yes. Thank you. Good morning. My question is on underwriting, or I guess, Slide 8. I'm having trouble connecting the descriptors under business highlights with the line chart showing deceleration. I guess it sounds like core growth is good. Life and SBS remain accretive. And two of the three bullets that you're talking about for transactional headwinds fall into claims. And I think marketing has been weak for a while. So what are the primary factors driving the OCC deceleration in underwriting just beyond the slowdown in auto rate shopping? Thank you."
},
{
"speaker": "Elizabeth Mann",
"content": "Yes. Jeff thanks for the question. To map it in underwriting solutions, that first descriptor, you've got the underwriting data analytics solutions. That is where the auto insurance shopping activity sits. So that's an element."
},
{
"speaker": "Operator",
"content": "The next question comes from the line of Kelsey Zhu from Autonomous Research. Please go ahead."
},
{
"speaker": "Kelsey Zhu",
"content": "Hi. Good morning. Thanks for taking my question. So there's been a lot of discussion around where we are in the cycle for the insurance industry and whether we'll see pricing kind of peaking in 2025. Since 20% to 25% of Verisk revenue comes from contracts that have premium growth as a direct input in price increases but also with a two-year lag, does this basically insulates there into 2027 if 2025 was kind of the pricing peak for insurance companies. Or how should we think about the cyclical dynamics here?"
},
{
"speaker": "Elizabeth Mann",
"content": "Yes. Kelsey, thanks for the question, and welcome to the call. On the question of the insurance cycle, look, we've talked over time about being in a hard market broadly in the property and casualty industry. That's hitting different segments, certainly at different times. But we know it's not going to last forever. So it's a when, not an if that hard market begins to peak and becomes more competitive. I think one of the strengths of Verisk, you have seen us continue to grow historically through both hard markets and softer markets in the insurance cycle. I would not go so far as to say we are insulated. I think the pressure remains on us to continue to deliver value to our clients through all the innovations and product strength that we've talked about on the call. So I think if we continue do that, we will continue to deliver value to our customers and continue to grow revenue throughout the cycle."
},
{
"speaker": "Operator",
"content": "The next question comes from the line of Jeff Silber from BMO Capital Markets. Please go ahead."
},
{
"speaker": "Jeff Silber",
"content": "Thanks so much. My question is about your outlook. I know you don't give quarterly guidance, but you had some pretty good quarters in the first half of this year from a bottom line perspective. By maintaining your guidance, it implies a pretty slow down in adjusted EPS growth in the back half of the year. I know you called out accelerated hiring. Is there anything going on maybe from a timing perspective, but if you can provide a little bit more insight that would be appreciated. Thanks."
},
{
"speaker": "Elizabeth Mann",
"content": "Yes. Thanks for the question, Jeff. A couple of things. We have historically talked about some of the seasonality in our margin. Any quarter's margin can vary based on revenue mix as well as just the timing of spending. And we've signaled - we’ve commented that we intend to invest in the business. So that our margin guidance gives you and our EBITDA guidance gives you a good feeling of where we expect to end up on an EBITDA basis. If you look at the EPS rate, in addition, there's the tax rate where we've had certain benefits in the first half of the year that we don't expect to continue in the second half of the year."
},
{
"speaker": "Operator",
"content": "The next question comes from the line of Heather Balsky from Bank of America. Please go ahead."
},
{
"speaker": "Heather Balsky",
"content": "Hi. Good morning. I just wanted to piggyback on Kelsey's question earlier on pricing and just ask, your net written premiums as we go into next year, I guess, the 2023 net written premiums were quite strong. It sounds like you're seeing very good value realization in terms of pricing from what you're doing in Core Lines. As we think about your 3% to 4% pricing target that you said at your Investor Day, do you think you're positioned to be at the higher end of that or even above based on what you're seeing? And how should we think about pricing in the near term? Thank you."
},
{
"speaker": "Lee Shavel",
"content": "Yes. Thank you, Heather. I appreciate the question. One, I'm not going to go beyond the guidance the guidance questions or the guidance statement that we've made, just remaining confident in that we've provided. I do want to try address the pricing aspect a little further. And as I mentioned in my earlier comments, the fundamental dynamic almost regardless of the premium growth, which does, I think, influence it, in some cases, directly to a modest impact but also from a psychological standpoint, it's helpful. But even with those two, if we aren't providing value to our clients and they don't perceive that value then that's where we are going to run into challenges in improving pricing and driving the revenue. That's why the value of the investments that we have made in our Core Lines business and with our reimagine initiative, while one example of how we are driving value is what's critical - is the most critical factor in what sustains our revenue growth. And that's where we continue to get very strong feedback for how we are helping our clients improve the value of what they're doing. And I'd like to ask Saurabh Khemka, who leads that business and initiative to share a little bit about what we are hearing from clients and how they perceive the value of the investments that we have made. And hopefully, that will provide more context for how we've been able to overachieve on those - on that renewal pricing."
},
{
"speaker": "Saurabh Khemka",
"content": "Absolutely. Thanks, Lee. Yes, if you look on the Core Lines Reimagine side, our engagement with our customers has really demonstrated the value of our content, and the upcoming innovations that we have is delivering additional value for them. So for example, the feedback has been very encouraging across the spectrum of our customers, large and small. They are seeing additional value in the new insights like the Experience Index, the executive insights as well as the new technology innovations that we have on delivery of our content, which is creating efficiencies for them. And so what we are hearing from our customers is these new insights is helping them be better in terms of reacting to market conditions, and these new efficiency tools are helping them to be more efficient in their operations. So it's been very good. I would also say that we've been flexible in terms of how we deliver our content. So some of our smaller customers like the packaged insights and the turnkey solutions. And our larger customers prefer some of the access to underlying components to our analytics so that they can create more differentiation. And so by being flexible, we're benefiting all our customers."
},
{
"speaker": "Lee Shavel",
"content": "And Heather, to give you two specific examples, one product innovation has been the update to our Mozart product, which allows our clients to manage their policy forms much more efficiently because they have thousands of forms based upon product line and state and different product areas. It is a very time-consuming, laborious process to keep those updated, particularly if the reference are ISO policy forms. And so the investment that we've made is effectively in a document management platform that allows them to do that much more easily and more quickly. That's one dimension where they clearly see significant value increase. Another as we've talked about is on the Experience Index. This is where they have asked us to move further beyond those traditional loss costs that we provide to them in the underwriting process and give them a more current read on what's happening, what we see evolving. And so we are able to provide them more actionable information on a more timely basis. That provides value to them on the underwriting side, just to kind of tie that down to some specific products that we've been investing in."
},
{
"speaker": "Operator",
"content": "The next question comes from the line of Russell Quelch from Redburn Atlantic. Please go ahead."
},
{
"speaker": "Russell Quelch",
"content": "Yes. Hi. Thanks for taking my question. You made a point in the pre-remarks about putting out the fact that you're at the bottom end of the target leverage range. I'm keen to hear your thoughts on future capital deployment and potential use of that debt capacity. I'm wondering if you might look to inorganic growth again soon. We've, obviously, had a period where you haven't been that active, particularly if rates come down. And if you do, maybe could you talk to what areas you might target for inorganic growth, particularly wondering if there's more you could do, for example, in the life space, that would be great? Thanks."
},
{
"speaker": "Elizabeth Mann",
"content": "Yes. Thanks for the question, Russell. So yes, as we look at our target leverage range and where we are relative to the two to three times, we go back to our capital allocation philosophy. We are willing to deploy to support the business. We do remain active in M&A markets and looking at what is available. We tend to focus on businesses that are unique in their markets that serve our insurance end market, but for which Verisk has a unique reason to be the right owner of that business. And so those can be data opportunities that we can add to our existing services. They can be customer opportunities or geographic or market expansion."
},
{
"speaker": "Operator",
"content": "The next question comes from the line of George Tong from Goldman Sachs. Please go ahead."
},
{
"speaker": "George Tong",
"content": "Hi. Thanks. Good morning. Going back to transactional revenue performance, the 3% decline you saw in quarter, were there any unusual headwinds you would call out that may not persist? Just trying to understand the overall trend since if you look at the quarterly cadence, the swing from plus three in 1Q to down three in 2Q was quite significant and want to understand if that trajectory should be carried forward into future quarters or if the 2Q decline is a reasonable rate to persist into 3Q, which also represents a tough comp if you look at the year-ago period."
},
{
"speaker": "Elizabeth Mann",
"content": "Yes. Thanks for the question, George. So yes, we always highlight that our transactional revenue does have some variability to it. One important thing that I will point to, of course, from a growth perspective, we always look year-over-year, but it is interesting also to look on a sequential basis this quarter relative to the first quarter. Our total revenues grew relative to the first quarter. And in fact, our transactional revenues also grew relative to the first quarter. So it's just the year-over-year that has that pattern. Now there's some seasonality and things that hit the second quarter typically and that we're particularly strong in the second quarter of last year. And the ones that we called out were the weather impact, which was historically strong in the second quarter of last year, the auto shopping activity for which we've anniversaried that tough comp, and then the transition of transactional revenues to subscription."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] The next question comes from the line of Alex Kramm from UBS Financial. Please go ahead."
},
{
"speaker": "Alex Kramm",
"content": "Hi, thank you for the follow-up. Just quickly, and you mentioned, Lee, the Experience Index here just a couple of questions ago. But as an outsider to the industry, I can certainly see the applicability here pretty strongly. So I know it's early days, and it's good to see this finally being launched. But can you just maybe talk about the reception you've seen with that? Because again, it seems like a lot of customers should kind of move to a more real-time index. And if so, is this definitely a new revenue opportunity? Or do you think it's going to get kind of included in upgrades? Thank you."
},
{
"speaker": "Lee Shavel",
"content": "Alex, thanks for the follow-up. I'm going to actually ask Saurabh talk about that - addressing your question."
},
{
"speaker": "Saurabh Khemka",
"content": "Yes, absolutely, Alex. So the feedback has been very positive. First of all, as you noted, getting more frequent data and more current data is always helpful to our customers. And this is a tool that helps them very easily benchmark their experience versus the industry. And it becomes an additional input into their own internal decision-making and priorities. So what we're hearing from customers is this is a very good innovation. We've launched it for the homeowners' line of business. And the most frequent comment I hear is, when are you going to launch the other lines of business? So, we're excited about it, and we're going to continue launching other lines of business. And as we get feedback from customers, adding more elements to the Experience Index."
},
{
"speaker": "Lee Shavel",
"content": "And I think regardless of whether it's priced separately or it's part of the broader element, this is an example of where we expect to capture value from that greater - the greater currency, I mean, kind of recency of that data. I want to take that, Alex, just given the question and kind of broaden it. We recently did a Voice of the Customer exercise and isolated 3 primary asks that we have had from our clients. The first of which the Experience Index addresses is that they wanted more - they wanted to see greater investment in data, both broadening the data set that we have and the currency of the data sets that we have. So this is an opportunity to improve the currency and the actionability of that data set. Now the other thing that's important is that the client is also asking for more data, which means that there's an implicit desire on their part to give us more data so that we can expand and develop it. So that in and of itself creates more value for us. And we've seen a variety of initiatives and appetite from the clients in the excess and surplus area, which for insurance industry analysts will recognize has been a growing area of the - of industry underwriting. The second theme that we heard was more insights. And we talked about the emerging issues, providing greater insights from the data on what trends are that are taking place. And so that has been a key enhancement. And then the final theme that we heard from clients is connecting the ecosystem. They want us to be that that central provider building network aspect so as to improve the efficiency that the overall system and their ease of operating within that. So all of these elements I share because their reflection is not entirely of us saying, this is what the industry needs, but what we are hearing from clients that they expect from us given our role, given our centrality and the data sets that we have."
},
{
"speaker": "Operator",
"content": "Ladies and gentlemen, this concludes our Q&A session and today's conference call. Thank you for your participation. You may now disconnect."
}
] |
vrsk | 2,024 | 1 | [
{
"speaker": "Operator",
"content": "Good day, everyone, and welcome to the Verisk First Quarter 2024 Earnings Results Conference Call. This call is being recorded. [Operator Instructions]"
},
{
"speaker": "",
"content": "For opening remarks and introductions, I would like to turn the call over to Verisk Head of Investor Relations, Ms. Stacey Brodbar. Ms. Brodbar, please go ahead."
},
{
"speaker": "Stacey Brodbar",
"content": "Thank you, operator, and good day, everyone. We appreciate you joining us today for a discussion of our first quarter 2024 financial results. On the call today are Lee Shavel, Verisk President and Chief Executive Officer; and Elizabeth Mann, Chief Financial Officer."
},
{
"speaker": "",
"content": "The earnings release referenced on this call as well as our traditional quarterly earnings presentation and the associated 10-Q can be found in the Investors section of our website, verisk.com. The earnings release has also been attached to an 8-K that we have furnished to the SEC. A replay of this call will be available for 30 days on our website and by dial-in."
},
{
"speaker": "",
"content": "As set forth in more detail in today's earnings release, I will remind everyone, today's call may include forward-looking statements about Verisk's future performance, including those related to our financial guidance. Actual performance could differ materially from what is suggested by our comments today. Information about the factors that could affect future performance is contained in our recent SEC filings."
},
{
"speaker": "",
"content": "A reconciliation of reported and historic non-GAAP financial measures discussed on this call is provided in our 8-K and today's earnings presentation posted on the Investors section of our website, verisk.com. However, we are not able to provide a reconciliation of projected adjusted EBITDA and adjusted EBITDA margin to the most directly comparable expected GAAP result because of the unreasonable effort and high unpredictability of estimating certain items that are excluded from projected non-GAAP adjusted EBITDA and adjusted EBITDA margin including, for example, tax consequences, acquisition-related costs, gain/loss from dispositions and other nonrecurring expenses, the effect of which may be significant."
},
{
"speaker": "",
"content": "And now, I'd like to turn the call over to Lee Shavel."
},
{
"speaker": "Lee Shavel",
"content": "Thanks, Stacey. Good morning, and thank you for participating in this morning's call."
},
{
"speaker": "",
"content": "2024 is off to a solid start at Verisk as we are building upon the strong performance we delivered in 2023. Elizabeth will provide the detailed financials, but I am pleased to share that we delivered 6.9% organic constant currency revenue growth with strong underlying subscription growth of 7.8% that was broad-based across most of our businesses."
},
{
"speaker": "",
"content": "Our focus on cost discipline and operating efficiency produced strong double-digit organic constant currency adjusted EBITDA growth and healthy margin expansion, translating into 26% adjusted EPS growth."
},
{
"speaker": "",
"content": "This quarter's performance was in line with our 2024 guidance. We are driving predictable and consistent growth by harnessing the power of our more integrated insurance-focused company and executing against our strategy to partner with the insurance ecosystem to help all participants address their most pressing challenges."
},
{
"speaker": "Our execution priorities are unchanged from those that we communicated to you a year ago at Investor Day. We are building on the progress that we made in 2023 as we continue to focus on three key things",
"content": "one, delivering consistent and predictable revenue growth; two, driving operating efficiency and profitability; and three, allocating our strong free cash flow with discipline and a focus on return on investment."
},
{
"speaker": "",
"content": "I've spoken on this call many times about our efforts to engage with our clients on a more strategic level. To that end, in April, we hosted the Verisk Insurance Conference, or VIC as it is affectionately known in the industry, which attracted a record number of attendees from across the global insurance ecosystem, including representatives from the carriers, reinsurers, regulators and our channel partners."
},
{
"speaker": "",
"content": "VIC is our flagship event where we strategically engage with all our ecosystem clients and partners through joint discussions and presentations as an integrated One Verisk."
},
{
"speaker": "",
"content": "This year's event featured over 70 different educational sessions and panel discussions on some of the industry's top-of-mind issues, including fairness, generative AI, fraud, climate risk, rate adequacy and social inflation."
},
{
"speaker": "",
"content": "One of the best attended sessions was a panel discussion about Florida property insurance and featured representatives from key market players, including the carriers, regulators, legislators and Verisk. The discussion focused on lessons learned from the insurance crisis in this important and high-risk market and what other states can learn from this experience."
},
{
"speaker": "",
"content": "The event also featured a solutions gallery that showcased many of our offerings, covering risk, natural perils, commercial property, home and auto as well as several of our key technology ecosystem partners. The event has generated strong collaboration ideas with our clients and partners as well as leads for our sales teams."
},
{
"speaker": "",
"content": "It also builds upon the goal that we set last year to elevate the strategic dialogue with our clients and continue our path to serve as a data and technology partner to the global insurance ecosystem."
},
{
"speaker": "",
"content": "During the Verisk Insurance Conference, our Extreme Events division unveiled its latest innovation, Next Generation Models or NGM, for insurers, brokers and reinsurers. Verisk is the first firm to release its full suite of over 100 models across all perils and geographies to a next-generation financial modeling framework. And these models are all now accessible via our Touchstone platform."
},
{
"speaker": "",
"content": "As the rising cost of catastrophes and an increase in losses from frequency-driven perils such as severe convective storms has challenged the industry, Next Generation Models provide a better quantification of uncertainty and enhanced capabilities to assess insured losses across the insurance industry more accurately."
},
{
"speaker": "",
"content": "With next-generation models, our clients can make better financial assessments of loss potential and more accurately represent the risk to their policyholders, their businesses and their partners. NGM also offers new advantages to support complex insurance policy structures and deal with new terms and conditions that previously went unmodeled. Clients can effectively manage risk, both at the portfolio and individual levels using the NGM suite of models."
},
{
"speaker": "",
"content": "NGM represents the next step in our journey towards a fully SaaS native platform, underscoring our commitment to continuous investment in advanced data and technologies and capabilities on behalf of the industry."
},
{
"speaker": "",
"content": "Next, I'd like to provide you with an update on our Core Lines Reimagine program. As previously mentioned, we are on a journey to digitize and enhance our essential suite of industry standard solutions to make our forms, rules and loss cost content easier to access, use and customize and provide much needed updates and insights. We have made good progress in modernizing our internal systems and processes for digital-first content creation, enabling us to deliver new client-facing modules."
},
{
"speaker": "",
"content": "We recently introduced Filing Intelligence, which is accessible on our new platform. This tool simplifies our filings delivery process by consolidating all necessary documents, forms, rules and loss costs into one accessible interface, eliminating the need for manual review and piecing together multiple documents. Filing Intelligence digitally connects all documents related to each filing, streamlining the process for users and ensuring seamless access to essential information."
},
{
"speaker": "",
"content": "On the actuarial front, we recently added Actuarial Hub to the new platform. Within the hub, clients can access new insights such as the ISO Experience Index, the loss cost activity dashboard and a new series of actuarial prospective articles. These resources offer deeper insights into our filings and data, empowering our clients to make quicker, well-informed decisions."
},
{
"speaker": "",
"content": "Looking ahead, we plan to launch additional customer-facing modules that will provide even more value to our clients by introducing new proprietary analytics, workflow tools and insights to further streamline processes and enhance underwriting accuracy for our clients."
},
{
"speaker": "",
"content": "Overall, we're excited about the progress of the Reimagine program. This initiative is already driving returns for Verisk as we are receiving positive client feedback and experiencing better price realization in contract renewals."
},
{
"speaker": "",
"content": "Lastly, today is an important day as May 1 is officially Verisk Generative AI day. Our technology teams from across our global offices and business units are gathered at our Jersey City headquarters to collaborate and share best practices and learnings on their work with GenAI for both customer-facing initiatives and internal efficiencies."
},
{
"speaker": "",
"content": "More specifically, all of our divisions have active GenAI pilots running with many other areas in active development. And within our claims business, we have three solutions in production and available today for clients."
},
{
"speaker": "",
"content": "Generative AI continues to be top of mind for our clients and is a topic of much discussion in my conversations with industry executives. One very promising application that I'm seeing is the use of generative AI to gather and predigest massive amounts of information to organize and distill it for the insurance professional, improving and focusing their expertise, not replacing it."
},
{
"speaker": "",
"content": "This is a natural fit and opportunity for the work we do in curating and managing the needs of the global insurance industry to facilitate more effective and efficient workflows. As we have done with other forms of advanced technology, GenAI is an area where we can invest for the benefit of the industry at a lower cost of investment in ownership than any single client can do on their own."
},
{
"speaker": "",
"content": "With that, I will turn it over to Elizabeth to cover the detailed financial review."
},
{
"speaker": "Elizabeth Mann",
"content": "Thanks, Lee, and good day to everyone on the call."
},
{
"speaker": "",
"content": "I am pleased to share that Verisk delivered a solid first quarter of 2024. On a consolidated and GAAP basis, first quarter revenue was $704 million, up 8% versus the prior year, reflecting solid growth in underwriting and more modest growth in claims."
},
{
"speaker": "",
"content": "Income from continuing operations was $219 million, up 12.9% versus the prior year, while diluted GAAP earnings per share from continuing operations were $1.52, up 19.7% versus the prior year. This level of EPS growth reflects strong revenue and profit growth, combined with a lower effective tax rate and a lower average share count due to the large accelerated share repurchase program in 2023."
},
{
"speaker": "",
"content": "Moving to our organic constant currency results for the first quarter. Adjusted for nonoperating items, as defined in the non-GAAP financial measures section of our press release, our operating results demonstrated solid growth for most of our businesses. OCC revenues grew 6.9% with growth of 7.8% in underwriting and 4.7% in claims. This was an acceleration from the fourth quarter in both subsegments and was in line with our expectations and 2024 financial guidance."
},
{
"speaker": "",
"content": "Our subscription revenues, which comprised 80% of our total revenue in the quarter, grew 7.8% on an OCC basis during the first quarter. We experienced broad-based growth across most of our subscription-based solutions, with strong renewals and expanded relationships with existing customers and solid sales of new solutions."
},
{
"speaker": "",
"content": "The largest contributor to subscription growth was forms, rules and loss costs. We are benefiting from a stronger renewal cycle and improved price realization as we continue to modernize our platform and deliver more value and insights to our clients through our Core Lines Reimagine program that Lee spoke about earlier."
},
{
"speaker": "",
"content": "In anti-fraud, we experienced underlying strength in the business with growth augmented by the continued benefit from the conversion to subscription from previously transactional customers that we mentioned throughout 2023. Most of our clients have successfully completed this transition. Therefore, the benefit will continue to taper throughout 2024."
},
{
"speaker": "",
"content": "And within underwriting data solutions, we are seeing a positive client response to our enhanced commercial lines property solutions, which have benefited from our expanded coverage as our database of commercial property records has grown by over 200% since 2020 and now has over 15.9 million records."
},
{
"speaker": "",
"content": "Our transactional revenues, representing 20% of total revenue in the first quarter, increased 3.1% on an OCC basis, reflecting a tough comparison versus the prior year which benefited from the strong auto shopping activity and nonreaction activity. During the quarter, we saw continued growth across our auto suite of solutions, though growth rates have moderated as we expected."
},
{
"speaker": "",
"content": "Regarding auto, due to recent changes in our data source, we have decided to discontinue our existing telematics offering. The impact of this is immaterial in 2024 with less than $1 million of revenue impact. We do not expect this to have any impact on the remainder of our auto solutions."
},
{
"speaker": "",
"content": "Our transactional revenue growth also benefited from double-digit growth within life insurance solutions as we saw strong customer demand for incremental services."
},
{
"speaker": "",
"content": "And within our extreme events business, we saw better-than-expected transactional growth driven by securitization. This was offset in part by lower weather-related transaction volumes in property estimating solutions and the impact of the conversion to subscription within our anti-fraud business."
},
{
"speaker": "",
"content": "Moving now to our adjusted EBITDA results. OCC adjusted EBITDA growth was 10.6% in the quarter, while total adjusted EBIT margin, which includes both organic and inorganic results, was 54%, up 180 basis points from the reported results in the prior year."
},
{
"speaker": "",
"content": "As we've said in the past, the margin rate in any given quarter can be influenced by revenue mix and timing of spending, so we think it's useful to look at our margin on a trailing 12-month basis which, as of March 31, 2024, was 53.9%, up 120 basis points over last year's level. This level of margin expansion reflects the positive impact of sales leverage and cost discipline."
},
{
"speaker": "",
"content": "We also experienced a modest margin benefit from nonoperating items, including foreign currency changes, but this was largely offset by margin impact from recent acquisitions. Our current margin rate also reflects continued organic investment for future growth, including our Reimagine program, the replatforming of key solutions in extreme events and property estimating solutions, our new financial and human capital systems as well as exploration of advanced technologies like GenAI. We remain confident in our ability to meet our margin expansion targets, while strategically investing in future growth opportunities."
},
{
"speaker": "",
"content": "Continuing down the income statement. Net interest expense was $29 million for the first quarter compared to $26 million in the prior year. The current level of net interest expense reflects interest income on lower cash balances than 1 year previously."
},
{
"speaker": "",
"content": "Our reported effective tax rate was 20.3% compared to 27.1% in the prior year quarter. The year-over-year decrease in the tax rate is primarily due to tax charges incurred in structuring the sale of our energy business last year as well as certain discrete items that we do not expect to repeat in the remaining quarters of the year."
},
{
"speaker": "",
"content": "We continue to believe that our tax rate for the full year 2024 will be in the 23% to 25% range, so there could be some quarterly variability related to employee stock option exercise activity."
},
{
"speaker": "",
"content": "Adjusted net income increased 19% to $234 million, and diluted adjusted EPS increased 26% to $1.63 for the quarter. The increase is primarily driven by solid revenue growth, strong margin expansion, a lower effective tax rate and a lower average share count."
},
{
"speaker": "",
"content": "Our lower average share count reflects the impact of the large accelerated share repurchase program we completed in 2023 using the proceeds from the divestitures. This was partially offset by higher depreciation and amortization and higher net interest expense."
},
{
"speaker": "",
"content": "From a cash flow perspective, on a reported basis, net cash from operating activities increased 1.9% to $372 million, while free cash flow increased 4.2% to $317 million. Both cash flow metrics reflect the impact of our indemnification obligation related to our former financial services business, which we accrued for in 2023."
},
{
"speaker": "",
"content": "It is also important to note that the prior year cash flow figures still include the results of our previously divested energy business. So these growth figures understate the cash flow growth of our insurance-only business."
},
{
"speaker": "",
"content": "We are committed to returning capital to shareholders. During the first quarter, we initiated a $200 million accelerated share repurchase program, which was completed in April. Our $0.39 per share dividend was up 15% from the prior year. We continue to have $1.4 billion in capacity remaining under our repurchase authorization."
},
{
"speaker": "",
"content": "We are pleased with our results for the first quarter and reiterate our outlook for 2024. More specifically, we continue to expect consolidated revenue for 2024 to be in the range of $2.84 billion to $2.9 billion."
},
{
"speaker": "",
"content": "We expect adjusted EBITDA to be in the range of $1.54 billion to $1.6 billion and adjusted EBITDA margin in the 54% to 55% range. We expect our tax rate to be in the range of 23% to 25% and adjusted earnings in the range of $6.30 to $6.60 per share."
},
{
"speaker": "",
"content": "A complete listing of all guidance measures can be found in the earnings slide deck, which has been posted to the Investors section of our website, verisk.com."
},
{
"speaker": "",
"content": "And now, I will turn the call back over to Lee for some closing comments."
},
{
"speaker": "Lee Shavel",
"content": "Thanks, Elizabeth."
},
{
"speaker": "",
"content": "In summary, our execution priorities remain consistent with those communicated at Investor Day, continued focus on revenue growth, operating efficiency and disciplined cash flow allocation. Following a strong 2023, we are pleased to see 2024 off to a strong start with implied growth of 7% in consolidated revenue and 9.5% in adjusted EBITDA, at the midpoint of our 2024 financial guidance."
},
{
"speaker": "",
"content": "Our focus on heightened strategic engagement with clients has strengthened relationships and fostered new product and business opportunities for the industry where we can invest at scale to drive value for our clients, employees and shareholders."
},
{
"speaker": "",
"content": "We continue to appreciate the support and interest in Verisk. Given the large number of analysts we have covering us, we ask that you limit yourself to one question."
},
{
"speaker": "",
"content": "With that, I'll ask the operator to open the line for questions."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Your first question comes from the line of Andrew Steinerman with JPMorgan."
},
{
"speaker": "Andrew Steinerman",
"content": "How would you assess the health of your clients, meaning the P&C insurance industry now versus 3 or really kind of 6 months ago and how might that impact Verisk this year?"
},
{
"speaker": "Lee Shavel",
"content": "Thank you, Andrew. I've assessed the strength of our client as being very solid. And I would say in contrast to, I think, where we were 2 or 3 years ago, you are clearly seeing -- across the industry, and if you follow the quarterly releases of the property and casualty insurers, you are seeing very strong premium growth, which is a reflection of that hard market and the improving profitability as reflected in stronger combined ratios for the business."
},
{
"speaker": "",
"content": "And so I think the combination of that growth, the improved profitability, some reserve strengthening now beginning to offset some of the heightened cat losses that they've experienced has generally put them in a position where they are feeling positive about the outlook, the -- their ability to achieve better pricing and price adequacy from their standpoint on rate."
},
{
"speaker": "",
"content": "There clearly are risks that they continue to face in terms of heightened catastrophic losses or cyber exposure or exposure to increasing casualty losses. But generally, their financial position is stronger and that has, one, both a benefit for us because we do participate to some extent in their overall premium growth, but also, I think, importantly, is that, that financial strength is making them more constructive and engaged in where they can be making investments to improve their business, whether it's on the underwriting side or it's on the efficiency and processing front."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Jeff Meuler with Baird."
},
{
"speaker": "Jeffrey Meuler",
"content": "Yes. So Lee, that all sounds like the industry is going to start to lean in more on marketing, and it seems like we've seen some signs that marketing spend is positively inflecting following a challenging period."
},
{
"speaker": "",
"content": "But you continue to call out headwinds in your marketing solution revenue. So maybe talk through that and if it's just a lag effect and a pipe is building."
},
{
"speaker": "Lee Shavel",
"content": "Yes. Thank you, Jeff. I think that's an accurate observation. I think we are beginning to see some early signs that marketing is picking up. Within the industry, there is a lag impact. And so we will continue to look forward to hopefully seeing some of that translate into our business. That is a small business, so it may not be discernible overall within our business. But we do think that's a positive trend."
},
{
"speaker": "",
"content": "I would also note that within that business, it is not entirely insurance for us that we're providing insights to some other legacy industries. And so that may cause a differentiated output. But I think your general observation is true."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Ashish Sabadra with RBC Capital Markets."
},
{
"speaker": "Ashish Sabadra",
"content": "I wanted to focus on the solid sales of new solution. The question there was, Lee, thanks for providing some good details on the GenAI, but I was wondering if you could provide an example of new solutions that are gaining traction."
},
{
"speaker": "",
"content": "And then at the Investor Day, the new initiative was expected to generate 150 to 200 basis points of incremental revenue growth going into 2025. And I was just wondering if you could comment on how that's tracking."
},
{
"speaker": "Lee Shavel",
"content": "Thank you, Ashish. Let me take the first question since you're kind of referencing Investor Day, and I'll let Elizabeth add to this if she feels necessary. But what we outlined at Investor Day was incorporated into our guidance in terms of where we felt we could achieve incremental revenue growth."
},
{
"speaker": "",
"content": "Naturally, we saw the performance in 2023, which was a representative of the -- of achieving those higher growth rates. We're really pleased in the first quarter to be able to similarly deliver strong growth on top of that. And so we have kind of a compounding effect. And I think that reflects in large part, the achievement of some of that revenue growth upside. So I would look to the fact that we are meeting and exceeding the guidance that we set at Investor Day."
},
{
"speaker": "Elizabeth Mann",
"content": "Yes, I agree with Lee there. And I think in terms of examples of new products gaining traction, you've heard us talk about them on some of the recent calls, the Discovery Navigator product in claims, which is one that does -- now uses GenAI as well. We've talked about image forensics in the antifraud space and -- as well as a variety of innovations that we talked about in this call on our core products, including Core Lines Reimagine and the Next Generation Models in extreme events."
},
{
"speaker": "Lee Shavel",
"content": "Yes. And if I -- thanks, Elizabeth, for kicking off the first part of the question. We talked with Jeff's question on some of the headwinds we're facing on marketing, but I would also say, in terms of new product adoption in our life insurance offering, we are seeing very strong uptake in that category with the applicability of the low no-code solutions to the life business within our specialty business solutions area where we have seen very strong adoption on some -- from some major industry players onto the white space platform, which is a new product that we are growing."
},
{
"speaker": "",
"content": "And so in -- as well as internationally, as we have been bringing our products into that market, we're seeing the uptake and very strong double-digit growth across those businesses internationally."
},
{
"speaker": "",
"content": "And then finally, I would say, I think in terms of new product growth, we should never overlook the benefit or the uptake and receptivity that we are seeing to our existing product investments as with Core Lines Reimagine and other areas that we have been investing in similar to LightSpeed where we have improved those products, we have increased the value to the customer, we're integrating generative AI into a number of those products."
},
{
"speaker": "",
"content": "And in a way, that is new product adoption in terms of being able to realize incremental value in our revenues for those products. And I think that is reflected in our overall revenue growth as well here."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Andrew Nicholas with William Blair."
},
{
"speaker": "Thomas Roesch",
"content": "This is Tom Roesch on for Andrew. I wanted to ask about the pricing environment. It sounds like insurers are starting off the year on good footing. So I was wondering just kind of how the pricing environment, how you think about it this year relative to last year? And then also as it relates to those contracts that are tied to prior year net premium, just kind of how you think about those, too, this year."
},
{
"speaker": "Lee Shavel",
"content": "Sure."
},
{
"speaker": "Elizabeth Mann",
"content": "Thanks, Tom, for the question. Yes, it's good context. You heard Lee talk about the industry and the relative strength in the industry as well as the hard market that we are in. So as he highlighted for our contracts that have a tie to net written premium growth, we're seeing generally positive tailwinds in line -- I would say, in line overall with last year."
},
{
"speaker": "",
"content": "I think what's most important for us from a pricing standpoint is the increased engagement that we are having with our clients, and you're seeing the benefit of the investments that we're putting in our products and those are driving for us strong renewals, strong outcomes on the pricing conversations."
},
{
"speaker": "Lee Shavel",
"content": "Yes. And Tom, I'd say that on that, we are -- we see a receptive environment because I think the industry is doing well. We're seeing recognition of the value of the products. But I would also mention that I think with some of our efforts to improve our go-to-market strategy, we're seeing a more effective sales organization that is contributing to good outcomes on the pricing side as well."
},
{
"speaker": "",
"content": "So I think we feel very positive about some of the changes that we put in place in 2024 as a function of a close examination of what we could be doing better there."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Toni Kaplan with Morgan Stanley."
},
{
"speaker": "Toni Kaplan",
"content": "During the prepared remarks, you mentioned you're discontinuing the auto telematic offering. I was wondering, clearly, it's not generating much revenue for you, but was -- what was -- what prompted deciding to discontinue it? Was the data not valuable? Was it costly to maintain? Just any color there."
},
{
"speaker": "Lee Shavel",
"content": "Certainly. Thank you, Toni. And the short answer is, and first, it was a small financial impact for us. The simple answer is that the entities that were providing that data to us decided to discontinue collecting that data. And so there was really not sufficient analytical value in that without the data that was being provided. And I think it's fair to assume that it's a function of some of the media attention to collect connected car data. So that really was the simple reason."
},
{
"speaker": "",
"content": "It had been an area where we felt it was worth investing. We do believe in looking at broad data sets that are useful in evaluating driver risk. But I would emphasize that while we have discontinued that operation, and it was immaterial from a financial standpoint, we do continue to serve auto insurers in a significant way with a wide variety of products, including our LightSpeed auto, our coverage verifier, damage assessment from a claims perspective."
},
{
"speaker": "",
"content": "So this is a very substantial business for us, and the discontinuation of the Verisk Data Exchange will not have any impact in our legacy auto businesses."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Faiza Alwy with Deutsche Bank."
},
{
"speaker": "Faiza Alwy",
"content": "I wanted to talk about subscription growth. You mentioned the stronger renewal cycle and the price realization, but I'm curious if you held this level of subscription growth is normal for this year. And help us better understand some of the factors that can impact us."
},
{
"speaker": "",
"content": "I asked because there has been some quarterly variation here last year, so if there's anything that you would highlight as we look ahead."
},
{
"speaker": "Elizabeth Mann",
"content": "Yes. Faiza, thanks for the question. In terms of quarterly variations, there can always be minor puts and takes as things move from quarter-to-quarter, but nothing that we see at this point that would indicate significant quarterly changes."
},
{
"speaker": "",
"content": "The drivers of strength for us this quarter have been really broad-based across the business. Forms, rules and loss cost has been the largest driver as the largest business, and we talked about some of the trends benefiting it there."
},
{
"speaker": "",
"content": "We've had strong strength in the antifraud business. I would call that both absolute strength as well as benefiting from the conversion from transaction to subscription. And the extreme events business actually had strong subscription growth as well given the demonstrated value there."
},
{
"speaker": "Lee Shavel",
"content": "Yes. And Faiza, maybe to add a little additional color, and we use this as an opportunity to say we talked about the environment. We've talked about the benefit of engaging as partners with our leading clients, which I think has helped us on that front, probably most primarily at a senior level to help our clients understand the value that we are providing to them across the enterprise."
},
{
"speaker": "",
"content": "But something -- to your question of kind of sustainability and growth, we clearly want to grow the subscription revenues at a higher rate where possible. And coming out of a lot of intense engagement at a senior level in 2023, we have had three clients in different areas, one is an international insurer, one is a large U.S. insurer, one is outside of the insurer, but in a variety of areas, that have come to us with ideas of products that we might jointly develop or distribute with them. And I think it's a reflection of how we can potentially develop new incremental revenue sources."
},
{
"speaker": "",
"content": "This was certainly part of our plan originally, but we've been delighted to see that, that engagement has enabled real commercial opportunities that we are in the process of exploring and structuring at this stage. That is certainly a primary path for us to find ways to continue to sustain and grow that subscription growth."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Jeff Silber with BMO Capital Markets."
},
{
"speaker": "Jeffrey Silber",
"content": "I know you talked in the past about three, I guess, buckets of investment. You talked about the Core Lines Reimagine, investing in your sales force and investing in AI. Can we just get a refresh in terms of how much you're thinking of spending in those areas and where we are in that process?"
},
{
"speaker": "Elizabeth Mann",
"content": "Yes. Thanks for the question, Jeff. We don't break out sort of specific areas of investment by element. I think on the last quarter call, I mentioned those as some of the top areas for investment this year. And I think our investment in those areas is pretty much in line with our expectation for the year and embedded in the margin that you're seeing and the guidance for the full year."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Gregory Peters with Raymond James."
},
{
"speaker": "Charles Peters",
"content": "So I'm going to focus on the transactional revenue piece because if I look at the quarterly numbers last year, you had some pretty strong results for second and third quarter."
},
{
"speaker": "",
"content": "Given the conversion of the antifraud business, is it your expectation that the transactional piece of OCC will be having some headwinds for the next couple of quarters? Or any sort of visibility there would be helpful."
},
{
"speaker": "Elizabeth Mann",
"content": "Yes. Happy to cover that, Greg. Thanks. You are right that we do see headwinds on the transactional revenue side largely because the comps from last year have been so strong. You saw double-digit transactional growth for about a 1-year period last year."
},
{
"speaker": "",
"content": "I think some of the main areas of tough comps have been and will be on the auto transactional shopping activity, which was a real area of strength last year, in addition to the nonrate action activity. And we -- that really picked up in the first quarter of last year."
},
{
"speaker": "",
"content": "So we're starting to anniversary it now. The shopping activity did actually continue strong in the first quarter. But starting next quarter, we really anniversary strong growth there."
},
{
"speaker": "",
"content": "The other area where it could be tough comps has been on the weather activity. We called out through 2023 the elevated weather patterns that we were seeing. And so that could be a headwind this year."
},
{
"speaker": "",
"content": "Securitization activity was very strong last year in extreme events. So that's one that we are also waiting to see. So between those different areas, that's something we're looking at."
},
{
"speaker": "",
"content": "I think this quarter is a demonstration of the power of the business model and the bulk of our revenue coming in that subscription revenue, which continues to show very healthy signs of strength -- shows the strength that we can deliver, even compounding those tough comps."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Manav Patnaik with Barclays."
},
{
"speaker": "Manav Patnaik",
"content": "I guess, I'll just ask on capital allocation. It sounds like you guys are starting on the ASR, so that seems to be the priority. But maybe what is the small- to medium-sized kind of M&A pipeline looks like, some of the stuff that you've been doing over the last couple of years?"
},
{
"speaker": "Lee Shavel",
"content": "Thank you, Manav. I think I heard that. I think the focus is on capital allocation and how does the outlook for small- and medium-sized M&A opportunities. I would describe them as they are out there, that I think that valuations remain really high for those entities."
},
{
"speaker": "",
"content": "Our focus is always on how can we add value with our distribution, our data, our relationships. That has been a good equation for us. And valuations kind of continue to make that challenging for us to generate attractive returns."
},
{
"speaker": "",
"content": "But we are very engaged in that market and always looking for products that have achieved traction with the industry where we think we can accelerate the adoption and deliver value, both to our clients and to our shareholders."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Surinder Thind with Jefferies."
},
{
"speaker": "Surinder Thind",
"content": "Just a question around the internal investments. So when we think about the Core Lines Reimagine or replatforming or AI, how should we think about the absolute level of investment from the perspective of how much of this is part of a normal spend cycle? And then maybe how much is maybe a little bit elevated and perhaps how we might expect CapEx to evolve, so far, whether it's this year or the next couple of years?"
},
{
"speaker": "Elizabeth Mann",
"content": "Thanks -- yes. Thanks, Surinder. I can't break it out numerically. I would say that there are -- we've talked about the various projects that we are investing in now. Those are finite projects, which we will finish, and we've talked about the time lines for each."
},
{
"speaker": "",
"content": "There are some elements of those projects that is fixing or reinvesting in technology that has maybe been overdue. And so I would talk about our internal ERP systems as an area of that. Some of the places where we are doing tech replatforming would be those areas. And so those -- that level of investment may be elevated, and we may not need to continue going forward."
},
{
"speaker": "",
"content": "I would say there will -- we will always be investing in our products to maintain sort of their cutting-edge status. So after we finish Core Lines Reimagine, we will continue to invest and evolve in new projects that we may not know exactly what they are today."
},
{
"speaker": "Lee Shavel",
"content": "And I think what I would add to that, Surinder, is, I think, the short answer is that the ability for us to integrate generative AI technology as an expansion of a new form of artificial intelligence within the existing products is something that our businesses are effectively absorbing into their current financial models and thinking about where they're deploying capital within their own businesses."
},
{
"speaker": "",
"content": "There have been, and there may be in the future, areas where we have decided that -- or we have determined that there is a really interesting application in a new product upside that we want to invest heavily in or we want to accelerate, and that will be an opportunity for us to provide a focused amount of capital or investment."
},
{
"speaker": "",
"content": "At this stage, I think there were a couple of opportunities that we evaluated, and we determined kind of just maintaining our natural organic level of investment is the right path at this point. That may change in the future."
},
{
"speaker": "",
"content": "But I think Elizabeth's comments, I would just reinforce by saying, right now, we're finding a way to integrate this investment into the businesses and also recognizing that we are making a heightened investment on an ERP upgrade that we think will drive operating efficiencies and informational advantages for us over time."
},
{
"speaker": "",
"content": "And that will be one that, as we're going to finish that level of investment, may free up space, if there are good opportunities for us to invest. Otherwise, we'll return that capital as we always do with our discipline."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Russell Quelch with Redburn."
},
{
"speaker": "Russell Quelch",
"content": "You mentioned in the opening remarks, Lee, that you'd rolled out the next-generation nat peril model. I wondered if you could articulate what the additional upside opportunity for Verisk is there given you're already seeing strong subscription revenue growth in the extreme events business."
},
{
"speaker": "",
"content": "And I just wanted to check as well. You mentioned on pricing that you had been able to realize more pricing on renewals due to the product upgrades. Is that already -- is that as expected and therefore already factored into your guidance for '24? Or does it present a potential upside opportunity on the guidance?"
},
{
"speaker": "Lee Shavel",
"content": "Yes. Thank you, Russell. So first on the Next Generation Models, I think that this is a major upgrade in terms of the sophistication of the models, allowing our clients to better estimate and quantify the uncertainty of their losses across the industry."
},
{
"speaker": "",
"content": "And given -- you think about the Next Generation Models, it is taking a variety of the environmental, physical weather risk related and then translating into what are the real costs associated with damage, restructuring and the rest. And so we can take this and apply it to all of our perils and all of our geographies."
},
{
"speaker": "",
"content": "So it is a major enhancement to our portfolio of products, and it's also increased the sophistication of the ability to support complex insurance policy structures and deal with the new terms and conditions that weren't previously effectively captured the model."
},
{
"speaker": "",
"content": "It also is an important step for us to the SaaS model. Getting the next-generation financial model in place was critical, and what we heard from our clients is what they wanted to be addressed first. And now we can improve the functionality and the efficiency of that."
},
{
"speaker": "",
"content": "So we do think that this is a substantial opportunity for us to deliver more value to our risk modeling clients. And certainly, our expectations are reflected within our guidance in that regard. But it does, I think, open us up to continue to expand what we do for clients on that front."
},
{
"speaker": "",
"content": "With regard to your question on is the pricing upside, that is reflected within our guidance. We're pleased with the progress that we're making in the reaction to -- from our clients to the investments that we've made in a variety of our products. And that's reflected in the guidance that we have put forward."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Alex Kramm with UBS."
},
{
"speaker": "Alex Kramm",
"content": "Just maybe quickly on the international side. I think 23% growth year-over-year. I know that's not organic, but still pretty impressive. Can you just maybe give us an update where you're seeing the most growth in those businesses?"
},
{
"speaker": "",
"content": "And then maybe related to that, as historically viewed, those businesses are a disparate collection of different businesses in different regions. So curious if there's any efforts to maybe bring those businesses closer together or if you're already seeing any synergies between those businesses or if it is still just a lot of different disparate things."
},
{
"speaker": "Lee Shavel",
"content": "Thank you, Alex. It's a great question. So I think the first question relates to the overall growth. And I think when we look at the businesses on an organic basis, I think we are generally viewed, as we've spoken before, and we continue to believe that they have and will continue to drive double-digit growth within the -- within our business. And so I think that's kind of the baseline. We continue to see opportunity on that front."
},
{
"speaker": "",
"content": "Your question on the coordination, I think, is an important one. And I would say that each of those businesses are serving distinct insurance industry constituencies. And the opportunity, I think, has been less to tie all of those products together from a single client perspective, but to partner more effectively with the U.S. team to mix and the international team to make certain that we are integrating our expertise, our data, some of the investments that we've made in the U.S. to enhance and strengthen those client -- or those product sets."
},
{
"speaker": "",
"content": "And so I think we're seeing a heightened level of partnership in that regard, but not so much tying together, for instance, the claims and the underwriting businesses as well."
},
{
"speaker": "",
"content": "Another dimension, which I referenced earlier is that I think that we are seeing an opportunity to partner with institutions within Europe that see that value and through their existing distribution networks have an ability for us to deliver some of that value in partnership with other players within that market."
},
{
"speaker": "",
"content": "And so that, I think, becomes an enhancement opportunity for those products as well as some of even our U.S.-based products and technology that can be applied there."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Heather Balsky with Bank of America."
},
{
"speaker": "Heather Balsky",
"content": "I was really curious about the catastrophe bond piece of your business. There's been some really strong data out there, and it seems like there's some outlook for continuation of that. What's driving that? And can you also remind us just how you benefit from strength in that market?"
},
{
"speaker": "Elizabeth Mann",
"content": "Yes. Thanks, Heather. Yes, it is a strong market. I think it's -- what's driving it is both the need -- the increased catastrophe risk and the need for diversifying the set of investors in that space of risk. And for new investors, it's their own desire to diversify and find uncorrelated areas of investment. So that's been driving strength in that cat bond market."
},
{
"speaker": "",
"content": "How we benefit from it is our extreme event business is one of the primary providers of models and assessment of that risk, so that the investors and the issuers of those cat bonds can agree to transact on the pricing by assessing the risk."
},
{
"speaker": "Lee Shavel",
"content": "And Heather, the -- what we are seeing that is driving that is both demand from investors for noncorrelated returns and interest, particularly in this hard market from an insurance standpoint, what are perceived to be more attractive returns. We're also seeing that in terms of more capital being attracted into excess and surplus lines and reinsurance generally."
},
{
"speaker": "",
"content": "And it speaks to, I think, the ongoing development and the increasing sophistication of the portfolio -- active portfolio management of the insurance industry that is an opportunity for us given our modeling capabilities, given the loss costs and the rate modeling activities that we have. And that has been something that we have been engaged in thinking about at an enterprise level in terms of how we can support the development of that market."
},
{
"speaker": "",
"content": "One example would be there is a category of insurers that are ILS managers, insurance-linked securities managers. And those have been modeling clients of ours and also represent opportunities for us to build broader relationships and how our suite of products can serve their needs as they manage external sources of capital."
},
{
"speaker": "Operator",
"content": "[Operator Instructions] Your next question comes from the line of George Tong with Goldman Sachs."
},
{
"speaker": "Keen Fai Tong",
"content": "In the early part of last year, subscription revenue growth was in the 9% range. And over the past 2 quarters, growth was in the 7% to 8% range."
},
{
"speaker": "",
"content": "What's a reasonable and sustainable rate of growth for subscription revenue? And what are the top 1 or 2 factors that you believe will drive either acceleration or deceleration from current levels?"
},
{
"speaker": "Elizabeth Mann",
"content": "Yes. Thanks, George. We don't forecast subscription growth for you. We do -- we obviously give our medium-term target range for total revenue growth. That's 6% to 8% organic constant currency, and subscription has historically been 80% of that. So that's kind of what we can say numerally."
},
{
"speaker": "",
"content": "In terms of drivers for acceleration and deceleration, I think all of the things that we've been talking about are investment in our products, our customer engagement and our industry expertise drive strength in the subscription revenue, both from a renewal, from a new customer base and from a pricing perspective."
},
{
"speaker": "",
"content": "Headwinds can come with -- we've talked about this before, with potential attrition or industry consolidation or [indiscernible]."
},
{
"speaker": "Operator",
"content": "Your next question comes from the line of Gregory Peters with Raymond James."
},
{
"speaker": "Charles Peters",
"content": "Great. So Lee, in your comments, you talked about the hard market in non-life insurance. And one of the things that's becoming apparent is that the pricing trends are going to begin to moderate."
},
{
"speaker": "",
"content": "So building on Elizabeth's last answer, how does a market that's more normal affect subscription and transactional revenue growth as we look ahead?"
},
{
"speaker": "Lee Shavel",
"content": "Thanks, Greg, and thanks for coming back for seconds. We appreciate it. So I think that we are seeing -- I would first challenge that we are seeing kind of continued pressures on the industry, both in terms of ongoing inflation as well as increased risk that they are experiencing, that seemingly is continuing to support premium growth as well as kind of natural expansion in coverage for the industry."
},
{
"speaker": "",
"content": "So at this point, based upon the financial reports and our engagement with clients, we have not seen early signs of that market. In fact, a lot of the reading that I have seen has been to a sustained hard market. But we do have to anticipate at some point that there may be some pressure from a margin standpoint."
},
{
"speaker": "",
"content": "And in that context, our products and services remain critical in achieving a higher level of operational efficiency within the business in order to maintain or improve that combined ratio as well as the efficiency of making good underwriting decisions."
},
{
"speaker": "",
"content": "And I would use this as an opportunity to say I think one of the most promising dimensions of generative AI is in gathering and predigesting a lot of the information flow that the insurance industry relies upon to evaluate policy submissions, evaluating adequacy, going into the risk, not replacing the human, but enabling them to focus their expertise on the underwriting decision, the risk and the return decision."
},
{
"speaker": "",
"content": "We think that, that is a secular trend. As technology improves, as datasets expand, that will continue to provide ample opportunity for us to deliver value to the industry. It's nice to have some premium growth because I think it puts people in a constructive frame of mind. But these issues and challenges that the industry face are going to exist, regardless of whether it's a hard market or a soft market. And I think that's our fundamental opportunity."
},
{
"speaker": "Operator",
"content": "Ladies and gentlemen, there are no further questions at this time. Thank you for your participation. This concludes today's call. You may now disconnect."
}
] |
vrsn | 2,024 | 4 | [
{
"speaker": "Operator",
"content": "Please standby. Good day, everyone. Welcome to VeriSign, Inc.'s Fourth Quarter and Full Year 2024 earnings call. Today's conference is being recorded. Recording of this call is not permitted unless preauthorized. At this time, I would like to turn the conference over to Mr. David Atchley, Vice President of Investor Relations and Corporate Treasurer. Please go ahead, sir."
},
{
"speaker": "David Atchley",
"content": "Thank you, operator. Welcome to VeriSign, Inc.'s fourth quarter and full year 2024 earnings call. Joining me are Jim Bidzos, Executive Chairman, President, and CEO, and George Kilguss, Executive Vice President and CFO. This call and presentation are being webcast from the Investor Relations website, which is available under About VeriSign on verisign.com. There, you will also find our earnings release. At the end of this call, the presentation will be available on that site, and within a few hours, the replay of the call will be posted. Financial results in our earnings release are unaudited, and our remarks include forward-looking statements that are subject to the risks and uncertainties that we discuss in detail in our documents filed with the SEC, specifically the most recent report on Form 10-K. VeriSign, Inc. does not update financial performance or guidance during the quarter unless it is done through a public disclosure."
},
{
"speaker": "David Atchley",
"content": "The financial results in today's call and the matters we will be discussing today include GAAP results and two non-GAAP measures used by VeriSign, Inc.: Adjusted EBITDA and free cash flow. GAAP to non-GAAP reconciliation information is appended to the slide presentation, which can be found on the Investor Relations section of our website, available after this call. Jim and George will provide some prepared remarks, and afterward, we will open the call for your questions. With that, I would like to turn the call over to Jim."
},
{
"speaker": "Jim Bidzos",
"content": "Thank you, David. Afternoon to everyone, and thank you for joining us. I am pleased with VeriSign, Inc.'s success in continuing to deliver on our mission during 2024. We extended our unparalleled record of uninterrupted .com and .net resolution to more than 27 years, in an increasingly evolving cyber threat environment while protecting, improving, and strengthening our network. VeriSign, Inc.'s network now processes, on average, more than 400 billion transactions daily. Our focus remains on providing the security, stability, and resiliency Internet users worldwide have come to depend on not only for .com and .net but for the DNS root zone as well. Financially, in 2024, we delivered 4.3% year-over-year revenue growth while increasing operating income by 5.7%. Shares outstanding at the end of 2024 decreased by 6.2% from the total of outstanding shares at the end of 2023. Our financial and liquidity position continues to remain stable with $600 million in cash, cash equivalents, and marketable securities at the end of the year. During 2024, we returned $1.2 billion of capital to shareholders through the repurchase of 6.6 million shares. At year-end, $1 billion remained available and authorized under the current share repurchase program, which has no expiration. At the end of December, the domain name base in .com and .net totaled 169 million domain names, a decrease of 2.1% or 3.7 million names year-over-year. During the fourth quarter, the domain name base decreased by 500,000 names. From a new registration perspective, we saw improvements sequentially and year-over-year, with fourth quarter new registrations of 9.5 million compared with 9 million names for the same quarter last year and 9.3 million during the third quarter of 2024. The renewal rate for the fourth quarter of 2024, which is expected to be approximately 73.9%, shows improvement both sequentially and year-over-year. From a geographic region perspective during Q4, and the full year 2024, we saw decreases in the domain name base from both our US and China-based registrars. The domain name base in EMEA was up both sequentially and for the full year 2024. In 2024, the decrease in China volumes was in line with our expectations at the start of the year. For 2025, we continue to expect our China registrar segment to decline, albeit at a slower pace. As that segment now represents only 5% of our domain name base, the decrease from China will have a smaller impact. As we have previously reported, we have seen US registrars, through higher retail pricing levels, reduce spend on marketing to new customers compared with prior years, and an increased focus on the secondary market for domain names. These factors impacted new registrations and renewal rates in 2024 for our US region. In response to these trends, we began working to reengage registrars on new customer acquisition by launching new marketing programs for .com and .net to support our goal of returning to domain name base growth. We stated last quarter, we have seen positive response to our new programs, and we expect many of the registrars to engage more fully in 2025. It is early in this process, but we are optimistic that our efforts will start to improve the DMV growth trend in 2025. Given these conditions and trends for 2025, we are expecting the year-over-year change in the base to be negative 2.3% to negative 0.3%. And now I would like to turn the call over to George. Return when George has completed his financial report with closing remarks."
},
{
"speaker": "George Kilguss",
"content": "Thanks, Jim, and good afternoon, everyone. For the year ended December 31, 2024, the company generated revenue of $1.557 billion, up 4.3%. Operating expenses totaled $499 million and were up 1.4% from the previous year, resulting in operating income of $1.058 billion, up 5.7% from 2023. For the fourth quarter ended December 31, 2024, the company generated revenue of $395 million, up 3.9% from the same quarter of 2023, and delivered operating income of $264 million, an increase of 2.9% from the same quarter a year ago. Operating expense in Q4 2024 totaled $132 million, which compares to $121 million during the third quarter and $124 million a year earlier. As we discussed on our last quarter's earnings call, we expected an increase in Q4 operating expenses due to prior quarter spending delays. Net income in the fourth quarter totaled $191 million compared to $265 million a year earlier, which produced diluted earnings per share of $2 for the fourth quarter of 2024 compared to $2.60 for the same quarter of 2023. As previously discussed, net income in the fourth quarter of last year included the recognition of $69.3 million of income tax benefits, which increased diluted earnings per share by $0.68 in the year-ago quarter. Operating cash flow for the fourth quarter of 2024 was $232 million, and free cash flow was $222 million compared with $204 million and $199 million, respectively, in the year-ago quarter. Operating cash flow and free cash flow for the full year of 2024 totaled $903 million and $875 million, respectively. I will now discuss our full year 2025 guidance. Revenue is expected to be between $1.615 billion and $1.635 billion. Operating income is expected to be between $1.095 billion and $1.115 billion. Interest expense and non-operating income net, which includes interest income estimates, is expected to be an expense of between $50 million and $60 million. Capital expenditures are expected to be between $30 million and $40 million. And the GAAP effective tax rate is expected to be between 21% and 24%. Overall, VeriSign, Inc. continued to demonstrate sound financial discipline during the fourth quarter and throughout 2024. Now I will return the call back to Jim for his closing remarks."
},
{
"speaker": "Jim Bidzos",
"content": "Thank you, George. In summary, VeriSign, Inc. successfully concluded the year by renewing the .com Registry Agreement with ICANN and the cooperative agreement with the NTIA. We extended our unparalleled 27-year track record of resolution availability for .com and .net, and we delivered sound financial and operational results. As we look to 2025 and beyond, we will continue to focus on and be driven by our mission. It relates to the domain name base growth rate. For 2025, we see three positive trends taking shape. First, the decrease from China-based registrars is expected to be more muted. Second, the marketing programs we rolled out in 2024 and continue to offer for 2025 are being adopted by our registrars. Finally, while it is early in the cyclical trend, we do expect registrars to start refocusing on customer acquisition and are starting to hear from some registrars an expectation for increased marketing efforts in 2025. Although we expect a slight decline in the domain name base in 2025, we do expect trends to improve from what we saw in 2024. Thank you for your attention today. This concludes our prepared remarks. And now we will open the call for your questions. Operator, we are ready for the first question."
},
{
"speaker": "Operator",
"content": "Thank you. If you would like to signal with questions, please press star one on your touch-tone telephone. If you are using a speakerphone, please make sure your mute function is turned off to allow your signal to reach our equipment. Please mute your line. Again, that is star one if you would like to signal with questions."
},
{
"speaker": "Operator",
"content": "And we will take a question from Rob Oliver with Baird."
},
{
"speaker": "Rob Oliver",
"content": "Great. Thank you. Good afternoon. I had a couple of questions. Jim, first for you. In your closing remarks there, you mentioned it was a big year for you guys last year with the ICANN renewal as well as the cooperative agreement at the NTIA. And certainly, the investor focus now is pivoted towards the domain base, and you finished with three points as to why you are more optimistic on that. I guess, from your perspective, maybe looking at the macro as well in addition to those three points, if you could give us some more color on the three, but also just around the macro. Generally, I know you mentioned that you suspected that some of the registrars might be pivoting more towards new domains, which would be very encouraging. What gives you that comfort? And then I had a couple of follow-ups."
},
{
"speaker": "Jim Bidzos",
"content": "Okay. Thanks, Rob. Well, as you know, today, we guided the domain name base continuing to decrease during this year, 2025. Although, the midpoint of our range suggests an improving trend from what we saw last year. We do see the trends that have a negative impact as cyclical in nature, and we do expect the domain name base to return to growth once we work through those trends. As I said earlier, China is lessening and now only represents 5% of our business. Also, our new marketing programs are being adopted. We are seeing positive impact from them. It is early. We expect more throughout the year. Finally, while it is early in a cyclical trend, we do expect registrars to start refocusing on customer acquisition and are starting to hear from registrars, like I said, an expectation for increased marketing efforts. In fact, I would point out that two registrars are running Super Bowl ads, which will reach around 200 million viewers. So as you look back, the two main trends we called out, China and ARPU, were impacting the DNA DNB. And both seem to be easing. And where we could influence through marketing programs, there are encouraging signs. And also renewal rates have improved. So that is the picture we see."
},
{
"speaker": "Rob Oliver",
"content": "And on those marketing programs, Jim, if you could just provide a little bit more color perhaps on if there are particular regions where you guys are seeing early traction? I know you have said it is still early and the results will not be immediate, we get that, or perhaps this is for George. But any particular areas where you are seeing early signs that the marketing programs are starting to take hold or conversely where you had to tweak them and feel comfortable that you now have the formula right? Any color there would be great."
},
{
"speaker": "Jim Bidzos",
"content": "Okay. I will invite George to comment. I will just say that, you know, it takes time to get these things integrated. There is adoption, integration, and there is actual performance. So it may be early to give you a clear picture of where we are, but we do see..."
},
{
"speaker": "George Kilguss",
"content": "Yeah. Sure, Rob. I mean, as we have mentioned, the focus of our new programs is really to offer more options for our registered community to help them engage in a variety of programs that really are more aligned with their particular go-to-market strategies. So again, looking for opportunities for a win-win. As we talked about in 2024, we spent a lot of time developing and piloting a lot of these programs. We have gotten feedback. We have also refined and recently relaunched these programs late in 2024 here. We actually had a few programs that we rolled out here early in January as well. Again, from a little color, when we talk to registrars, we have gotten a lot of positive feedback from registrars that our programs are aligning with strategies that they are employing, and they feel they can use these programs within their own marketing programs. So that is good news for us. You know, as far as early adoption, I would say it is a little early right now. Most registrars are just starting to roll out there. Even though we have had these programs launched late last year and we have gotten good feedback and we have modified some of them, they are really gearing up to roll them out here in 2025. Some registrars do engage a little earlier than others, but I think it is a little early for us to comment on that. But we are optimistic about the programs we have rolled out. We have gotten great feedback."
},
{
"speaker": "Rob Oliver",
"content": "Great. That is helpful. And then the last one for me, Jim, back to you. Just we have got a couple of leadership changes happening. One obvious one, we have a new administration in DC. So we would be curious to hear from you what, if anything, you might expect or how we should think about that relative to VeriSign, Inc.'s business and, you know, number one. Number two, are discussions with the NTIA ongoing? I know that the NTIA obviously dictated did not ultimately request any changes. But, you know, you guys had agreed to sit down with them, so I would be curious to hear whether those discussions are ongoing. And then we have a new head of ICANN that came in in December. Any thoughts there would be helpful. I realize that is a lot. Thank you guys very much."
},
{
"speaker": "Jim Bidzos",
"content": "Okay. Thanks, Rob. Well, first of all, I would just point out that where we are today, VeriSign, Inc., the cooperative agreement, ICANN, this whole process is a result of decades of very successful policy across many different administrations of many political stripes. So we tend to sort of see that as not directly impacting factor, just a long-supported consistent policy with security and stability as the main driver. And as you mentioned, there are new folks in December. Of course, we have a new CEO in ICANN, and we will be getting a new NTIA administrator shortly, we believe. And we look we have great relationships with both organizations, and we look forward to continuing them. We have always maintained a good working relationship with ICANN for many decades, and we look forward to working with the new CEO, Curtis Linfist, and his leadership team, particularly in the areas we engage in mostly, which is security and stability of the DNS and DNS abuse. About the second part of your question, ongoing discussions with the NTIA, that is typical for our relationship. We look forward to working with the new NTIA assistant secretary, a partner confirmation, I look forward to meeting her. I think until then, I will not speculate. But let me add some background that might be a little bit helpful there. First, the cooperative agreement has long contained, as I think most of the listeners here know, strict requirements that VeriSign, Inc. meet the most rigorous availability and performance specifications of any TLD due to the reliance services and infrastructure on .com and .net. In 2018, amendment 35 retained these provisions. And while there was reduced regulation, there was also explicit protection for registrant first amendment rights by guaranteeing that the .com registry will remain content neutral. These and the other policies in a 2018 amendment have proven in the last six years to be successful in continuing the policy of security and stability. And resilience first and the critical importance of .com to the security and stability of the infrastructure that is literally critical to the digital economy of the US. And finally, I will just mention that the recent .com renewals enabled us to clear up some misinformation that was spread during that process. One, for example, is that we received money from the government, which simply is not true. Our cooperative agreement is not a procurement contract, and the US government does not fund VeriSign, Inc. for the secure and reliable Internet service that VeriSign, Inc. helps to preserve every day and has without interruption for 27 years. And as I mentioned, now processing an average of over 400 billion transactions every day, by the way, is 40 times the number of daily average Google searches. 40x there was a lot of misinformation about our pricing as well. As you know, our pricing is capped and it is transparent. It is a simple fact that our limited pricing flexibility at the wholesale level has not kept up with global CPI over the last six years. While at the same time, we have seen the unregulated retail price increases exceed our wholesale price increases. So, hopefully, that bit is helpful. Look forward to engaging with our new regulators, and we look forward to..."
},
{
"speaker": "Rob Oliver",
"content": "Great. Okay. I am going to go back and need to read that transcript. Thank you guys very much. I appreciate that, Jeff. Thanks."
},
{
"speaker": "Jim Bidzos",
"content": "Sure."
},
{
"speaker": "Operator",
"content": "And we will take our last question from Ygal Aronian with Citi."
},
{
"speaker": "Ygal Aronian",
"content": "Hey. Good afternoon, guys. Let me start on just coming back to the comments on the cyclical trends, that you are expecting from the registrar is to kind of go back and be a little bit more focused on the broader top of the funnel customer acquisition. And it sounds like what you guys were trying to accomplish with the marketing programs, but it also sounds like you are talking about both of those points as two distinct things. Is that true? And if, you know, for moving back in that part of the cyclical part of the cycle or why are the marketing programs important? Does it kind of help amplify that move back up cycle?"
},
{
"speaker": "Jim Bidzos",
"content": "I think if I understood the question, it is if a cyclical turn is coming, why the programs? Is that a hope that is not an unfair summary."
},
{
"speaker": "Ygal Aronian",
"content": "Okay. I guess are they two distinct points? And if yes, then why the..."
},
{
"speaker": "Jim Bidzos",
"content": "Yeah. So, okay. I would say two things. That we brought up in the past. First of all, we pointed out that the programs were actually being designed as a response to the evolving nature and structure of our channel. We got a lot of website owners who have become registrars. They have different business models. There are more of them. Some are large, some are small. So designing programs that met their needs and gave them flexibility as opposed to and I will generalize a bit here, you know, the one size fits all that we kind of used in the past, that was a primary motivator. And when we talked about the cyclical trend from ARPU back to customer acquisition, I think I remember a quarter or two ago saying that we would focus on programs and that we hope to get a tailwind from a return acquisition. So I do not think those it is not sort of one or the other. We certainly can do both because they are really for different reasons. Some of the programs maybe can incentivize a shift away from ARPU, but I do not think that has the same effect as giving our registrars the choice that the diverse nature of that channel is going to require. George, do you have any comment?"
},
{
"speaker": "George Kilguss",
"content": "I would just say, Ygal, you know, look at we clearly have a good channel. We want the stronger we can make that channel, the better it is for us. And so we are trying to support that channel because they are evolving, they have different needs, and sometimes, some of our previous programs may not have fit the needs of all registrars. We are taking that feedback. We are helping them. We are also trying to help them target registrations, new registrations to high renewal rate cohorts. Which would be good for them and good for us. And so as Jim said, the channel continues to evolve. The market continues to evolve. And we believe we need to continue to do the same to support the channel."
},
{
"speaker": "Jim Bidzos",
"content": "I guess one last thing I might add here is that we said, I think George mentioned in his remarks that we are seeing take up in the channel. I think this is a result of offering more flexibility and choice in our programs. In the past, when we had a fairly straightforward simple program offered to all. We saw that it worked for some and did not work for some. And what the feedback we are getting is that these choices are great, and they are finding programs that work for them. That is the initial take up. We will see where it goes. Of course, we will work hard to support them, but, you know, that is something we can put some energy into and hopefully get a return. But I would say ARPU is a cyclical tailwind in a sense. There is less we can influence there. We can benefit from it. And we are seeing signs that that shift is occurring as well."
},
{
"speaker": "Ygal Aronian",
"content": "Okay. Very helpful. A quick follow-up on that. Is it just a shift in strategy, or are you spending more on the marketing programs that maybe just if you could talk about how that is embedded in the operating income guidance for the year."
},
{
"speaker": "George Kilguss",
"content": "Yeah. I would say, primarily, it is a shift in strategy. Having said that, a lot of our programs are success-based. So if they are extremely successful, we will spend more, but those should be accretive to us over time. But it really is a shift to strategy recognizing the changing channel and trying to support them in their different strategies."
},
{
"speaker": "Jim Bidzos",
"content": "And the expense of all those programs is baked into our guidance. I would just add."
},
{
"speaker": "Ygal Aronian",
"content": "Okay. Alright. Helpful. I have two more, if you do not mind. One is the gross new registrations number was, if my numbers are right, the largest one since Q2 2021. Or year on the year-over-year growth. Sorry. Can you talk about that? What you are seeing there? And that is a pretty impressive number in the quarter. I know the renewal rates are still a little bit below where they are normally. But if you look at the gross numbers, it looks like some of the cyclicality is already coming back here in Q4."
},
{
"speaker": "George Kilguss",
"content": "Yeah. As you point out, Ygal, we did 9.5 million new registrations, up sequentially and also up year-over-year. Again, I would credit some of the early successes to some of the programs we launched in the fourth quarter that supported that. So we saw good engagement from some people. Again, it is only a partial year. And we think, you know, once we get further into the year, we will get more channel partners engaging in these programs, but it is some early successes from those programs. So, you know, not huge numbers, but we are seeing positive trends. And as you saw, and as Jim mentioned, the contraction of the domain name base a half a million dollars. That is, you know, it was 1.1 million down in the third quarter and 1.2 million down in the year-ago fourth quarter. So we saw some improvement here, and that gives some optimism here as we move into 2025."
},
{
"speaker": "Ygal Aronian",
"content": "Yeah. Okay. Helpful. And then last maybe a little bit of a bigger picture question. Or auctions coming up for some new generic TLDs later this year. Just wanted to get your thoughts on that. You know, particularly with the way NGTLDs have taken share of total domains over the last decade since they have been introduced. Are you interested in bidding for new domains? Has your strategy changed in the kind of amount of domains you want to be a registry for, especially think about that. And sorry. And within that, maybe you could just give us an update on .web. That is also a new TLD. Thanks."
},
{
"speaker": "Jim Bidzos",
"content": "I am glad you mentioned .web because I was going to sort of include that in the answer. We did some years ago, obviously, move to acquire another TLD and expand our portfolio there. So first of all, let me answer them in reverse order. So with .web, we are still very interested in being the registry operator for .web. Although this process has taken quite a few years, we still want to be able to offer .web domains to our customers. The process is still with ICANN, and it is their IRP or roughly translates to arbitration process. And we understand what we have come to understand here recently is that there will be more briefings and hearings in 2025 with a planned final merits hearing currently slated for later 2025. And we think that they are continuing to drag this process out and to abuse ICANN's rules actually is the intention of the competing party. As far as the new round, we are considering looking at it. Tossing ideas around, looking at the potential for applications, but we have nothing to share at this point."
},
{
"speaker": "Rob Oliver",
"content": "Alright. For taking fifteen questions from two analysts."
},
{
"speaker": "Jim Bidzos",
"content": "Anytime."
},
{
"speaker": "Operator",
"content": "And that does conclude the question and answer session. I will now turn the conference back over to Mr. David Atchley for final comments."
},
{
"speaker": "David Atchley",
"content": "Thank you, operator. Please call the Investor Relations department with any follow-up questions from this call. Thank you for your participation. This concludes our call. A good evening."
},
{
"speaker": "Operator",
"content": "Thank you. That does conclude today's conference. We do thank you for your participation. Have an excellent day."
}
] |
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